Sole Proprietorships, Partnerships, LLCs, and S Corporations Chapter 10 Sole Proprietorships, Partnerships, LLCs, and S Corporations McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

Objectives Explain effect of a sole proprietorship on an individual tax return Compute FICA taxes and self-employment taxes Differentiate between partnership distributive income versus cash flow Apply basis limitation on deduction of partnership losses Explain federal tax treatment of Limited Liability Companies (LLCs) Compute partnership adjusted basis Determine eligibility for S Corporation status Contrast basis limits for S Corporations versus partnerships

Business Organizations Taxpayer = owner(s) of flow-through entities Sole proprietorship Partnerships LLCs S Corporations Taxpayer = corporation C Corporation is taxed first, then shareholders may be taxed on distributions, resulting in double taxation

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 NOL (net operating loss) can be carried back 2 years and forward 20 years

Sole Proprietorship Special reporting rules Interest, dividends and rent income related to owner’s investments are not reported on Schedule C; see Schedules B and D instead Dispositions of business assets are reported on Forms 4797 and Schedule D Interest expense on business debt is deducted on Schedule C. Non-business interest expense may be deductible if it is for investments or home mortgages. More on these issues in Chapters 15 and 16

Home Office Deduction A portion of the taxpayer’s personal residence may be allowable as a Schedule C deduction if The office is used exclusively on a regular basis 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

Home Office Deduction If the home office qualifies Allocate expenses between business and personal use Utilities Home mortgage interest and taxes Insurance Repairs Depreciation Home office deduction cannot exceed taxable income of the business before this deduction

Employment Taxes Employer portion: Employee portion: FICA = 6.2% Social Security tax on wages up to $113,700 (2013) + 1.45% Medicare tax on all wages Employee portion: FICA = 6.2% in 2013 (4.2% for 2011 and 2012) Social Security tax on wages up to $113,700 (2013) + 1.45% Medicare tax on all wages Employers withhold income taxes and the employee’s share of FICA taxes Employers must remit the withheld taxes to the federal (and state if applicable) governments

Employment Tax Example In 2013, ABC Co. paid Ms. Smith $119,000 in salary and withheld $21,800 for federal income taxes. How much cash was disbursed to Ms. Smith and to the US Treasury on her behalf? Ms. Smith’s Social Security W/H = (.062 x $113,700) = $7,049 Ms. Smith’s Medicare W/H: (.0145 x $119,000) = $1,726 Cash disbursed to Ms. Smith = $119,000 - $21,800 - $7,049 - $1,726 = $88,425 ABC’s employer FICA = (.062 x $113,700) + (.0145 x $119,000) = $8,775 Cash disbursed to US Treasury = $21,800 + $7,049 + $1,726 + $8,775 = $39,350

Self-Employment (SE) Tax Self-employed persons pay SE tax on net earnings from self employment Tax base = 92.35% of net profit reported on Schedule C Tax rates Social security tax =12.4% in 2013 (10.4% in 2011 and 2012) of earnings up to $113,700 (2013) Medicare tax = 2.9% of earnings Self-employment tax is paid via estimated tax payments rather than through withholding 50% of self-employment tax (2013) on Form 1040 as deduction for AGI

Additional Medicare Tax on Wages Beginning in 2013, 0.9% additional Medicare tax on wages above a threshold amount $250,000 MFJ ($125,000 MFS) $200,000 single and H of H In 2013, Mr. Fox earned wage income of $220,000 and Mrs. Fox earned wage income of $115,000 On their joint return, they will owe additional Medicare tax of $765 (0.009 × ($220,000 + $115,000 - $250,000))

Partnerships The partnership agreement states the rights and obligations of partners, and the % of profits and losses allocable to each partner. Such agreements permit flexibility General partnership: all partners have unlimited liability - joint and severable Limited partnership: one or more limited partners are only liable for their contributed capital. Legally, all limited partnerships have at least one general partner

Limited Liability Partnership Limited liability partnership (LLP) used for professional services. General partners are not liable for malpractice of other partners but are personally liable for other debts of the LLP

Initial Tax Basis in Partnership Interest Cash plus adjusted basis of property contributed + Share of partnership debt for which partner could be responsible Two individuals, Jay and Kay, each contributed $25,000 cash to a new partnership. What is Jay’s basis in his partnership interest assuming that the partnership takes out a $10,000 loan and The partnership assets secure the loan? ($25,000 + (.5 × $10,000)) = $30,000 Jay personally guarantees the loan? $25,000 + $10,000 = $35,000

Partnership Reporting The partnership files an information return, Form 1065 Included with Form 1065 are Forms K-1, which show 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: muni interest, capital gains and losses Each partner reports his or her share of partnership income on Schedule E, as part of his or her Form 1040

