Tax Exam 3
S Corporation Basis
Initial tax basis is any cash contributed plus the FMV of other property contributed •Carryover basis is used rather than FMV for property if contributed in a nontaxable transaction Similar to a partnership, an owner's tax basis in his/her S Corp stock is adjusted annually to reflect share of items and changes in investment.
Partnership Basis
Initial tax basis is any cash contributed plus the adjusted basis of property contributed •A partner who personally guarantees a partnership debt is effectively contributing cash A partner's tax basis in his/her partnership interest is adjusted annually to reflect share of partnership items and changes in investment.
Sole Proprietorship Special Rules
Interest, dividends, and rent income related to owner's investments and farm income are not reported on Schedule C. •Dispositions of business assets are reported on Form 4797 and Schedule D. •Only interest expense on business debt is deducted. - Nonbusiness interest expense may be deductible if allowed under special rules (i.e., interest paid for investments or on home mortgages).
Creates incentive to UNDERSTATE salary.
Owner's share of ordinary income is NOT subject to self-employment tax, even if they are an employee.
•Excess losses are carried forward indefinitely until additional basis is restored either by additional contributions or additional positive income. •Undistributed S Corp income first increase basis in loans up to their face value, the increases basis in S Corp stock. - Loan repayment is treated as amount realized in a sale
Owners cannot deduct losses in excess of their basis in the S Corp or loans to the S Corp.
Involuntary Conversion
Requirements to defer gain: •Reinvest proceeds in property similar or related in service or use to converted property •Replacement property must be purchased within two taxable years following the year of the conversion. If taxpayer does not reinvest entire proceeds, gain is recognized to the extent of the proceeds not invested. •Unreinvested amount is treated as boot.
Partner Self Employment Income
SE tax must be paid by a general partner on •Guaranteed payments and •Distributive share of ordinary business income from partnership Limited partners do not pay SE tax on their share of ordinary income. Unclear when LLC income is subject to SE tax
•The M-1 was used by all corporations until 2004 and can still be used by corporations with total assets less than $10 million. •In 2004, the IRS developed the M-3 for use by large corporations (assets > $10 million); it requires more detailed information than the M-1 and enhances the transparency of book/tax differences.
Schedules M-1 and M-3 reconcile book income to taxable income.
•Social Security tax = 12.4% of earnings up to $137,700; Medicare tax = 2.9% of earnings •50% of self-employment tax on Form 1040 as deduction for AGI •Tax base = 92.35% of net profit
Self-employed persons pay SE tax on net earnings from self-employment.
estimated tax payments rather than through withholding.
Self-employment tax is paid via...
Qualified Business Income Deduction Requirements
Service businesses generally do not qualify. Cannot exceed greater of: •50% of W-2 wages, or •25% of W-2 wages plus 2.5% of unadjusted basis of qualified property Cannot exceed 20% of taxable income without regard to (1) QBI deduction and (2) net capital gain Exemption from both W-2 wage limitation and exclusion of service businesses for taxpayers whose taxable income (before this deduction) does not exceed: •$326,600 (MFJ) or •$163,300 (all others)
Salary is subject to payroll taxes and reduces ordinary income of the S corporation.
Shareholders can be employees and paid a salary.
•Only individuals, estates, and some trusts may be shareholders—no nonresident aliens, other corporations, or partnerships. •The number of shareholders is limited to 100 - Family members may be counted as one shareholder. •The corporation may only have one class of outstanding common stock. The election is permanent unless shareholders owning a majority of the stock revoke the election. •S status is forfeited if made ineligible (IRS mulligan)
Shareholders must unanimously elect S status
Wash Sales
Special rule prohibits loss recognition but not gain recognition on a wash sale. •If a taxpayer sells a security at a loss but repurchases substantially the same security within 30 days of the sale (before or after), the loss is disallowed. •The basis in the repurchased security equals cost plus disallowed loss.
