10 - 1

Sole Proprietorshipsand

Flow-Through Entities

Chapter 10

10 - 2

Flow-Through Entity

An operating business whose net income (and certain other items) passes directly through to the owners

The items passed through are included with the owners’ other income/loss items for taxation

10 - 3

Flow-Through Entities

Sole proprietorship General partnership Limited partnership Limited liability company (LLC) Limited liability partnership (LLP) S corporation

10 - 4

Sole Proprietorship

One owner business that is easy to form Owner (sole proprietor) must be an individual Sole proprietor has unlimited liability Business uses same tax year as owner Owner has no capital account and no basis in

the business as a wholeBasis of personal assets contributed is lesser

of their adjusted basis or FMV Owner must establish that the business is

legitimate and not a hobby

10 - 5

Sole Proprietorship

Owner uses Schedule C (or C-EZ) to report proprietorship income and expenses

Some transactions are not included in business operating incomeInvestment income and expensesCapital gains and losesSection 1231 gains and lossesCharitable contributions

10 - 6

Sole Proprietorship

When proprietor maintains an office in the homeAllocated space must be used exclusively and

on a regular basis for the businessDeduction is limited to taxable income from

business after deducting all other business expenses

Expenses related to use are separately reported on Form 8829

10 - 7

Sole Proprietorship

Sole proprietor does not receive a salary Taxed on the entire net income (or deducts the

loss) from Schedule C on Form 1040 Sole proprietor is not eligible for tax-free

employee fringe benefits Can deduct own health insurance premiums for

AGI Can deduct contribution to own retirement

account for AGI Can hire spouse as employee and spouse can

then participate in fringe benefits

10 - 8

Self-Employment Taxes

Self-employed individuals (sole proprietors, general partners, and managing members of LLCs) must pay self-employment taxes (Social Security and Medicare)Deduction allowed for 50% of self-employment tax for AGI

10 - 9

Partnerships

A partnership is a relationship between 2 or more individuals (or other entities) to operate a business and share profits

No limit on number of partners No restrictions on who can be a partner

Any type of entity, including an individual, another partnership, a corporation, an estate, or a trust

Most LLCs are partnerships for tax purposes

10 - 10

General Partnership

General partnerships have only general partners

General partners: 1) Are personally liable for all debts of the

partnership2) Have an active role in management3) Have the authority to bind the partnership with

respect to third parties

10 - 11

Limited Partnership

Limited partnerships have at least one general partner and at least one limited partner

Limited partners: 1) Liability is limited to invested capital2) Are not permitted to have an active role in the

management of the partnership 3) Do not have the authority to bind the

partnership with respect to third parties

10 - 12

Limited Liability Partnership

The LLP is a general partnership that conducts a business providing professional services

Partners in an LLP are fully liable for the general debts of the partnership

This entity protects partners from liability for malpractice of other partners, however

10 - 13

Limited Liability Company

An LLC is a separate entity from its owners (members)

LLCs provide members with limited liability LLCs can choose to be taxed as partnerships or

corporations for federal tax purposesSingle-member LLC cannot be taxed as partnership

Ownership structure allows different classes of ownership with different voting rights

Forming an LLC is a more formal process than forming a partnership and may be more costly

10 - 14

PLLC

The professional limited liability company is a professional service organization using the LLC form

PLLCs protect members from 1) Liability for malpractice of other members2) General liabilities of the business (similar to

corporate shareholders)

10 - 15

Partners Cannot Be Employees

General partners, managing LLC, and other active LLC members are considered self-employed individuals and are required to pay self-employment tax on net income passed through to themLimited partners and LLC members who are

only investors do not pay self-employment tax Partners and LLC members cannot be

employees and are not eligible for tax-free employee fringe benefits

10 - 16

Entity vs. Aggregate Concept

Entity concept – views the partnership as separate from the partnersPartner can sell property to partnership and

recognize gain or loss on sale Aggregate or conduit concept – views the

partnership as an extension of the partnersPartners are liable for debts of the partnershipPartners share gains and losses from operations

10 - 17

Partner’s Capital Account

Each partner’s capital account will show the partner’s claim on the net book value of the partnership assets

The difference between the partner’s capital account and partner’s tax basis is due to the unrecognized (deferred) gain or loss on property contributed

10 - 18

Partner’s Interests A partner has a proportionate interest in the

partnership assets A partner has a right to share in a

percentage of the partnership's profits and losses Share of income or loss is determined by

the provisions of the partnership agreement If no provision is specified, partners are

assumed to share profits and losses equally

10 - 19

Partnership Tax Year

Profits and losses flow through to partners on the last day of the partnership’s tax year

Partners report their share on their tax return in the year in which the partnership tax year ends

