Chapter 16
How does an LLC file taxes with two members?
An LLC with two or more members can elect to be taxed for federal income tax purposes as a partnership (Form 1065 with Schedule K-1s), an S corporation (Form 1120S with Schedule K-1s), or a C corporation (Form 1120 with W-2 income to the owners). The LLC is not taxed at the entity level if it is taxed as a partnership. As a pass-through entity, an LLC's income is taxed to members at their personal rates. LLC losses are deductible on personal income tax returns to the extent of basis and may be limited by the passive activity rules. A unique characteristic of LLCs is that no gain or loss is recognized upon the distribution of appreciated property from an LLC to an LLC member. Gain will only be recognized to the extent that cash received exceeds the members adjusted basis.
What are S Corporations?
An S corporation is normally created under state law by first forming a C corporation and then filing an "S" election with the IRS. Issue stock.
What is a rental real estate enterprise?
An interest in real property held for the production of rents. A rental real estate enterprise may consist of an interest in multiple properties, although residential and commercial real estate may not be part of the same enterprise. The individual or relevant pass-through entity relying on the safe harbor must hold the interest directly or through a disregarded entity. If the taxpayer used the property as a vacation home, however, the safe harbor will not be available.
How do corporations file taxes?
C corporations must file Form 1120. The owner/employees of both C corporations and S corporations are treated as employees for payroll tax purposes. Therefore, the entity withholds 7.65 percent of the employee's pay for Social Security taxes and matches such withholding for Social Security taxes. The owner/ employee's compensation is not considered to be self-employment income.
Explain how basis formed in a general partnership?
If the partners contribute assets which are subject to liabilities to the partnership, the transfer is still tax-deferred. A partner's basis in his or her partnership interest is equal to the basis the partner had in the property contributed, less the share of the liability assumed by new partners. Example: Sophia contributes a building with a $120,000 value and a basis of $80,000, subject to a mortgage of $40,000, to an equal partnership with JoJo. Sophia will not recognize gain on the transaction, and her basis in the partnership interest is the $80,000 basis from the building less the $20,000 (half) of the mortgage assumed by JoJo.
Explain the process of gifting in a FLP?
It is not uncommon for the discount of such interests to range between 20 and 40 percent for the purpose of calculating gift taxes payable by the transferor. The original transferor (grantor) then begins an annual gifting program utilizing the discounts, the gift tax annual exclusions, and gift-splitting (where applicable) to transfer limited partnership interests to younger generation family members at reduced transfer costs
What is the major disadvantage for a sole proprietorship?
Legal liability. Personally legal for the debts and torts of his business.
What is the principal disadvantage and advantage for a LLP?
Liability. However, general partners of an LLP can insulate themselves from liabilities arising from the acts of other partners. General partners of an LLP will not be personally liable for the debts and obligations arising from errors, omissions, negligence, incompetence, or acts committed by another partner or representative of the partnership who is not under the supervision or direction of the first partner.
What is a limited liability company?
Limited Liability Companies are separate legal entities formed by one or more individuals by meeting state statutory requirements necessary for the formation of an LLC.
What are limited partnerships?
Limited partnerships are associations of two or more persons as co-owners to carry on a business for profit except that one or more of the partners have limited participation in the management of the venture and thus limited risk exposure. At least one general partner. A limited partner's assets cannot be seized to satisfy obligations.
What is the liability associated with a corporation?
Limited to invested capital.
How are corporations managed?
Managed by one or more officers appointed by the board of directors. The board of directors is the governing body of a corporation.
What is the "Checking the Box" choice for LLPs?
May file as a corporation or as a partnership. Choosing to be taxed as a C corporation allows owners to take advantage of tax-free fringe benefits which may be provided by C corporations. Operating as a partnership has the disadvantages of subjecting income to employment taxes and limited fringe benefits for owners.
Is it easy to dispose of limited partner interest in a LP?
No, because limited liability partners are not allowed a say in the actual management activities.
Are FLPs subject to income or gift tax consequences?
No, because the entity created is owned by the same person.
Partnership dissolution is either voluntary or judicial. Explain.
Partners usually vote for voluntary dissolution and, if affirmed, pay creditors and then distribute remaining assets to partners in accordance with either the partnership agreement or in proportion to their individual partnership interests. Judicial dissolution may be necessary when the partners cannot agree on how to conduct the business or whether to dissolve the entity.
What are general partnerships?
Partnerships are joint business ventures among two or more persons or entities to conduct a business as co-owners under their names or under a trade or fictitious name.
How are S corporations taxed?
Passed through to shareholders. Prevents double taxation. The owner/employees of S corporations are employees for payroll tax purposes. Therefore, the entity withholds 7.65 percent of the employees' pay for Social Security taxes and matches such withholding for Social Security taxes. The owner/employee compensation is not considered self-employment income. Additional distributions to shareholders beyond reasonable compensation are treated as dividends not subject to payroll tax.