Corporations
taxpaying entities that are distinct from their owners •Income is reported on Form 1120 which resembles a financial income statement •General rules covered in chapters 6, 7, 8, and 9
Personal Holding Company Tax
•Applies to corporations whose income is principally dividends, interest, rents, and royalties. •Assesses tax on undistributed earnings at 20%.
Accumulated Earnings Tax
•Assesses tax on accumulated taxable income •Penalty is 20% of accumulated taxable income - Taxable income minus income tax, dividends paid and reasonable needs of business •Common traits that IRS looks for when investigating corporate tax shelters: - Little or no dividends paid - Abundance of liquid assets not reinvested in production capacity - Especially substantial loans to shareholders •"No questions asked" accumulation is exempt •Amount exempted is $250,000 ($150,000 for PHC)
Dividends received deduction (DRD)
•Corporations receiving dividends from other taxable domestic corporations are entitled to this deduction. •Intended to help alleviate "triple" taxation <20% = 50% DRD 20-80% = 65% DRD >80% = 100% DRD
Owner liability protection (P vs SC)
•Historically, S Corps have provided owners greater levels of protection from business liabilities •This difference has greatly diminished with the advent of LLP's and LLC's
Income Shifting - Limits
•Income of all S corporations is allocated according to the proportionate shares of stock held by each shareholder. •Income of family partnerships is allocated according to proportionate interests in partnership capital. •Family members cannot be partners in a personal service business unless they are personally qualified to perform the services. •Family members can be a partner in a business in which property is a material in producing income. - Family members providing services must first receive guaranteed payments that constitute reasonable compensation before net income is allocated.
Unlimited life
•Legal existence not affected by changes in ownership
Partnership Formations
•No gain or loss is recognized by the partner or the partnership on the exchange of property for an interest in the partnership. - No control requirement •Partner's basis in the interest equals the partner's basis in the transferred property (substituted basis). •Partnership's basis in the transferred property equals its basis in the hands of the partner (carryover basis).
Limited liability of shareholders
•Owners of closely held corporations often are required to personally guarantee repayment of debt. •Licensed professionals must still carry malpractice insurance.
Complexity (P vs SC)
•Partnership code sections are more out of date and are generally considered to be more complex and difficulty to apply than S Corp code sections •Provides some benefits (e.g., rules allowing partners to increase basis by partnership debts)
Flexibility (P vs SC)
•Partnerships offer greater flexibility in how profits and losses are distributed to owners, but require more care in drafting the partnership agreement •S Corp shares are more easily transferred
Effect of Boot on the Payer
•Paying boot does not trigger gain recognition. •Basis of qualifying property received equals: - Basis of qualifying property surrendered + FMV of boot paid - Alternatively: FMV of qualifying property received − Deferred gain/+ Deferred loss
Cost of formation and operations (P vs SC)
•Potential gain on transfer of property to an S Corp •Entity level income or franchise tax on S Corps •Timely S election, and ownership monitoring
Free transferability of interests
•Through regulated markets with maximum convenience and minimal transaction cost •For closely held corporations, a buy-sell agreement may prevent transferability.
•Exchange of one qualifying property for another •Equal FMVs of properties exchanged (value-for-value presumption, arms length transaction) •Realized gain or loss is not immediately recognized, but built into the substituted basis
Common characteristics nontaxable exchanges:
•Limited liability of shareholders •Unlimited life •Free transferability of interests •Centralized management
Corporate Legal Characteristics
21%
Corporate income is taxed at a flat rate of
•Charitable contributions deduction limitation •Dividends received deduction (DRD)
Corporate taxpayer special rules
Tax Credits
Credits directly reduce computed tax. •$1 of credit provides $1 of benefit. - $1 of deduction provides ($1 × rate) of benefit. Tax credits are generally limited to some percent of tax before credits. •Often, a provision permits carryback or carryforward of excess credits. Biggest credits: R&D credit, foreign tax credit
Charitable contributions deduction limitation
Deductions for charitable contributions are limited at no more than 10% of taxable income BEFORE: •Charitable contributions •Dividends received deduction •NOL carryback Excess contributions can be carried forward for five years.