Partnership tax year is one of following:1) Tax year of its partners who own majority

interest2) Year of all the principal partners (owning more

than 5% interest)3) Month that provides least aggregate deferral of

income4) Natural business year (no more than 3-month

deferral of flow-through items)

10 - 20

Operating Results

Form 1065, information return, includes Schedule K (and K-1 for each partner) which shows separately stated items and aggregate income or lossSeparately stated items are those that cannot

be aggregated into net income because they are subject to some special treatment or limitation at the owner level

Partnership net income is the aggregate of all items that are not separately stated

10 - 21

Separately Stated Items

Capital gains and losses Section 1231 gains and losses Dividends and interest (and related expenses) Section 179 deductions Charitable contributions Medical and dental expenses paid by

partnership for partners Passive income AMT preferences and adjustment items Self-employment income

10 - 22

Operating Results

Partners must report their share of partnership income even if they receive no distributions from which to pay taxesPartners who need money to pay taxes on

income that is passed through should make sure partnership agreement permits withdrawals of cash for this purpose

10 - 23

Partner's Basis

Basis determines Maximum amount a partner can withdraw tax-

free from the partnership Limit on the amount of loss a partner can

deduct A partner's basis in his partnership interest

begins with his contribution to the partnership If property is contributed, partner’s basis

equals the adjusted basis of the property contributed

10 - 24

Partner's Basis

The partner's basis is increased by:1) Partner's share of income (including tax-

exempt income) 2) Recourse debt — creditor can look only to

general partners for repayment on default3) Nonrecourse debt — creditor can look only

to collateral for repayment on default4) Partner’s share of liabilities

General partner's share in all partnership liabilities Limited partner’s share in nonrecourse liabilities

10 - 25

Partner's Basis

The partner's basis decreased by:1) Reduction in liabilities 2) Partner's share of loss3) Distributions made to partner

Partner can never have negative basis To prevent negative basis, partner

recognizes gain equal to the amount by which a cash distribution exceeds basis

10 - 26

General Loss Limitation

If a partner’s share of losses exceeds the partner’s basis Partner can only deduct losses to the

extent of basis Excess losses are carried forward

(indefinitely) to future years until there is sufficient basis against which to deduct the unused losses

10 - 27

At-Risk Rules

Limits losses by recognizing partners are not at-risk for nonrecourse debt

At-risk rules limit deductibility of losses to partner’s basis minus nonrecourse debt Losses are carried forward until partner has

sufficient at-risk basis

10 - 28

Passive Loss Rules

The rules limit deduction of losses by passive investors, such as limited partners

Passive losses can only be deducted against income from other passive investmentsPassive losses cannot be deducted against

active income (including salaries) or portfolio income (interest & dividends)

10 - 29

Partner’s Guaranteed Payment

A fixed or guaranteed payment (or salary) made to a partner for services or use of capital is treated as a business expense deduction by the partnership and ordinary income to the partner receiving it

If the payments are dependent upon partnership operations, they are not guaranteed payments

10 - 30

Nonliquidating Distributions

Distributions are generally tax-free to partners

Distributions reduce the partner’s basis Reduce basis first for cash received then

for basis of other property distributed (partner takes partnership’s basis for property)

If cash distribution exceeds partner’s basis, the partner recognizes gain for the excess

Loss is never recognized on nonliquidating distributions

10 - 31

Liquidating Distributions

Gain recognized only if cash received exceeds partner’s basis (same as nonliquidating distribution)

A partner may recognize loss only if the total basis of cash and ordinary income property received is less than his partnership basis If partner receives any other property, the partner

allocates basis remaining in the partnership interest to that property (and loss is not recognized)

10 - 32

Sale of Partnership Interest

Any gain or loss recognized on sale of partnership interest is normally capital gain or loss If partnership owns ordinary income assets (hot

assets), the sale must be partitioned between the hot assets and all other assets to prevent the partner from converting gain on sale of ordinary income assets to capital gains

Any reduction in liabilities is treated as cash received

Partnership tax year closes for selling partner

10 - 33

S Corporations

Qualifying corporations that elect S corporation status use conduit (flow-through) concept to achieve only one level of tax

Profits and losses allocated to shareholders according to the number of shares of stock owned on each day of the tax year

Afford shareholders the limited personal liability of a regular corporation

10 - 34

S Corporation Requirements

1) Must be a domestic corporation2) Have only one class of stock outstanding3) Have no more than 100 shareholders (family

members are considered one shareholder)4) Can have only individuals, estates and certain

trusts as shareholders5) Individual shareholders must be either U.S.

citizens or resident aliens

10 - 35

Electing S Status

File Form 2553 by 15th day of the 3rd month of the year in which election is to be effective File by March 15, 2010 for calendar year

