Module 9 - Tax Characteristics of Entities

Basis of Partnership Interest

- If Section 721 nonrecognition rules apply, Section 722 provides a substituted basis rule for determining the basis of a partnership interest. - basis of the contributing partner's partnership interest equals the sum of money contributed plus the adjusted basis of other property transferred to the partnership - if a contributing partner renders services to the partnership in exchange for a partnership interest, the contributing partner's basis equals the amount of income recognized from rendering the services

Section 721

- Nonrecognition Rules, prevents the recognition of gain or loss upon either the transfer of property in exchange for a partnership interest or subsequent transfers of property by the partners in exchange for a pro rata increase in their partnership interests EXCEPTIONS (1) do not apply if the partner acts in a capacity other than a partner (2) if partner contributes services instead of cash or property in exchange for an unrestricted partnership interest, the FMV of the services is taxed as compensation to the contributing partner because services do not qualify as property (3) contributing partner recognizes gain if liabilities transferred to the partnership exceed the partner's basis in the partnership (4) contributing partner recognizes gain if the partnership is treated as an investment company had it be incorporated under Section 351

Negative Basis Rule

- Per Section 731, the basis of a partnership cannot be negative - therefore, recognition of gain is required in situations where a negative basis would otherwise occur

Transaction between Partner and Partnership

- Section 707(b) forestalls potential abuses by disallowing losses and by providing ordinary income (rather than capital gain) treatment under the following conditions: (1) losses disallowed on sales/exchanges between a partner and partnership if the partner owns more than 50% interest (2) gains treated as ordinary income if the partner owns more than 50% interest

Sole Proprietorships

- a business owned and controlled by one person and is not a separate entity from its owner - easy to establish because there are no legal requirements for forming/dissolving - IRS selects this form of business if an owner does not formally select a business entity - owner assumes full responsibility for all business debts and liabilities - no continuity when the owner dies or terminates the business

Limited Liability Company (LLC)

- combines the advantages of C corp with those of a partnership - all owners enjoy limited liability - can have an unlimited number of members who can be individuals, corporations, estates or trusts - formed by a state registration process similar to that used for corporations - if 2+ shareholders, can choose to be taxed as corporation or partnership - if 1 shareholder, automatically taxed as sole proprietorship unless the S election is chosen - files form 1065 and individual members receive K1 which details all items of revenue and expense which is reported on their Form 1040

Accumulated Earnings Tax

- discourages companies from retaining excessive amounts if the funds are invested in assets unrelated to business needs so the tax could be avoided if earnings are reinvested in operating-type assets or retained for the reasonable needs of the business - imposed on a corporation's accumulated taxable income for a particular year at a rate of 20%

Partnerships

- entity owned by two or more people who have joined together to operate a business for profit. a partner can be an individual, corporation, trust or estate - legal entity separate from the owners - partnership agreement details how profits and losses are shared - partners have unlimited personal liability for all debts incurred by the business, degree of liability is directly proportionate to the amount of control a partner has in the partnership

Family Limited Partnerships (FLP)

- financial planning technique that enables a family to hold and manage its wealth, including the family business, with several generations of family members as the partners - allows families to (1) retain control of family business or investment assets by senior family members as general partners (2) develop and implement a succession plan for transferring management (3) transfer the family business or assets to future generations at the lowest permissible cost in estate and gift taxes (4) reduce the income tax liability on partnership income when it is allocated to limited partners in a lower tax bracket **must be designed to accomplish a valid business or investment purpose or gift taxes may apply**

Separately Stated Items on K1

- guaranteed payments to partners - charitable contributions - investment interest income and expenses - foreign income taxes paid or accrued - specially allocated income, deduction, loss, gain and credit items - tax exempt interest income - capital gains and losses - section 1231 gains or losses - tax credits - tax preference items

Holding Period for Partnership Interest

- if a partner contributes only cash to the partnership in exchange for a partnership interest, the holding period begins on the date that the interest is acquired - if partner contributes property, the holding period for the partnership interest generally includes the holding period of the contributed property - if the contributed property is other than a capital asset or Section 1231 property, the holding period begins on the date that the partnership interest is acquired

Disadvantages of S Corp

- limits placed on types and number of shareholders can hamper the corporation's ability to raise capital - must use calendar year - shareholders who own more than 2% stock are not eligible for tax free employee fringe benefits. instead they are included in their gross income