What does piercing the veil mean?
Piercing the veil means disregarding the legal status of the entity that gives the owners limited liability. Secondary source of protection is liability insurance, which could be sufficient in amounts to provide risk coverage, to cover the claims of creditors.
Explain the disposal of interest in an LLP?
Same for general partnership.
How do corporations dispose of interest?
Shares of stock.
Why is income produced by a self-employed person denoted as earned income?
Since self-employed individuals do not have W-2s, the IRC uses the term "earned income" to denote the amount of compensation that is earned by the self-employed individual.
What are sole proprietorships?
Sole proprietorships are business ventures owned and operated by a single individual. A sole proprietorship arises when an individual engages in a business for profit. A sole proprietorship can operate under the name of the owner or it can conduct business under a trade or fictitious name such as "The Corner Pocket."
Where is the opportunity for a high income earner to lower their tax bill?
Taxpayers in the higher marginal income tax brackets may want to incorporate a profitable business as a C corporation to take advantage of the lower tax rate of 21 percent on corporate taxable income. Tax savings can be retained and reinvested in the company for growth. When a C corporation retains earnings, however, those earnings are taxed only to the entity, relieving the owners of paying tax on that retained income.
How should a FLP avoid contestation by the IRS?
The FLP should possess economic substance by having its own checking accounts, tax identification number, payroll (including payment of reasonable compensation to the general partner if he is managing the business), and should not allow family members to withdraw funds at will, nor should the FLP pay for personal expenses of its owners.
What is an Operating Agreement?
The agreement specifies how and who will manage the LLC, how interests may be transferred, etc. Note that an LLC is not legally required to have an operating agreement. If not, governed by state laws.
What is the limitation on contributions to retirement accounts made by an employer?
The deduction for contributions to a defined contribution plan cannot exceed 25 percent of the compensation paid or accrued during the year to eligible employees participating in the plan.
How does the FLP help with liability?
The use of the FLP structure can also help protect family assets. By placing the assets in the FLP and only making gifts of limited partnership interests to heirs, judgments or liens entered against a donee (limited partner) will not jeopardize the assets of the partnership.
Explain the capital structure of an LLC?
There is no limitation on the number of members or the types of members in an LLC. Members may include foreign (nonresident aliens) individuals, estates, trusts, corporations, etc. LLCs may allocate items of income and gains in any manner agreed to by the members in the operating agreement and can also create different classes of ownership interests which have different rights.
How does an S Corporations raise capital?
They have limited liability protection, but have a limited number of allowable shareholders. Allow close family members to be treated as a single shareholder. Limited to 100 shareholders. Only class of stock.
What are C Corporations?
chartered legal entities formed by one or more individuals by meeting state statutory requirements necessary for the formation of a corporation.
Are LLC partners liable?
individual owners are protected from personal liability for the LLC's debts and obligations unless they personally guarantee such obligations.
How should a partner avoid piercing the veil?
the entity should keep its books and records separate from the personal books and records of the owners, segregate activities of business from personal affairs, follow corporate formalities such as meeting requirements and filings, and address all content in contracts and correspondence from the view point of the business entity.
How do you calculate self-employment tax?
1. Calculate the self-employed individual's contribution rate: Self-employed contribution rate = (contribution rate to other participants/1+ contribution rate to other participants) 2. Calculate self-employment tax. Net self-employment income X 92.35% = Net earnings subject to self-employment tax X 15.3% up to $137,700 Plus: 2.9% over $137,700 =Self employment tax. 3. Calculate the self-employment individual's contribution: Net self-employment income- 1/2 self employment taxes - Adjusted Net Self-employment income (earned income) X self-employed contribution rate. = Self-employed individuals qualified plan contribution.
How do you form a corporation?
1. Charter document Articles of Incorporation.
How do you form a LLP?
1. File with the state. 2. Requires initial filings and annual filings.
What are the three most important factors for choosing a business entity formation?
1. Formation. 2. Liability protection. 3. Manner of taxation.
Explain how a sole proprietorship is formed?
1. Might need to obtain local business license. 2. If collecting sales taxes, must register with the state or local taxing authority. 3. Add a Schedule C to Form 1040. 4. If employees are hired, need to obtain an EIN. 5. Does not pay unemployment taxes, but must for employees. 6. Does pay self-employment tax (up to 15.3%).
What is to be included in the Articles of Incorporation?
1. Name. 2. Number of shares. 3. Purpose of the corporation.
How do you form an LLC?
1. Register with the Secretary of State. 2. Charter document is called the Articles of Organization. 3. Have a resident agent. 4. Requires annual filings.
What is a Keogh plan?
