Module 5: Essentials of Business Entity Taxation

Question 1

What is the cash accounting method?

Answer 1

When a taxpayer generally reports income when cash is collected (or constructive receipt income tax doctrine applies), and expenses when any cash payment is made. Used by taxpayers whose annual average gross receipts do not exceed $27 million for the three prior tax years.

Question 2

Who may use the cash method of accounting?

Answer 2

Individuals, sole proprietorships, partnerships that don’t have C corps as partners and whose average annual gross receipts for any three-year preceding period do not exceed $27m, C corps with the $27mm rule, and qualified personal service corporations.

Question 3

What is the accrual method of accounting?

Answer 3

The conceptual opposite of the cash method, and requires recognition of taxable income in the same tax year it is reported on the taxpayer’s financial statements, and for expenses to be reported as they are incurred.

Question 4

For whom is the accrual method mandatory?

Answer 4

For any business that maintains inventory, unless the average annual gross receipts are $27 million or less.

Question 5

What is the hybrid method? Can you give me an example?

Answer 5

Taxpayers may account for some items of income using the accrual method and others with the cash method. example would be an automobile dealership, where the accural method would report income from car sales and the cash method would be used to recognize income from service-related transactions involving car repairs and maintenance.

Question 6

What is the stipulation for changing accounting method?

Answer 6

Must have IRS approval.

Question 7

What is specific identification?

Answer 7

The specific identification method requires the owner to keep track of the cost of each item in inventory, and is only feasible in small businesses that have a relatively small number of relatively high-value items in inventory (e.g., art gallery or car dealer).

Question 8

What is the difference between a fiscal year and a calendar year? What is the requirement to change it?

Answer 8

A fiscal year is a 12-month period that ends on the last day of any month other than December. Must have IRS approval to change it.

Question 9

What does NOL stand for and who can claim it?

Answer 9

Net Operations Loss - available to self-employed individuals, regular corporations, and estate and trust entities. Not allowed for partnerships or S corporations.

Question 10

For how long can NOL be carried forward?

Answer 10

Indefinitely.

Question 11

WhaFt is the limit of the loss of an NOL?

Answer 11

80% of the total taxable income reported for the carryforward years.

Question 12

What is a C corp?

Answer 12

A person (entity) separate from its shareholders/owners for income tax purposes.

Question 13

How are the earnings from a C corp taxed?

Answer 13

They are taxed to the corporation at special corproate income tax rates.

Question 14

What is the major disadvantage of the corporate form?

Answer 14

The double taxation of profits. The corporation is taxed on income and pays dividends from after-tax income to shareholders, who are then taxed on the dividend.

Question 15

What is the major advantage of the corporate form?

Answer 15

The limited liability accorded to the shareholders for corporate obligations.

Question 16

What is the dividends-received deduction?

Answer 16

A special that allows a corporation to deduct dividends received from another company. If the receiving corporation owns less than 20% of the distributing corporation, then it may deduct 50% of the dividends. It it owns 20% or more, it may deduct 65% of the dividends.

Question 17

What is the objective of the accumulated earning tax?

Answer 17

To coerce the regular corporation into paying dividends to its shareholders.

Question 18

When does the accumulated earning tax apply?

Answer 18

When a corporation accumulated earnings beyond its reasonable business needs.

Question 19

What is the accumulated earnings credit?

Answer 19

$250k for non PSCs (personal service corporations, and $150k for PSCs.

Question 20

What are the fields that qualify to be a PSC?

Answer 20

HALE: health, accounting, law, and engineering (and consulting).

Question 21

What are the 2 stipulations for being a PSC?

Answer 21

1: Substantially all of the activities perform one of the services in the approved fields (health, accounting, law, engineering).

2: At least 95% of the stock by value must be owned by employees performing the services.

Question 22

What is the objective of the personal holding company tax?

Answer 22

To discourage closely held corporate owners from using the separate corporate entity as an investment shell.

Question 23

What are the two tests for the PHC?

Answer 23

An ownership test- more than 50% of stock is owned by five or fewer individuals.

Passive income test - at least 60% of the corporations adjusted ordinary income comes from securities and other income-producing property.

Question 24

How much is the PHC tax?

Answer 24

20% flat rate of the undistributed personal holding company income (income produced from securities and other income-producing property).

Question 25

What are the stipulations for Section 1244 stock?

Answer 25

Capital contributions to the company cannot exceed $1mm at the time of forming, and stock must be exchanged for investor money, and not services.

Question 26

What is special about Section 1244 Stock?

Answer 26

Sale of the stock at a loss is treated as an ordinary loss, and may be deducted against ordinary income, reducing the individual’s tax liability.

Question 27

What is the maximum amount of loss that can be deducted as an ordinary loss Section 1244 stock?

Answer 27

$50k for single taxpayers, $100k if married.

Question 28

What is special about Section 1202 Stock?