S Corp Distributions to Shareholders

- money or property distributed to shareholders is considered a tax free return of capital if the S Corp has no accumulated earnings and profits - the S corp recognizes gain but not loss if it distributes nonmoney property to its shareholders. the distribution is treated as a sale at FMV

Tax Treatment of a Sole Proprietorship

- net income reported on the individual income tax return IRS Form 1040 - Schedule C Profit or Loss from Business (Individuals) is used to report the income and expenses of the sole proprietorship business - max tax rate applicable is 39.6% - also subject to self-employment tax on net earnings - if there are employees, it must obtain an Employer Identification Number (EIN), otherwise they use their Social Security Number - must used a calendar year

Advantages of S Corp

- not subject to double taxation -shareholders enjoy limited liability

Basic Tax Rules for S Corp

- ordinary losses and separately stated loss and deduction items are allocated to the shareholders on a per share per day basis - the last day of the S Corp's tax year determines the year in which the shareholders report - basis cannot be reduced below zero - losses initially reduce the shareholder's stock basis. any excess losses then reduce the basis of debt owned by the S corp to the shareholder - unused losses are suspended and carried over until the shareholder again has basis to absorb the losses - net positive basis adjustments in subsequent years initially increase the shareholder's debt basis until fully restored. any additional net positive basis adjustments increase the basis of the shareholder's S corp stock

Partnership Operations

- partnership files Form 1065 provides information regarding the measurement and reporting of income, deductions, losses and credits that pass through to the partners - certain separately stated items are segregated and passed through to the partners without losing their identity. they are reported on Schedules K and K1 of the partnership return - items that do not have special tax effects are netted at the partnership level and are reported on page 1 of Form 1065. these items are allocated to the partners depending on the profit and loss sharing ratios contained in the partnership agreement

Items Affecting Partnership Basis

- pass through of ordinary net income (+) - pass through of ordinary loss (-) - cash contribution from partners (+) - cash distributions to partners (-) - partnership increases liabilities (+) - partnership decreases liabilities (-) - partnership makes charitable contributions (-) - partnership has section 179 expenses (-) - pass through of capital gain (+) - pass through of capital loss (-) - pass through of dividend and interest income (+) - partnership has tax exempt income (+) - partnership has nondeductible expenses (-)

Personal Holding Company Tax

- prevents closely held companies from converting an operating company into a non-operating investment company by reinvesting substantial amounts of earnings into passive investments. this tax forces a company to distribute its earnings to shareholders as dividends if the earnings are not invested in operating assets - the tax is the highest individual tax rate for dividends times undistributed personal holding income

Corporations

- separate legal entity apart from its owners, therefore shareholders, directors and officers are generally protected from personal liability - owners are investors who transfer cash (or non-cash assets) to the corporation in exchange for shares of stock. they do no manage directly but periodically elect directors who are required by statute to manage the enterprise. they in turn select officers to manage daily operations. - formation requires legal documentation and must be created in compliance with state statutes - unaffected by the death or withdrawal of shareholders - losses are borne by the corporation to the extent of its assets. profits are distributed to the shareholders as dividends or retained in the business - two types: (1) C-Corp and (2) S-Corp

Separately Stated Items for S Corp

- short and long term capital gains and losses - section 1231 gains and losses - charitable contributions - credits - interest on investment indebtedness - AMT adjustments and tax preference items - foreign taxes paid or accrued - dividends and other portfolio income

S Corporations

- the same as other corporations but taxed as a flow-through entity - formed under state law and must file articles of incorporation files Form 1120S - to achieve this status (1) all shareholders must consent (2) must meet the definition of a small business corporation (3) have no more than 100 shareholders (4) be a domestic corporation (5) have no shareholder who is a nonresident alien (6) have only one class of stock (7) C corp or partnership cannot own stock

Limited Liability Partnership (LLP)

- usually consists of professionals - partners are liable for their own acts and the acts of individuals under their direction but they are not liable for the negligence of other partners - not all states recognize LLPs

Penalty Taxes for Corporations

1. accumulated earnings tax 2. personal holding company tax

Types of Partnerships

1. general 2. limited

Disadvantages of a Partnership

1. general partners do not enjoy limited liability 2. cannot choose tax year 3. business may be altered or even destroyed by the death or withdrawal of a partner