Partnership Reporting Because the partnership does not pay tax, the partnership is referred to as a ‘flow-through’ or ‘pass-through’ entity Publicly Traded Partnerships Partnership interests traded on an established securities market Generally taxed as corporations

Guaranteed Payments A guaranteed payment is a special allocation of ordinary income to the partner receiving it; similar to a salary, except that FICA and income tax are not withheld Partnership is allowed a deduction for the guaranteed payment The receiving partner reports as ordinary income His guaranteed payment and His share of partnership income after the guaranteed payment Other partners report their shares of partnership income after the guaranteed payment

Example: Guaranteed Payment Robert, John and Joseph form the RJJ partnership. Robert will do most of the work, so he will receive a guaranteed payment of $25,000 per year. The partners agree to share any remaining income one-third each The partnership earns $85,000 during the year Robert reports $45,000 of partnership income ($25,000 + 1/3 x $60,000) John and Joseph each report $20,000 of partnership income (1/3 x $60,000)

Self-Employment Income From Partnership SE tax must be paid by a general partner on Guaranteed payments + Distributive share of ordinary business income from partnership Limited partners do not pay SE tax on their share of ordinary income

Adjusting Partnership Basis A partner’s tax basis in his/her partnership interest is adjusted annually to reflect share of partnership items and changes in investment These items increase basis Contributions (initial and ongoing): cash + adjusted basis of property contributed Positive income (taxable and tax-exempt) Share of partnership liabilities for which partner is liable (Also allow nonrecourse real estate loans for limited partners)

Adjusting Partnership Basis These items decrease basis Distributions Losses and deductions (and shares of nondeductible expenses)

Partnership Losses Limited to Basis Partners cannot deduct losses in excess of basis Excess losses are carried forward indefinitely until additional basis is restored either by additional contributions or additional positive income This rule applies to each partnership separately

Example: Partnership Losses Mr. Q is a 1/3 partner in QRS Partnership. His basis in the partnership at the beginning of the year is $3,000. The partnership had ordinary income of $30,000; capital gain of $4,500; and guaranteed payments to Mr. Q of $45,000 for the current year Mr. Q’s share of the operating loss is (1/3 * ($30,000 - $45,000) = $5,000), but the current year deduction is limited to basis What is Mr. Q’s basis as of Dec. 31? Beg. of Year Basis $ 3,000 Share of capital gain 1,500 Share of operating loss ( $4,500) End of Year Basis $ 0

Limited Liability Company LLCs are an alternative to a general or limited partnership. All members of an LLC have limited liability for LLC’s debt Treated as a corporation for liability purposes, but as a partnership for federal tax purposes Relatively new organizational form - less legal precedence Every state (and DC) permits LLCs Still unclear when LLC income is subject to SE tax

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 non-taxable recoveries of investment, similar to partnership distributions Not treated as dividends (C corporation treatment)

S Corporation Eligibility Only individuals, estates and some trusts may be shareholders – not nonresident aliens, other corporations, or partnerships The number of shareholders is limited to 100; all family members may be counted as 1 shareholder The corporation may only have one class of outstanding common stock Shareholders must unanimously elect S Corp status; the election is permanent unless shareholders owning a majority of the stock revoke the election

Shareholder Basis Initial basis = cash + adjusted basis of contributed property Loan from a shareholder to S Corp increases basis for that shareholder. Any other debt of the S Corp does not increase shareholder basis (E.g., a bank loan guaranteed by shareholder does not increase basis for any shareholder, even the one that guaranteed the loan) Like partnerships, basis is increased by contributions and income items; basis is decreased by distributions and loss items

S Corporation Operation Shareholders can be paid a salary Salary is subject to payroll taxes and reduces ordinary income of the S Corporation S Corp can use corporate employee benefit plans for shareholder/employees Share of ordinary income is NOT subject to Self-Employment tax

S Corporation Operation Allocable share of loss items can only be deducted up to basis, as with partnerships If the shareholder loans money to the S corporation, additional loss equal to the basis of debt may be taken Losses in excess of basis are carried over until the shareholder has basis again

Example: S Corporation Loss Assume that Mr. Q owns 1/3 of the stock in an S Corporation and that the basis in his stock on Jan. 1 is $3,000. In addition, Mr. Q loaned the S corp. $1,000 during the year. The S Corp. had ordinary income before salary payments to Mr. Q of $30,000; capital gain of $4,500; and salary payments to Mr. Q of $45,000 for the current year. Stock Loan Beg. of Year Basis $ 3,000 $1,000 Share of capital gain 1,500 - Share of operating loss ( $4,500) ($ 500) End of Year Basis $ 0 $ 500