Answer 28

Taxpayers other than C corporations that hold qualified small business stock for more than five years may exclude a portion of the gain on the sale of the stock.

Question 29

What is the maximum of the gain eligible for the exclusion for Section 1202 Stock?

Answer 29

The greater of 10 times the taxpayer’s basis or $10 million of gain from the stock in that corporation.

Question 30

What are the stipulations for Section 1202 stock?

Answer 30

The qualified small business corporation must be a C corporation and must not have aggregate gross assets in excess of $50 million when the stock is issued. Also, 80% or more of the value of corporate assets must be used in the active conduct of one or more qualified trades or businesses. Additionally, the stock must be original issue stock acquired after August 10, 1993 for money or property other than stock, or as comp for services other than underwriting.

Question 31

What are the defining characteristics of a sole prioprietorship?

Answer 31

No formal legal documents are required, and all income and losses pass directly through to the businessowner and are reported on the businessowner’s income tax return. The taxable income is reported on Schedule C of IRS form 1040, and the owner is subject to self-employment tax on business net income. If business loss exceeds allowable excess business loss limits, the owner may carry the excess loss forward indefinitely.

Question 32

What is the overwhelming disadvantage of a sole proprietorship?

Answer 32

The businessowner is personally liable for all debts and claims against the business.

Question 33

What are some other drawbacks of a sole proprietorship?

Answer 33

Difficulty of raising capital, lack of creditor protection, and the fact that the business dies with the owner.

Question 34

What are the defining characteristics of a general partnership?

Answer 34

There is common ownership in the business, there is sharing of profits and losses of the business, and gneeral partners are afforded the right to participate in the management.

Question 35

What is the taxation status for a general partnership?

Answer 35

Because they are pass-through entities, a tax return is filed for the partnership that is for information purposes only (Form 1065). The income and deductions are not taxed on the business level, but are passed-through to the partners on K-1s. They report their proportionate income on Schedule E of form 1040.

Question 36

How is the basis for ownership of a general partnership calculated?

Answer 36

It consists of the original cash or property contribution, which is then adjusted by earnings and losses and may be further increased by any direct loans to the partnership plus the share of any money borrowed by the entity on either a recourse (personal liability) or nonrecourse (secured by collateral) basis.

Question 37

What is a limited partnership?

Answer 37

A partnership in which the partner is liable to the creditors only to the extent of their contributed or promised cash or property.

Question 38

Does a limited partner have authority to bind the partnership entity or partcicipate in its management?

Answer 38

No.

Question 39

What is one main difference between a limited and a general partnership?

Answer 39

A limited partnership requires a written agreement. There is at least one general partner, responsible for day-to-day operations, and at least one limited partner.

Question 40

How are general and limited partners taxed? What is one main difference?

Answer 40

Both are self=employed for income tax purposes and pay self-employment taxes, half of which is a deductible expense by the taxpayer. However, a limited partner is only a passive owner for income tax purposes, and is subject to the passive activity rules. Most importantly, it is difficult for a limited partner to deduct any annual losses incurred from the operations of the partnership entity.

Question 41

What is a family limited partnership?

Answer 41

A type of limited partnership typically set up by a senior family member. They transfer assets to the FLP in exchange for a 1% GP interest and a 99% LP interest. Over time, they make transfers to the younger members of the family. Frequently used to transfer privately owned farming operations from one generation to the next, and a major benefit is the ability to reduce the gift and estate tax exposure.

Question 42

What is a limited liability partnership?

Answer 42

It exemplifies the characteristic of a general partnership with one major difference - in an LLP, the GPs are not liable for the acts of other partners. They are state-created entities, and the form is typically only available to professionals.

Question 43

What is an S Corporation?

Answer 43

A type of regular corporation that has made a special election to be taxed as a general partnership to obtain pass-through tax treatment.

Question 44

What are a few stipulations of S corps?

Answer 44

They must be organized under state law, and shareholders mut be US Citizens or residents. A partnership or regular corporation may not be a shareholder. An S corporation may only have one class of outstanding stock, and no more than 100 shareholders.

Question 45

How does the IRS treat S corporation shareholders?

Answer 45

As general partners. They are required to report the pro rata shares of corporate income that pass through. S corporations may not implement the special allocations of income and loss that general partnerships can.

Question 46

How does the basis calculation differ between an S corp and general partnership?

Answer 46

A general partner can report recourse and nonrecourse loans made to the partnership, whereas an S corp shareholder is only what they have personally loaned to the corporation in addition to their investment.

Question 47

What is the maximum deduction of pass-through income allowed to a noncorporate taxpayer who has QBI from a partnership, S corporation, or sole proprietorship?

Answer 47

20%

Question 48

What is the built-in gains tax as it applies to S corps?

Answer 48

Used to prohibit an S corp conversion to avoid a taxable liquidation. There is a tax applied on any disposition within five years after conversion.

Question 49

What is the LIFO recapture tax?