Disadvantages of the C-Corp

1. if corporation was not property formed, creditors may be able to the pierce the corporate veil and seek payment from the shareholders 2. income is taxed twice, at the entity level and again at the shareholder level 3. complex computations are necessary for filing on consolidated taxable income

Advantages of a Partnership

1. no restrictions on either the number or type of partners 2. not subject to double taxation

Types of Flow-Through Entities

1. partnerships 2. limited liability partnerships 3. family limited partnerships 4. S corporations 5. limited liability companies

Special Corporations

1. personal service corporations 2. personal holding companies 3. professional corporations

Advantages of the C-Corp

1. shareholders have limited liability 2. easier to raise capital by issuing new stock 3. corporate form involves special shareholder and employee tax rules and the ability to file a consolidated tax return 4. no restriction on the number or types of shareholders that can own stock

Corporate Tax on Built-In Gains

A 21% corporate tax on built-in gains applies if a corporation that previously was a C corporation elects to be an S corporation. a built-in gain exists if the FMV of an asset exceeds its adjusted basis on the first day the S election is effective. If the corporation sells an asset with a built-in gain within the five-year period beginning on the effective date for the election, the S corporation is taxed on the built-in gain. Built-in losses existing on the first day of the S election period can be used to reduce built in gains.

Tax on Excess Net Passive Income

A 21% excess net passive income tax applies when an S corporation has passive investment income for the tax year that exceeds 25% of its gross receipts and, at the close of the tax year, the S corporation has accumulated Subchapter C E&P. Subchapter C E&P is the earnings and profits the corporation earned when it was taxed as a C corporation

Revocation of S Corporation Status

S election may be terminated either voluntarily by the shareholders or involuntarily if the corporation fails to continue to meet the requirements for a small business corporation. If the IRS deems the termination was inadvertent and S corp or its shareholders take the necessary steps within a reasonable time period to restore its small business corporation status, the S corp status is considered to have been continuously in effect ** if an S corp terminates its election either by ceasing to be a small business corporation or by revocation, the corporation may not re-elect S corp status for 5 years unless the IRS consents to reelection

Special Allocations

Section 704 permits partners to decide how income, deductions, losses and credits are to be allocated among individual partners. unique to partnerships and permit flexible arrangements among the partners for sharing specific income and loss items

Basis of Partnership Assets

Section 723 provides a carryover basis rule for property contributed to the partnership. the partnership's basis in the property is the same as that of the transferor partner, even if the contributing partner recognizes gain

How to Calculate Accumulated Taxable Income

Taxable income (+) dividends-received deduction (+) net operating loss deduction (-) net capital losses (-) net long term capital gains over net short term capital losses (-) federal income tax liability (-) charitable contributions exceeding the 10% limit (-) deductions for dividends paid or deemed paid (-) accumulated earnings credit PSC allowed an accumulated earnings credit of $150,000 while non-personal service corporations are allowed a credit of $250,000

Classification of Business Entities

Under Treasury regulations, a business entity with two or more owners is classified as either a corporation or a partnership. an entity having only one owner is classified as a corporation or a sole proprietorship

Partnership Distributions

a distribution of cash or property from the partnership to a partner is generally treated as a tax-free return of capital

An Association

a group of people who have joined together for a common purpose, ranging from social to business purposes. not a legal entity

Section 752 Adjustment

a partner's basis for his/her partnership interest includes the partner's ratable share of partnership liabilities as well as the basis attributable to any property and services contributed to the partnership. in addition, the following rules apply if a partnership assumes a partner's liability or if the partner transfers property to the partnership subject to a liability (1) all partners treat an increase in partnership liabilities as a cash contribution, which increases their bases by their ratable share of the assumed liabilities (2) the partnership's assumption of a liability is treated as a cash distribution to the partner whose liability is assumed, which decreases his basis in the partnership **this adjustment to a partner's basis is made for both recourse liabilities and qualifying non-recourse liabilities

Partnership Organization and Syndication Fees

a partnership can deduct up to $5000 of costs of organizing the partnership in the year the partnership begins business. the deduction is limited to the lesser of (1) the amount of organizational expenditures or (2) $5000 reduced by the amount by which such organizational expenditures exceed $50,000. any organizational expenditures exceeding the first year deduction can be deducted ratably over the 180 month period beginning within the month the partnership begins business

