1. 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.

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. Employment Taxes Employer portion: Employee portion:
FICA = 6.2% Social Security tax on wages up to $113,700 (2013) % 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) % 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

9. 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

10. 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 as deduction for AGI

11. 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))

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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, /3 x $60,000)
John and Joseph each report $20,000 of partnership income (1/3 x $60,000)

19. 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

20. 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)

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

22. 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

23. 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 ,500
Share of operating loss ( $4,500)
End of Year Basis $

24. 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

25. 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)

26. 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

27. 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

28. 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

29. 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

30. 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 ,
Share of operating loss ( $4,500) ($ 500)
End of Year Basis $ $ 500