Business Income Taxes - Chapter 12 - Entities Overview

Tax classification of legal entities

- Corporations are C corporations unless they make a valid S election. - Unincorporated entities are taxed as partnerships if they have more than one owner. - Unincorporated entities are taxed as sole proprietorships if held by a single individual or as disregarded entities if held by a single entity. - Unincorporated entities may elect to be treated as C corporations. They then may make an S election if eligible.

Legal classification and nontax characteristics of entities

- State law generally classifies entities as either corporations, limited liability companies, general partnerships, limited partnerships, or sole proprietorships. - Corporations and limited liability companies shield all their owners against the entity's liabilities. - Corporations are less flexible than other entities but are generally better suited to going public.

Although there are other types of legal entities, there are really only four categories of business entities recognized by the U.S. tax system, as follows:

1. C corporation (separate taxpaying entity; income reported on Form 1120). 2. S corporation (flow-through entity; income reported on Form 1120S). 3. Partnership (flow-through entity; income reported on Form 1065). 4. Sole proprietorship (flow-through entity; income reported on Form 1040, Schedule C).

Sole Proprietorship

A business entity owned by one person that is not legally separate from the individual owner of the business. The income of a sole proprietorship is taxed and paid directly by the owner sole proprietorships are not treated as legal entities separate from their individual owners. As a result, sole proprietors are not required to formally organize their businesses with the state, and they hold title to business assets in their own names rather than in the name of their businesses.

S Corporation

A corporation under state law that has elected to be taxed under the rules provided in Subchapter S or the Internal Revenue Code. Under Subchapter S, an S corporation is taxed as a flow-through entity.

Certificate of Limited Partnership

A document limited partnerships must file with the state to be formally recognized by the state. The document is similar to articles of incorporation or articles of organization.

Articles of Organization

A document, filed by a limited liability company's founders with certain states, describing the purpose, place of business, and other details of the company (depends on the state - either CoO or AoO)

Certificate of Organization

A document, filed by a limited liability company's founders with certain states, describing the purpose, place of business, and other details of the company (depends on the state - either CoO or AoO)

Single Member LLC

A limited liability company with only one member. Single member LLCs with single owners are taxed as sole proprietorships and as disregarded entities otherwise.

Limited Partnership (LP)

A partnership with at least one general partner with unlimited liability for the entity's debts and at least one limited partner with liability limited to the limited partner's investment in the partnership limited partnerships are usually organized by written agreement and typically must file a certificate of limited partnership to be recognized by the state.

General Partnership (GP)

A partnership with partners who all have unlimited liability with respect to the liabilities of the entity General partnerships may be formed by written agreement among the partners, called a partnership agreement, or they may be formed informally without a written agreement when two or more owners join together in an activity to generate profits. Although general partners are not required to file partnership agreements with the state, general partnerships are still considered to be legal entities separate from their owners under state laws.

Limited Liability Company (LLC)

A type of flow through entity for federal income tax purposes. By state law, the owners of the LL have limited liability with respect to the entity's debts or liabilities. LLCs are generally taxed as partnerships for federal income tax purposes State laws also recognize limited liability companies (LLCs) as legal entities separate from their owners (members). Business owners create limited liability companies by filing either a certificate of organization or articles of organization with the state in which they are organizing the business (depending on the state).

How do we determine whether a particular business entity is treated as a separate taxpaying entity or as a flow-through entity for tax purposes?

According to Treasury Regulations, commonly referred to as the "check-the-box" regulations, entities that are legal corporations under state law are, by default, treated as C corporations for tax purposes. These corporations and their shareholders are subject to tax provisions in Subchapter C (and not Subchapter S) of the Internal Revenue Code. C corporations report their taxable income to the IRS on Form 1120. However, shareholders of legal corporations may qualify to make a special tax election known as an "S" election, thus permitting the corporation to be taxed as a flow-through entity called an S corporation. S corporations and their shareholders are subject to tax provisions in Subchapter S of the Internal Revenue Code. S corporations report the results of their operations to the IRS on Form 1120S. Also under the check-the-box regulations, unincorporated entities are, by default, treated as flow-through entities. However, owners of an unincorporated entity can still elect to have their business taxed as a C corporation instead of as the default flow-through entity. In fact, the owner(s) of an unincorporated entity could elect to have the business taxed as a C corporation and then make a second election to have the "C corporation" taxed as an S corporation (provided that it meets the S corporation eligibility requirements). Before making such elections, however, the business owner(s) would need to be convinced that the move makes sense from a tax perspective. The nontax considerations do not change because these elections do not affect the legal classification of the entity. Finally, unincorporated flow-through entities (all flow-through entities except S corporations) are treated for tax purposes as either partnerships, sole proprietorships, or disregarded entities (considered to be the same entity as the owner). Unincorporated entities (including LLCs) with more than one owner are treated as partnerships. Partnerships report their operating results to the IRS on Form 1065. Unincorporated entities (including LLCs) with only one individual owner such as sole proprietorships and single-member LLCs are treated as sole proprietorships. Income from businesses taxed as sole proprietorships is reported on Schedule C of Form 1040. Similarly, unincorporated entities with only one corporate owner, typically a single-member LLC, are disregarded for tax purposes. Thus, income and losses from this single, corporate-member LLC is reported as if it had originated from a division of the corporation and is reported directly on the single-member corporation's return.

Partnership agreement

An agreement among the partners in a partnership stipulating the partner's rights and responsibilities in the partnership

Specified trade or business

Any trade or business involving the performance of services in the fields of health, law, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities partnership interests, or commodities. Architecture and engineering services are specifically excluded from the definition of specified service trade or business.