A qualified retirement plan selected by a self-employed individual is referred to as a Keogh plan. A Keogh plan is simply a qualified plan for a self-employed person usually structured as a profit sharing plan, a money purchase pension plan (MPPP), or a combination of both.
What is liability protection?
If liability protection is available, the investors in such business ventures or entities will not have their personal assets exposed to business (entity) debts or obligations.
What requirements must be met to qualify for safe harbor in regards to real estate?
1. Separate books and records must be maintained for each rental real estate enterprise. 2. a. For rental real estate enterprises that have been in existence less than four years: 250 or more hours of rental services (defined below) are performed per year with respect to the rental real estate enterprise. b. For rental real estate enterprises that have been in existence at least four years: in any three of the last five consecutive years, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise. 3. Contemporaneous records must be kept, including time logs regarding dates and hours for all services performed and who performed the services. 4. A statement must be attached to the taxpayer's timely filed tax return in each taxable year in which the taxpayer relies on the safe harbor. The statement must include a description of all properties held in the rental real estate enterprise, a description of properties acquired and disposed of during the year, and a representation that the requirements of Revenue Procedure 2019-38 have been satisfie
How does a general partnership facilitate formation?
1. Written agreement based on ownership percentage. 2. Because they're legal entities, must obtain a Federal Employer Identification Number (FEIN).
What is considered a rental service?
1. advertising to rent the real estate, 2. negotiating and executing leases, 3. verifying information in prospective tenant applications, 4. collection of rent, 5. daily operation, maintenance, and repair of the property, including purchase of materials and supplies, 6. management of the real estate, and 7. supervision of employee
How do you form a limited partnership?
1. file a partnership agreement with the state. 2. Annual filings to maintain entity status. 3. Specifies limited and general partners.
What are the two exceptions to self-employment tax on the tax returns of individual members?
1. for LLC income derived from rental real estate. 2. for LLC members who are not the managing member and are on the equivalent of limited partners.
What are family limited partnerships?
A family limited partnership (FLP) is a special type of limited partnership created under state law with the primary purpose of transferring assets to younger generations using annual exclusions and valuation discounts for minority interests and lack of marketability.
What is a limited liability partnership?
A limited liability partnership (LLP) is a hybrid entity that provides partial liability protection to its members and may be taxed as either a corporation or partnership.
How could a minority shareholder and member protect themselves?
A minority shareholder or member who is also an employee should have two protections from termination by having an employment agreement (rather than being an employee at will) and should also have a shareholder agreement with a buyout provision in the event of termination
What is the main disadvantage of general partnerships?
A principal disadvantage of the general partnership arrangement is that all general partners in a partnership are subject to joint and several liability for the debts and obligations of the partnership.
How do you dissolve a sole proprietorship?
Discontinue business operations.
How could corporation income be taxed twice?
Distributions of cash and other assets to a shareholder/ employee in his capacity as a shareholder rather than as an employee are considered to be dividends. A C corporation is not allowed to take a tax deduction for dividends distributed to shareholders, but shareholders must include the dividends in gross income. Therefore, the income of a C corporation can be taxed two times, once at the corporation level and a second time at the shareholder level when dividends are distributed. In a closely-held corporation, careful tax planning can minimize or even eliminate this double taxation.
What is earned income?
Earned income is defined as net earnings from self-employment less one-half of self-employment tax less the deduction for contributions to the qualified plan on behalf of the self-employed person.
What is the QBI deduction in relation to the W-2 wage limitation?
For pass-through entities, other than sole proprietorships, the QBI deduction generally cannot exceed the greater of: 1. 50 percent of the W-2 wages (including owner-employees) with respect to the qualified trade or business (W-2 wage limitation); or 2. the sum of 25 percent of W-2 wages (including owner-employees) plus 2.5 percent of the unadjusted basis, immediately after acquisition (UBIA), of all "qualified propert
Which form does a partnership use to file taxes?
Form 1065
Which form does a C corporation use to file taxes?
Form 1120
Which form does an S-corporation use to file taxes?
Form 1120S
How is a FLP formed?
General partner has unlimited liability. Limited partners are passive interest holders with limited liability. Transferor transfers valuable property to a FLP General partner has 1% ownership. Limited partner has 99% ownership. Managed by general partner.
What happens when a C corporation or an S corporation receive an in-kind distribution of appreciated assets?
Will be treated as a sale. Generate capital gains for all shareholders in proportion to their ownership even if the asset was only distributed to one shareholder. File Form 1120S. provides each shareholder Form 1120S Schedule K-1.
Is it easy to accumulate capital in a limited partnership?
Yes, because of the availability of the liability shield.
What is the benefit of having a C corporation?
advantage of being able to accumulate profits at the corporate level without the owners having to pay income taxes on those profits until they are distributed as dividends to the owners by the corporation.