Substituted Basis
Deferred gain or loss is embedded in the tax basis of the qualifying property received. •Nonrecognized gain or loss is deferred until the qualifying property received is disposed of in a taxable transaction. If no boot is involved, the tax basis equals: •Basis of property surrendered •Alternatively: FMV of property received − Deferred gain/+ Deferred loss
•Applies only to exchanges of business or investment realty •Major change to definition by Tax Cuts and Jobs Act of 2017 - Depreciable personalty, intangible assets, inventory, stocks, bonds, partnership interests, and personal assets are not eligible for like-kind exchange treatment.
Definition of like-kind property:
Schedule E, as part of Form 1040.
Each partner reports his or her share of partnership income on...
Employment Taxes
Employer portion: •FICA = 6.2% Social Security tax on wages up to $137,700 (2020) + 1.45% Medicare tax on all wages Employee portion: •FICA = 6.2% Social Security tax on wages up to $137,700 (2020) + 1.45% Medicare tax on all wages
the withheld taxes to the federal (and state, if applicable) governments.
Employers must remit...
income taxes and the employee's share of FICA taxes.
Employers withhold...
Tax Payments
Estimated payments are due on the 15th day of the 4th, 6th, 9th, and 12th months. •Must pay 100% of tax due •Small corporations (TI < $1 million) may use safe harbor rule of paying 100% of prior year tax. Underpayment penalty is computed like interest expense but is nondeductible.
Partnerships
Formed by a partnership agreement which states the rights/obligations of partners and the percent of profits and losses allocable to each partner. Such agreements permit flexibility.
•Like-kind exchanges •Involuntary conversions •Exchanges of property for equity in a corporation or partnership •Wash sales
Four categories of nontaxable exchanges:
All partners have unlimited liability—joint and severable.
General partnership:
Qualified Business Income Deduction
Deduction equals 20% of qualified business income earned by an individual through a sole proprietorship, partnership, or S corporation.
the taxpayer may elect to defer gain recognition.
If insurance proceeds exceed basis of converted property...
Parent corporation that directly owns at least 80% of at least one domestic subsidiary + All other domestic subsidiaries that are 80% owned within the group
Affiliated groups =
applies to all members of affiliated group. •Advantage: Losses and profits of affiliated members offset each other.
Affiliated groups may elect to file a consolidated tax return—
One or more limited partners are only liable for their contributed capital. All limited partnerships have at least one general partner.
Limited partnership:
Tax Return Due Dates
15th day of 4th month following the end of the tax year (15th day of the 3rd month for June 30 tax years). •May extend to 15th day of 10th month - Extension is 6 months for most taxpayers - Extension is 7 months for June 30 year end taxpayers - Extension does not extend the payment deadline.
Home office deduction (sole prop.)
A portion of the costs for a taxpayer's residence may be allowable as a Schedule C deduction if the office is used exclusively and regularly as: •The principal place of business operated by the homeowner OR •A place to meet with patients, clients, or customers A home office used exclusively for administrative or management activities qualifies if the taxpayer has no other fixed location where such activities are conducted. If the home office qualifies, expenses must be allocated between business and personal use •Qualifying expenses include items such as utilities, home mortgage interest and taxes, insurance, repairs, depreciation, etc. Home office deduction cannot exceed taxable income of the business before the deduction
Basis of qualified property acquired
Basis of qualified property surrendered + Gain recognized - FMV of boot received + FMV of boot paid OR FMV of qualified property acquired - Deferred gains + Deferred losses =
•$250,000 MFJ ($125,000 MFS) •$200,000 single and head of household
Beginning in 2013, 0.9% additional Medicare tax on wages above a threshold amount
Sole Proprietorship
Business income and expenses are reported on Schedule C, filed with the individual Form 1040. •Net income or loss on Schedule C is ordinary income or loss; combine this net amount with other items of gross income on page 1 of Form 1040. •If the Schedule C business loss is greater than other sources of income, the net operating loss (NOL) can be carried forward indefinitely.