2010 Prospective election (effective for following

tax year) can be made any time IRS has authority to accept late filing if

corporation can show reasonable cause

10 - 36

Affirmative Terminationof the S Election

A retroactive revocation must be made by the 15th day of 3rd month by a simple majority of the shareholders

A prospective termination can be made at any time for any future date specified by a simple majority of the shareholders

10 - 37

Inadvertent Terminationof the S Election

If the S corporation fails to satisfy any of the S corporation requirements at any time, the election is terminated as of the day before the disqualifying event occurredFor example, exceeding the 100 shareholder limit

If termination inadvertent, IRS can allow corporation to continue as S corporation

10 - 38

S Corporation Operations

Determination of net income and separately stated items is similar to partnerships

S corporation net income not subject to self-employment taxesEmployment taxes paid only on salariesShareholder cannot participate in employee fringe

benefits if ownership is greater than 2% Form 1120S reports operations

Income and loss allocated on number of days ownership and number of shares owned

10 - 39

Loss Limitations

Limitations on loss deductions for shareholders similar to those for partners

Liability treatment very different from partnershipNo basis increase for any corporate liabilityShareholder can deduct loss to the extent of

basis in debt for money loaned directly to corporation

10 - 40

Stock Basis

Each shareholder must keep track of stock basis, similar to tracking a partnership basisBasis begins with contribution to capital or

purchase of stockIncreased for income and gainsReduced first for distributions and then for

deductions and losses (including nontaxable income and expenses), but not below zero

Distributions are tax-free if they do not exceed basis; gain recognized if distribution exceeds basis as if stock is sold for excess

10 - 41

AAA

Accumulated adjustment account – a corporate account that tracks a corporation’s undistributed but previously taxed earningsThe positive balance in AAA is the measure of

the value of cash and property that can be distributed to shareholders without additional tax

Unlike basis, AAA may be negative from losses (but distributions cannot make AAA negative)

10 - 42

Property Distributions

Corporation Recognizes gain on distribution of appreciated

propertyDoes not recognize loss on depreciated property

Shareholders Increase their stock basis for the gain recognized Basis is then reduced for FMV of distributed

propertyUnrecognized loss reduces basis, however

Shareholders use FMV for basis of all property received

10 - 43

Schedules M-1, M-2 and M-3

Schedule M-1 reconciles book to tax income and is similar to C corporation’s M-1 without contribution carryovers or taxes paid

Schedule M-2 reconciles AAA account at beginning of year to balance at end of yearOAA reconciles items that do not affect AAA (tax-

exempt income and expenses) Schedule M-3 is a detailed reconciliation of book to

tax income and is required for corporations with $10 million or more in assets

10 - 44

S Corporation Taxes

Under normal circumstances, an S corporation does not pay taxes

If it was previously a C corporation, it may pay taxes in a few special cases for1) Built-in-Gains2) Excess Net Passive Investment Income3) LIFO Recapture

10 - 45

Redemptions and Liquidations

S corporations follow C corporation rulesIn a redemption of stock for property, S

corporation recognizes gain on distribution of appreciated property (but not loss)

Recognized gain flows through to shareholders and increases basis

In liquidation, both gains and losses are recognized; these gains (losses) flow through and increase (decrease) stock basis

10 - 46

U.S. Production Activities

Deduction is 6% of income from qualifying U.S. production activitiesDeduction determined at the owner level

based on owner’s share of qualifying production activities income

Limitation based on 50% of W-2 wages paid is determined at entity level

10 - 47

Passive Income and Losses

Passive losses can only be deducted by owner/recipient to the extent there is passive income from a prior year or from another passive activity

Passive losses may be deducted against nonpassive income in year activity is completely disposed of

10 - 48

Types of Income and Losses

Active – salary and wages of an employee and income earned from a business in which the owner/recipient materially participates

Portfolio – interest and dividends Passive – tax shelter income, income passed

through to limited partners, and income from other businesses in which owner/recipient does not materially participate

10 - 49

Material Participation

Current activity levela) 500 hours or more participation during yearb) Participation is substantially all the activity by all

personsc) At least 100 hours and no one else participates

mored) At least 100 hours in more than one activity and

aggregate of activities exceeds 500 hours Prior activity level

a) Materially participated in 5 of preceding 10 yearsb) Materially participated in 3 prior years in

personal service activity

10 - 50

Rental Real Estate Relief

Taxpayers can qualify for up to $25,000 deduction for rental real estate losses

Taxpayer must own at least 10% and actively participate in managementSet rents, qualify renters, approve repairs

Deduction phases out for AGIs between $100,000 and $150,000

10 - 51

Real PropertyBusiness Exception

Taxpayer may deduct loss currently if:Taxpayers spends more than half their time in

real property businesses in which they materially participate and time spent equals or exceeds 750 hours

Usually eliminates persons who hold full-time positions in other occupations

10 - 52

The End