Corporation

Business entity recognized as a separate entity from its owners under law Business owners legally form corporations by filing articles of incorporation with the state in which they organize the business

Business Entities

Classified as a: - corporation - limited liability corporation (LLC) - general partnership (GP) - limited partnership (LP) - sole proprietorship

Self-employment tax and the additional Medicare tax

Self-employment income is subject to self-employment tax and the additional Medicare tax. Whether a flow-through entity's business income is considered to be self-employment income to an owner depends on the type of entity and the owner's involvement in the entity's business activities. An S corporation's business income allocated to a shareholder is not self-employment income to the shareholder. In contrast, a sole proprietorship's income is self-employment income to the sole proprietor. The determination isn't as clear for the business income allocated to owners of entities taxed as a partnership. For these entities, whether business income is self-employment income to an owner depends on the owner's involvement in the entity's business activities. When an owner's allocation of business income is determined to be self-employment income, the owner must pay self-employment tax and potentially the additional Medicare tax on the income. Both the self-employment tax and additional Medicare tax are based on the taxpayer's net earnings from self-employment. Net earnings from self-employment is 92.35 percent of a taxpayer's self-employment income. For 2018, the self-employment tax is 15.3 percent of the first $128,400 (reduced by compensation received as an employee) of net earnings from self-employment plus 2.9 percent of net earnings from self-employment above $128,400 (reduced by compensation received as an employee). Taxpayers can deduct 50 percent of the self-employment taxes they pay as a for AGI deduction. The additional Medicare tax is .9 percent of the earned income (employee compensation plus net earnings from self-employment) in excess of a threshold amount. The threshold amount is $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 for all other taxpayers. Taxpayers are not allowed to deduct any of the additional Medicare tax they pay.

Intitial Public Offering (IPO)

The first sale of stock by a company to the public

Qualified Business Income (QBI)

The net amount of qualified items of income, gain, deduction, and loss with respect to the taxpayer's qualified trade or business conducted within the US. Qualified items do not include specified investment-related income, deductions, or loss (ie: capital gains or losses, dividends, interest income not allocable to a trade or business, etc)

Taxation of flow-through entity business income

The tax that flow-through entity owners pay on the entity's business income depends in large part on the owner's marginal income tax rate. For 2017, the maximum marginal tax rate was 39.6 percent. For 2018, the top rate declined to 37 percent. Nevertheless, flow-through entity owners' tax burden on the flow through income also depends on whether the income is eligible for the qualified business income deduction, whether it is subject to the net investment income tax, and whether it is subject to self-employment tax and the additional Medicare tax. Below, we discuss the deduction for qualified business income, the net investment income tax, the self-employment tax, the additional Medicare tax, and the overall tax rate on flow-through entity income (assuming the owners are individuals).

Deduction for qualified business income

This deduction applies to individuals with qualified business income (QBI) from flow-through entities, including partnerships, S corporations, or sole proprietorships. That is, this is a deduction for individuals not for business entities. In general, a taxpayer can deduct 20 percent of the amount of qualified business income allocated to them from the entity, subject to certain limitations. Qualified business income is the net business income from a qualified trade or business conducted in the United States. To qualify, the business income must be from a business other than a specified service trade or business. In general, a specified service trade or business includes all service businesses other than architecture and engineering. Business income does not include income earned as an employee or investment type income such as capital gains, dividends, and investment interest income. The deduction is a from AGI deduction but is not an itemized deduction. Therefore, individuals can claim the deduction even though they claim the standard deduction instead of itemized deductions

Disregarded Entities

Unincorporated entities with one owner that are treated as flow-through entities for U.S. income tax purposes. Considered to be the same entity as the owner

Net investment income tax

When an owner of an entity taxed as a partnership or a shareholder of an S corporation does not work for the entity (that is, the owner is a passive owner or investor in the entity), the business income allocated to the taxpayer is considered to be "passive" income. Because passive income is considered to be investment income for purposes of the net investment income tax, passive owners of flow-through entities may be required to pay net investment income tax on income allocated to them from the business. The net investment income tax rate is 3.8 percent and it applies only when a taxpayer's (modified) AGI exceeds certain thresholds. The threshold amount is $250,000 for married taxpayers filing jointly and surviving spouses, $125,000 for married taxpayers filing separately, and $200,000 for all other taxpayers.

Responsibility for liabilities

Whether the entity or the owner(s) is ultimately responsible for paying the liabilities of the business depends on the type of entity. Under state law, a corporation is solely responsible for its liabilities. Similarly, LLCs and not their members are responsible for the liabilities of the business. For entities formed as partnerships, all general partners are ultimately responsible for the liabilities of the partnership. In contrast, limited partners are not responsible for the partnership's liabilities. However, limited partners are not allowed to actively participate in the activities of the business. Finally, if a business is conducted as a sole proprietorship, the individual owner is responsible for the liabilities of the business. However, individual business owners may organize their businesses as single-member LLCs. In exchange for observing the formalities of organizing as an LLC, they receive the liability protection afforded LLC members

C Corporation

a corporate taxpaying entity with income subject to taxation. Such a corporation is termed a "C" corporation because the corporation and its shareholders are subject to the provisions of Subchapter C of the Internal Revenue Code.

Articles of Incorporation

a document, filed by a corporation's founders with the state, describing the purpose, place of business, and other details of the corporation

Flow-through entities

legal entities like partnerships, limited liability companies, and S corporations that do not pay income tax. Income and losses from flow-through entities are allocated to their owners.

Business entities can be classified as either:

separate taxpaying entities or flow-through entities Separate taxpaying entities pay tax on their own income Flow-through entities generally don't pay taxes because income from these entities flows through to their business owners, who are responsible for paying tax on the income.