Compensation Deduction Limitation

a publicly held corporation is denied a deduction for compensation paid to its chief executive officer and its four highest-compensated officers if the compensation amount for any individual exceeds $1 million per year. the following types of compensation are not taken into account: - commission - compensation based on individual performance goals - payments to a qualified retirement plan - tax free employee benefit

Losses and Limitations for S Corps

a shareholder's deduction for ordinary losses and separately stated items cannot exceed his or her basis for the S Corp stock plus the debt basis for any shareholder loans made to the S Corp. the following rule apply: (1) a positive basis adjustment is made to the stock basis for ordinary income and separately state income or gain items (2) shareholder's deduction for pass through losses is limited to the stock basis after the above positive adjustments and after distributions (3) a shareholder's pass through loss first reduces the shareholder's stock basisi (4) if the loss exceeds the stock basis, the remaining pass through loss then reduces the shareholder's debt basis (5) if the loss exceeds both the stock and debt basis, the shareholder carries over the excess loss and deducts it in subsequent year when the shareholder again has basis in stock or debt

S Corp Basis Adjustments

a shareholder's original basis for S corp stock is either the amount paid for the stock or a substituted basis from a nontaxable transaction. adjustments are subsequently made for ordinary income or loss and separately stated items that flow through to the shareholders, as well as additional capital contributions by shareholders and distributions to shareholders

A Business Trust

a trust created for the purpose of making a profit. characterized by some kind of commercial activity, transferable certificates of interest, continuity after the death of beneficiaries, limited liability, legal title in the hands of trustees and officers having duties management

Subsidiaries of S Corps

an S corp may not have a corporate shareholder, but it may own stock in a C corp. if this stock ownership equals or exceeds 80%, the S corp and the C corp are considered an affiliated group.

Tax-Exempt Organization

an entity that is organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes

Passive Activity Loss Limitation

apply to partners who do not materially participate in the business of the partnership. if a loss is determined to be passive, a partner may not deduct the loss against either earned income or portfolio income, but may deduct the loss only against other passive income

Personal Service Corporation (PSC)

business that provides personal services to customers in such fields as accounting, law, health, architecture and consulting. certain federal tax rules apply differently to a PSC than to a c-corp Advantage: a qualified personal service corporation (QPSC) is exempt from using the accrual method of accounting Disadvantage: (1) QPSC must use flat rate 21% corporate tax rate (2) cannot elect alternative tax year

A Trust

can be created for business purposes. it can be a combo of firms or corporations formed by an agreement. shareholders in the separate corporations exchange their shares, for shares representing proportionate interest in the trust's principal and income. subject to the same tax rates as individuals, though the taxable income levels at which each tax rate begins is much lower

Personal Holding Company (PHC)

closely held C corporations with a certain percentage of their income derived from investments, such as interest, dividends and real estate rents. PHC's are subject to a tax on their undistributed PHC income in addition to the regular income tax they owe. When the PHC tax is owed, there is 3x taxation that occurs a company must meet two tests to be classified as a PHC: (1) more than 50% of the value of outstanding stock is owned by 5 or fewer individuals AND (2) 60% or more of adjusted ordinary gross income is personal holding company income which consists of passive types of income (dividends, interest, rental income)

Professional Corporation

closely held corporation formed by professionals such as doctors, lawyers, accountants and engineers. all shareholders of this type of corporation must be licensed in a particular profession. the shareholders remain personally liable for their professional acts to third parties

Limited Partnership

consist of one or more general partners and one or more limited partners. limited partners are not involved in the day-to-day operations and as such they have limited liability

Dividends-Received Deduction

corporations may deduct a percentage of dividends received from a domestic corporation if the recipient corporation owns a percent of the voting power and shares outstanding of the issuing corporation's stock - less than 20% of stock owned = 50% deduction - 20% thru 79.99% = 65% deduction - 80% or more = 100% deduction Limitations to the 65% and 50% categories: - dividends-received deduction is limited to taxable income without regard to the net operating loss deduction - does not apply if the dividends-received deduction creates a NOL for the current year - not available if stock is held 45 days or less

Corporate Tax Rate

flat 21% of taxable income

Section 741: Recognition of Gain or Loss from Selling a Partnership Interest

gain or loss is measured by the difference between the amount realized and the selling partner's share of partnership liabilities from which the partner is released as a result of the sale. the basis of the partnership interest is also adjusted by the selling partner's distributive share of the partnership income or loss, which must be computed up to the sale date

