9-1 Non-Corporate Forms of Business  Sole Proprietorship  Partnership  LLC  S corporation

9-2 Sole Proprietorship  Trade or business conducted by one individual in an unincorporated form  Operating income and expenses reported on Schedule C of individual Form 1040  Net loss deductible against other income

9-3 What is a Trade or Business?  Term is never defined in the Code or Regulations  Criteria:  Profit motive  Continuous, regular involvement in the activity  Livelihood, not a hobby  If an activity is a hobby, not a trade or business, related expenses are deductible only against income from the activity  Business presumption if activity shows a profit in 3 of 5 consecutive years

9-4 Home Office Deduction  Qualification  Part of home used regularly and exclusively as principal place of business or to meet with clients, customers or patients  Use for administrative activities qualifies if taxpayer has no other location for such activities  For employees, use must be for convenience of employer and required as a condition of employment  Amount of deduction  Allocable portion of expenses of maintaining home (mortgage interest, taxes, insurance, utilities, repairs, depreciation)  Deduction limited to net income earned from the home office activity

9-5 Employee/Employer Payroll Taxes  Employees and employers each pay:  Social security tax = 6.2% of compensation up to $87,000 (2003)  Medicare tax = 1.45% of compensation  Employee portion is withheld and remitted by employer  Employer portion is deductible for income tax purposes, employee portion is not deductible

9-6 Self-Employment (SE) Tax  Sole proprietors pay SE tax on net earnings from self employment  tax base = 92.35% of net profit  tax rate: Social security tax =12.4% of earnings up to $87,000 (2003) Medicare tax = 2.9% of earnings  Self-employment tax is paid via estimated tax payments rather than through withholding  50% of SE tax deductible for income tax purposes

9-7 Example: Tax Treatment of Conduit Entities and their Owners  Conduit entity X is owned in equal shares by Bob and Martha. In year 1, X earns taxable income of $100,000. All of this income is retained by X to develop the business; Bob and Martha receive no distributions in year 1. In year 2, X earns taxable income of $200,000 and distributes $100,000 in total to its owners. In year 3, X earns $100,000 and distributes $150,000 in total to its owners.

9-8 Example continued  How much income will Bob and Martha report in years 1, 2, and 3 as a result of their ownership of X? Year 1: $50,000 income per owner Year 2: $100,000 income per owner Year 3: $50,000 income per owner  Critical point: The owners are taxed when the entity earns income, regardless of when or if such income is distributed to the owners The amounts distributed to each owner are not included in taxable income

9-9 Partnerships  A ‘syndicate, group, pool, joint venture, or other unincorporated organization’ carrying on a business, financial operation or venture  General partner: Typically involved in partnership management, has unlimited liability for partnership debts  Limited partner: Cannot be active in partnership management, liability limited to investment in partnership

9-10 Partnerships continued  Taxation of partnership income  Partners are taxed on their ‘distributive share’ of partnership income Reported to each partner on Schedule K-1 Partners are taxed when income is earned by the partnership, regardless of when or if any cash is distributed to the partners ‘Special allocations’ are permitted, as specified in the partnership agreement, to reflect differences in partner contributions and liability

9-11 Partnerships continued  Taxation of partnership income continued  Special items of income and deduction retain their character at the partner level Examples: muni interest, capital gains and losses  Publicly Traded Partnerships  Partnership interests traded on an established securities market  Generally taxed as corporations

9-12 Partnerships continued  Tax basis of partner’s interest in a partnership  Initial tax basis = cost if acquired by purchase, or carryover basis + gain recognized if acquired in a non-taxable exchange (Chapter 8)  Adjusted annually to reflect activity of partnership Ending Adjusted tax basis = Beginning adjusted basis + allocable share of partnership income or gain - allocable share of partnership loss or deduction + additional capital contributions - distributions +/-changes in share of partnership debt

9-13 Debt As Investment Basis  Partners may include their allocable share of partnership debt as basis  Determination of ‘allocable share’ is complicated when both general and limited partners exist and depends on recourse vs. nonrecourse nature of the debt General rules –recourse debt allocated to general partners –nonrecourse debt allocated to all partners

9-14 Importance of Basis Calculation  Basis determines gain/loss on disposition of partnership interest  Partners may not deduct allocations of losses in excess of tax basis  Distributions in excess of tax basis result in taxable gain

9-15 SE Tax Assessments on Partners  Self-employment earnings include  General partners’ distributive share of net partnership earnings Limited partners not subject to SE tax  Guaranteed payments from the partnership Fixed distributions of earnings, usually as compensation for time and effort expended in the partnership business Partners cannot be regular employees of partnership, so not subject to payroll taxes

9-16 Limited Liability Company  An unincorporated business entity, usually taxed as a partnership  Primary advantage of an LLC  Provides the limited liability not available to general partners, without the participation restrictions of limited partners  Potential disadvantage of an LLC  Relatively new form, with undeveloped case law

9-17 S Corporations  Requirements for election  No more than 75 shareholders  Shareholders must be individuals, estates or certain trusts; no nonresident alien shareholders  Must be an eligible domestic corporation with only one class of stock issued and outstanding  All shareholders must consent to the election, which is binding until revoked or terminated

9-18 S Corporations continued  Advantages of S Corporation treatment  S corporation income avoids the double taxation of the corporate income tax system  S corporation income, gains and losses are passed through and taxed to its shareholders  S corporations are not subject to the corporate alternative minimum tax, the accumulated earnings tax or the PHC tax

9-19 S Corporations continued  Taxation of S Corporation income  Shareholders are taxed on their prorata share of S corporation income or loss  Special items of income and deduction retain their character at the shareholder level  S corporation is subject to certain special taxes at the entity level Examples: Built-in gains tax, excess net passive income tax

9-20 S Corporations continued  Tax basis of shareholder’s investment in S corporation stock adjusted annually in same manner as partner’s basis in partnership interest  Exception: shareholder’s basis in S corporation stock does not include share of debt Loans from shareholder to S corp. create basis in debt  Distributions to S corporation shareholders Generally treated as non-taxable recoveries of investment, in manner similar to partnership distributions Not treated as dividends (C corporation treatment)

9-21 S Corporations continued  Basis limitations  S corporation shareholders may not deduct losses in excess of both basis in stock and basis in loans from shareholder to corporation  Distributions in excess of basis result in taxable income  Shareholder compensation  S corporation shareholders can be employees  Earnings not subject to SE tax