Principles of Taxation

1. Principles of Taxation Chapter 9 Sole Proprietorships, Partnerships, and S Corporations

2. 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 partnerships. • Differentiate between partnership distributive income versus cash flow. • Compute partnership adjusted basis. • Determine eligibility for S Corporation status. • Contrast basis limits for S Corporations versus partnerships.

3. Business Organizations • Taxpayer = owners = passthrough entities • sole proprietorship • partnerships • LLCs • S Corporations • Taxpayer = corporation • C Corporation is taxed first, then shareholders may be taxed on distributions (double taxation).

4. Sole Proprietorship • Business income and expenses are reported on Schedule ____, filed with the individual form 1040. • 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 ___ years and forward ___ 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. See 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 • 1) as the... • or • 2) as a place to meet with____________ ____________or ____________. • A home office used exclusively for administrative or management activities qualifies as a principal place of business under what conditions?

7. Home Office Deduction • If the office qualifies under above rules: • Allocate expenses between business and personal use. What are some examples? • Home office deduction cannot exceed taxable income of the business before this deduction. See AP2. • IR3, 4

8. Employment Taxes • FICA = _______% Social Security tax (on wages up to $________ in 2001) + _____% 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 ______% of net earnings from self-employment. (See footnote 20 for details). _______ of SE tax is deductible on Form 1040.

9. Partnerships • Are partnership agreements flexible? • 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.

10. Partnership Reporting • The partnership files an information return, Form 1065. • Included with the Form 1065 are Forms ______, 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 1040. Certain items are separately stated. Q9 • Does the partnership pay tax?

11. 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.

12. 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 $_________ of partnership income ($25,000 + 1/3 x $60,000). • John and Joseph each report $________ of partnership income (1/3 x $60,000).

13. Self-Employment Income From Partnership • SE tax must be paid on • Guaranteed payments + • ____________ partners do NOT pay SE tax on share of ordinary income.

14. Partnership Basis • These things increases basis: • Contributions (initial and ongoing): cash + ______ ________ 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).

15. Partnership Losses Limited to Basis • Partners CANNOT deduct losses in excess of ________ . 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. • AP11, 12 • Are there questions about examples in the text? This can be complicated.

16. Other Entities • Limited Liability Company • Treated as a corporation for liability purposes, but as a partnership for federal tax purposes. • Limited Liability Partnership • A partnership in which each partner’s liability is limited to his or her own actions. Used by professional service firms.

17. S Corporations • Legally a corporation under state law. • An S Corporation is a passthrough entity for tax purposes. • Income and loss items are allocated among shareholders based on what?(This allocation is not flexible like partnership agreements.) • Passthrough items retain their character on the individual tax return (e.g. ordinary income, capital losses, charitable contributions, etc).

18. S Corporation Eligibility • What kinds of taxpayers can be shareholders? • The number of shareholders (not including spouses) is limited to ____. • The corporation may only have one class of outstanding common stock. • Shareholders must unanimously elect S Corp status.

19. Shareholder Basis • Initial basis = cash + adjusted basis of contributed property. • How do loans affect shareholder’s basis? Contrast this to partnerships. See AP19, 20 • Like partnerships, basis is increased by contributions and income items. Basis is decreased by distributions and loss items.

20. S Corporation Operation • Shareholders can be paid a salary. The salary is subject to payroll taxes and reduces ordinary income of the S Corporation. • Is ordinary income subject to self-employment tax? • Allocable share of loss items can only be deducted up to BASIS, like with partnerships. What happens to losses in excess of basis?