LIFO Recapture

if a C corp converts to an S corp and used LIFO method of accounting for its inventories, the firm must recapture the LIFO reserve. if the FIFO method of accounting for inventory is higher, the firm must pay tax (21%) on this LIF recapture in four annual installments

Independent Contractor vs. Employee

if a worker is an employee, the employer is responsible for paying payroll taxes and filing payroll tax returns. employers must withhold income taxes, Social Security and Medicare taxes and pay unemployment tax on wages paid to an employee. if the worker is an independent contractor, the employer has no such obligations

A Common-Law Employee

if someone can control what services will be performed and how it will be one, even if the employee has the freedom of action

Independent Contractor

if the person for whom the service are performed has the right to control or direct only the result of the work and not the manner and methods of accomplishing the result

Statutory Employee

if worker falls into one of four categories: (1) driver who is paid on commission or is your agent (2) a life insurance sales agent (3) a person who works at home on materials or goods supplied by the employer (4) a salesperson who turns in orders for resale from wholesalers, retailers, contractors or hotel or restaurant establishments

Recourse Debt

lenders have recourse back to the individual partners should the partnership default on its obligations

Section 704(d)

limits deductibility of the losses to the partner's adjusted basis in his or her partnership interest as determined at the end of the partnership's tax year. any unused losses and deductions carry over indefinitely and are allowed in subsequent years when the partner again has a positive basis in her partnership interest

Capitalization of a Corporation

may be capitalized with both equity (stock) and long-term debt issued to the shareholders. issuance of debt in the capital structure has advantages: (1) interest payments on debt are deductible, but dividends on stock are not (2) redemptions of stock may result in dividend income treatment to the shareholders unless certain requirements are met, whereas a repayment of debt is a tax-free return of capital **BUT if the corporation is too thinly capitalized, the IRS may attempt to recharacterize the debt as equity by denying an interest deduction to the corporation

Earnings and Profits (E&P)

measure a corporation's economic ability to pay dividends from its current and accumulated earnings without impairment of capital, meaning that the corporation has generated an operating surplus on its capital. if a corporation has no E&P, a distribution represents a tax-free return of capital and possibly a capital gain rather than a taxable dividend

Section 751

ordinary income rather than capital gain treatment may result if a partnership has unrealized receivables or inventory items when a partnership interest is sold. a sale of section 751 assets by the partnership results in ordinary income, which eventually flows through to the partners. 751 Assets include: - inventory - unrealized receivables

Accumulated Earnings and Profits

represents the total of all prior years' undistributed E&P amounts as of the first day of the tax year. distributions are deemed to be made out of accumulated E&P only after the current E&P (if any) is exhausted

Netting Process for Capital Gains (Losses)

rules are the same for corporations and individuals: - long term capital gains (LTCG) are netted against long term capital losses (LTCL) - short term capital gains (STCG) are netted against short term capital losses (STCL) - a net long term capital gain (NLTCG) is then offset against a net short term capital loss (NSTCL) - a net long term capital loss (NLTCL) is then offset against a net short term capital gain (NSTCG) - if a corporation reports both a NLTCG and a NSTCG after the netting procedure is completed, both the NSTCG and the NLTCG are taxed at the same rates as ordinary income the net results are then taxed to the individual as follows: - NSTCG netted against NLTCL and any excess amount is taxed at the same rates as ordinary income - NLTCL and NSTCL cannot be deducted from ordinary income for corporations

General Partnership

simplest form of business using two or more owners and no formal partnership is required. no partner has limited liability

Non-recourse debt

situations where the lenders do not have recourse with the partners should the partnership default on its payments

Section 705

the basis of each partnership interest is adjusted to reflect the partner's share of income and deduction items. basis adjustments for income and deduction items are made currently regardless of whether an actual distribution is made to the partners

Sale of Partnership Interest

treated as a sale even though the sale results in the termination of the partnership. a partnership interest is a capital asset similar to a corporate security

Net Operating Losses (NOL)

under Section 172 generally involves only business income and expenses, occurs when taxable income for any year is negative because business expenses exceed business income. a deduction arises when a taxpayer carries the NOL to a year in which the taxpayer has taxable income. a NOL for one year becomes a deduction against taxable income in a subsequent year

Formation of a Partnership

when formed, the partners often contribute property or services. in exchange, a partnership interest is received