Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Principles of Taxation Chapter 9 Sole Proprietorships, Partnerships, and S Corporations

Slide 9-2 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Objectives  Explain effect of sole proprietorship on individual tax return.  Describe requirements for home office deductions.  Compute FICA taxes and self-employment taxes.  Distinguish general and limited partnerhips.  Differentiate between partnership distributive income versus cash flow.  Compute partnership adjusted basis.  Determine eligibility for S Corporation status.  Constrast basis limits for S Corporations versus partnerhips.

Slide 9-3 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Business Organizations  Taxpayer = owners = flow-through entities  sole proprietorship  partnerships  LLCs  S Corporations  Taxpayer = corporation  C Corporation is taxed first, then shareholders may be taxed on distributions (double taxation).

Slide 9-4 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Sole proprietorship  Business income and expenses are reported on Schedule C, filed with the individual form  Net income or loss on Schedule C is ordinary income or loss; combine this net with other items of gross income.  If the Schedule C business loss > other sources of income, the NOL (net operating loss) can be carried back 2 years and forward 20 years.

Slide 9-5 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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. See Chapters 15 and 16.

Slide 9-6 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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  1) as the principal place of business operated by the homeowner, OR  2) as a place to meet with patients, clients or customers.  A home office used exclusively for administrative or management activities qualifies as a principal place of business if the taxpayer has no other fixed location where such activities are conducted.

Slide 9-7 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Home office deduction  If the office qualifies under above rules:  Allocate expenses between business and personal use. For example:  utilities  home mortgage interest and taxes  insurance  repairs  depreciation.  Home office deduction cannot exceed taxable income of the business before this deduction. See AP2.

Slide 9-8 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Employment taxes  FICA = 6.2% Social Security tax (on wages up to $72,600 in 1999) % Medicare tax on all wages. Both employer and employee must pay this tax.  Employers withhold income taxes and the employee’s share of FICA.  Employers must remit the withheld taxes to the federal (and state if applicable) governments.  Self-employed taxpayers must pay SE (self- employment) tax, equal to 2 x FICA, or 15.3% of net earnings from self-employment. (See footnote 20 for details). 1/2 of SE tax is deductible on Form 1040.

Slide 9-9 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Partnerships  The partnership agreement stipulates rights and obligations of partners and the % of profits and losses allocable to each partner. Such agreements permit large flexibility.  General partnership: all partners have unlimited liability  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 company (LLC). Treated as a partnership for tax purposes but every owner has limited liability.

Slide 9-10 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Partnership reporting  The partnership files an information return, Form  Included with the Form 1065 are Forms K-1, which show EACH partner’s share of income and deductions.  EACH partner reports his or her share on partnership income on Schedule E, as part of his or her Form  Because the partnership does not pay tax, but each partner reports income and loss, the partnership is referred to as a FLOW- THROUGH ENTITY.

Slide 9-11 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Guaranteed payments  A guaranteed payment is a special allocation of ordinary income to the partner receiving it - similar in nature to a salary.  The receiving partner reports as ordinary income BOTH:  1) his guaranteed payment  2) his share of partnership income after the guaranteed payment.  Other partners report their shares of partnership income after the guaranteed payment.

Slide 9-12 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Guaranteed payment example  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 1/3 each.  RJJ earns $85,000 during the year.  Robert reports $45,000 of partnership income ($25, /3 x $60,000).  John and Joseph each report $20,000 of partnership income (1/3 x $60,000).

Slide 9-13 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Self-employment income from partnership  SE tax must be paid on  Guaranteed payments +  Distributive share of ordinary business income from partnership  Limited partners do NOT pay SE tax on share of ordinary income.

Slide 9-14 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Partnership basis  These things increases basis:  Contributions (initial and ongoing): cash + adjusted basis 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).  These things decrease basis:  Distributions  Losses and deductions (and shares of nondeductible expenses).

Slide 9-15 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Partnership losses limited to basis  Partners CANNOT deduct losses in excess of basis. See AP13, 14  Excess losses are carried forward indefinitely until additional basis is restored  by additional contributions or additional positive income.  This rule applies to EACH partnership separately.  Are there questions about examples in the text? This can be complicated.

Slide 9-16 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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 on the individual tax return (e.g. ordinary income, capital losses, charitable contributions, etc).

Slide 9-17 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 S Corporation eligibility  Only individuals, estates and some trusts may be shareholders.  The number of shareholders (not including spouses) is limited to 75.  The corporation may only have one class of outstanding common stock.  Shareholders must unanimously elect S Corp status.

Slide 9-18 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 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). See AP19, 20  Like partnerships, basis is increased by contributions and income items. Basis is decreased by distributions and loss items.

Slide 9-19 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 S Corporation operation  Shareholders can be paid a salary. The salary is subject to payroll taxes and reduces ordinary income of the S Corporation.  Share of ordinary income is NOT subject to Self-Employment tax.  Allocable share of loss items can only be deducted up to BASIS, like with partnerships. Losses in excess of basis are carried over until the shareholder has basis again.

Slide 9-20 Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc., 2000 Other entities  Limited Liability Company.  Treated as a corporation for liability purposes, but as a partership for federal tax purposes.  Limited Liablity Partnership.  A partnership in which each partner’s liability is limited to his or her own actions. Used by professional service firms.