Effect of Boot
Debt relief is treated as boot received by the party relieved of debt and boot paid by the party assuming debt. •If both parties to the exchange are relieved of debt, only the net amount is treated as boot.
Constructive Dividends
IRS challenge turns "unreasonable" payments into constructive dividends. •Reasonableness relative to other similar situations Thin Capitalization •The IRS may contend that some or all the interest payments are nondeductible dividends - Principal and interest payments are taxable dividends to the shareholder/creditor •Rule of thumb: A debt-to-equity ratio greater than 3 to 1 may appear "unreasonable."
the taxpayer recognizes ordinary loss
If basis of converted property exceeds insurance proceeds...
Passthrough Income Shifting
Individual owners/partners have different tax rates •Income shifting is the result of shifting property ownership—can't assign income. •If children or other relatives are made partners or co-shareholders, they own part of the business and are entitled to their share of any cash distributions from the business. The transfer of ownership may have gift tax consequences if relatives don't pay FMV.
Nonprofit Corporations
Includes corporations formed exclusively for religious, charitable, scientific, literary, educational purposes, etc. •Section 501(c)(3) organizations require IRS recognition of tax-exempt status. •Tax-exempt organizations may pay tax on "unrelated business taxable income."
Used for professional services. General partners are not liable for malpractice of other partners but are personally liable for other debts of the LLP.
Limited liability partnership:
•Theft or vandalism •Government claim of property or condemnation •Natural disasters such as fire, hurricane, tornado, earthquake, and flood
Involuntary conversion includes:
•Excess loss limitation •Business interest deduction limitation •NOL deduction limitation •Rules for disposition of the assets and nontaxable transactions
Keep in mind many provisions we have previously discussed also apply to individuals with income from pass through entities
S Corporations
Legally a corporation under state law, an S corporation is a flow-through entity for tax purposes. •Income and loss items are allocated among shareholders based on their % ownership of stock; this allocation is not flexible like partnership agreements. •Flow-through items retain their character (e.g., ordinary income, capital losses, charitable contributions, etc.). •Distributions to S corporation shareholders are generally treated as nontaxable recoveries of investment. - Not treated as dividends (C corporation treatment)
•An alternative to a general/limited partnership. All members have limited liability for LLC's debt. •Treated as a corporation for liability purposes, but as a partnership for federal tax purposes.
Limited liability company:
Corporate Formations
No gain or loss is recognized by a taxpayer who transfers property to a corporation solely in exchange for stock if the transferor is in control of the corporation immediately after the exchange. •Control is defined as ownership of 80% or more of the corporation's outstanding stock. •If two or more taxpayers transfer property in the same transaction, control is determined in the aggregate.
Like-kind Exchanges
No gain or loss is recognized on the exchange of like-kind properties. •Receipt of boot triggers gain recognition. Nonrecognition is mandatory, not elective. •Taxpayers usually prefer to sell loss properties in order to recognize their realized loss.
defer tax recognition of a gain or loss, so the tax law is neutral. •Does not distort taxpayer behavior.
Nontaxable exchanges...
•Excess losses are carried forward indefinitely until additional basis is restored either by additional contributions or additional positive income. This rule separately applies to each partnership in which an individual is involved.
Partners cannot deduct losses in excess of their basis in the partnership.
Single Layer of Taxation
Partnerships (and LLCs) and S corporations are not taxed as entities; investors pay tax on their share of entity income. •This treatment results in a single level of taxation. Cash distributions are generally not taxable. •The cash represents a return of investment and does not affect the income or loss reported by the owner.
Self employment taxes (P vs SC)
Partnerships will generally pay more in self employment taxes than S Corps (see chapter 11)
Passthrough Losses
Passthrough losses are generally deductible in the year the loss is generated, producing an immediate tax benefit at the individual's marginal tax rate. •Can offset the owner's other sources of ordinary income For corporations, loss must be carried forward and can only be used to offset the corporation's income in a taxable year where profits are reported. •NOL deduction is limited to 80% of taxable income. •NOL deduction at the corporation's tax.
15-39%
Prior to 2018, rates ranged from
•Deductible portion of self employment taxes •Deduction for self employed health insurance •Deduction for contributions to qualifying retirement plans (if based on trade or business income)
QBI is reduced by:
Effect of Boot on the Receiver
Realized gain is recognized up to the FMV of boot. •Boot cannot increase the amount of realized gain. •Receiving boot does not cause loss recognition. Basis in qualifying property received equals: •Basis of property surrendered + Gain recognized − FMV boot received •Alternatively: FMV of qualifying property received − Deferred gain/+ Deferred loss Basis in boot equals FMV.
C Corporation Benefits
Tax rates on the earnings of corporations have typically been lower than for individuals •Biggest challenge - double taxation on distributions - Some relief - lower tax rates on dividend and capital gains Investors in a closely held corporation may assume an additional role in the corporation such as creditor, employee, or landlord •Also gives rise to some deductible expense for the corporation (e.g., interest, salary, rent, etc.)
C corporation is taxed first, then shareholders may be taxed on distributions, resulting in double taxation.
Taxpayer = Corporation
•Sole proprietorships •Partnerships •LLCs and LLPs •S corporations
Taxpayer = Owner(s) of flow-through entities
Income Shifting - Other Factors
The creation of a passthrough entity results in the dilution of parents' wealth and control of the business. •Transfers must be complete, binding, and irrevocable. •Buy-sell agreements can prevent family members from selling their equity interests to an unrelated third party. To retain control, the entrepreneur should consider: •A limited partnership with the entrepreneur as sole general partner, or •An S corporation with voting and nonvoting stock.
Like partnerships, S Corps must also issue Form K-1 to owners to who each owner's distributive share of income and separately reported items
The S Corp files Form 1120S (information return)
the basis of the transferred property (substituted basis).
The basis of the stock received in the exchange equals... (Corporate Formations)
its basis in the hands of the transferor (carryover basis). •A corporation never recognizes gain or loss on the exchange of its stock for property.
The basis of the transferred property to the corporation equals... (Corporate Formations)
Form 1065 (information return) •Included with Form 1065 is Form K-1, which shows each partner's "distributive share" of income and deductions. •"Non-ordinary" items are separately stated and retain their character on the partner's return. - Examples: Municipal bond interest, capital gains and losses
The partnership files
•Distributions to the partner •Losses and deductions (and shares of nondeductible expenses)
These items decrease basis: (Partnership)
•Distributions to the owner •Losses and deductions (and shares of nondeductible expenses)
These items decrease basis: (S Corp)
•Contributions (cash and adjusted basis of property) •Positive income (taxable and tax-exempt) •Share of partnership liabilities for which a partner could be held liable (all general partnership debts)
These items increase basis: (Partnership)
•Contributions (cash and FMV or adjusted basis of property) •Positive income (taxable and tax-exempt)
These items increase basis: (S Corp)
Boot
any nonqualifying property in the exchange including cash and relief of debt.
1.Single layer of taxation 2.Immediate passthrough of losses 3.Availability to shift income among taxpayers
Three major benefits to using a passthrough:
Guaranteed Payments
a special allocation of ordinary income to the partner receiving it •Like a salary, except no FICA or income tax withheld. •A deduction is allowed for the guaranteed payment. The receiving partner reports their guaranteed payment and their share of partnership income after the guaranteed payment as ordinary income •Other partners report their shares of partnership income after the guaranteed payment.