Answer 49

If a C corporation used the LIFO method of inventory valuation for its last year before making an S corporation election, then it must include in income the amount of excess found when comparing the inventory’s value under FIFO with the LIFO value.

Question 50

What is the net passive income penalty tax?

Answer 50

Applies to an S corporation that accumulated earnings and profits as a C corporation from prior periods, and more than 25% of the S corporation’s receipts are from passive investment income.

Question 51

What is a limited liability company?

Answer 51

Hybrid entity that combines the limited liability normally associated with either a C or S corporation and the pass-through tax treatment of a general partnership. Also allows for more than 100 shareholders.

Question 52

How may an LLC be taxed? There are four options.

Answer 52

As a:
-sole proprietorship (only permitted for on-member LLCs - owner files Form 1040)
-partnership - available for LLCs with two or more members and follows tax treatment accorded to general partners, including the basis advantages. If an LLC has two or more members, this is the default.
-regular or C corporation - this is available for any LLC and, just like a regular corporation, the entity will have two levels of taxation
-S corporation: members report income on their individual Forms 1040 based on the K-1s

Question 53

What is the QBI Deduction? What did it set out to do?

Answer 53

The deduction allows for a 20% deduction on pass-through business. This set out to reduce the amount that other non-C corporations paid as the TCJA reduced corporate tax rates.

Question 54

Who qualifies for a QBI deduction?

Answer 54

The income must be received from a qualified trade or business, which is not well defined. Rental real estate may qualify.

Question 55

What income qualifies for the QBI deduction? What else reduces the QBI?

Answer 55

20% of Net amount of income, gain, deduction and loss. Investment income is not included. It’s reduced by 1/2 of the self-employment tax, the self-employed health insurance deduction, and the Keogh deduction.

Question 56

What does the QBI reduce?

Answer 56

It reduces taxable income, rather than AGI, and is available to taxpayers who take the standard deduction. It is taken after AGI and is not an itemized education. The basic rule is: 20% of q

Question 57

What does the QBI deduction reduce?

Answer 57

It reduces taxable income, rather than AGI, and is available to taxpayers who take the standard deduction. It is taken after AGI and is not an itemized education.

Question 58

What is the basic rule for the QBI deduction and to whom does it apply?

Answer 58

The LESSER of 20% of QBI or taxable income in excess of net capital gains. Applies to those who make below the phaseout range.

Question 59

What are the specific restrictions on QBI deductions for earners who make above the phaseout range?

Answer 59

There is no QBI deduction allowed if the business is SSTB (specified service trade or business- health, law, accounting, actuarial science, performing arts, consulting, atheltics, financial services, brokerage services). For non-SSTBs, the deduction is the lesser of 20% of QBI or the greater of 50% of taxpayer’s allocable share of the W-2 wages paid by the business, or 25% of the share of wages paid plus 2.5% of the taxpayer’s share of unadjusted basis of all qualified property.

Question 60

What is the limit for a QBI deduction?

Answer 60

20% of the taxpayer’s taxable income, reduced by any capital gains included in the taxable income.

Question 61

What is qualified property?

Answer 61

Tangible property subject to depreciation used in the production of QBI. Depreciation period is ether 10 years or last day of service.

Question 62

What is the calculation done for someone within the phaseout range? How does it differ for SSTB vs non SSTB?

Answer 62

First, you find out what percentage they are within the range. Then you take that percentage and multiply it by the difference of 20% of the QBI and the greater of 50% of the allocation to wages paid by the business or 25% of the wage allocation plus 2.5% of unadjusted basis in qualified property. That is the amount by which the basic QBI deduction, 20% of QBI is reduced. If an SSTB, then the percentage is (1 - way through phaseout range).

Question 63

What is the self employment tax rate?

Answer 63

There is a 12.4% tax for Social Security up to the wage base, and a 2.9% Medicare tax rate for a total tax rate of 15.3%.

Question 64

What is the minimum earnings for the self employment tax rate?

Answer 64

$400 / year.

Question 65

What is the deductible portion of the self employment tax?

Answer 65

Half.

Question 66

What does self employment income include?

Answer 66

Net schedule C income, income paid to a partner, part-time earnings of an individual, and board of director fees.

Question 67

What is the formula for calculating self employment tax when income is at or below the wage base?

Answer 67

Calculate employment income, then subtract 7.65% (to account for the substitute deduction allowed), and multiply the remaining amount by 15.3%, the combined account for Medicare and Social Security.

Question 68

What is the formula for calculating self employment tax when income is above the wage base?

Answer 68

Calculate employment income, the subtract 7.65%, then subtract the wage base and multiply the excess by 2.9%, and multiply the remaining portion (the wage base) by the total amount (15.3%). Sum those two numbers.

Question 69

What portion of health insurance and qualified long-term care insurance is deductible for a sole proprietor, and with what stipulations?

Answer 69

They must be the spouse, dependent, or child of the taxpayer. The insurance plan generally must be established under the taxpayer’s business, though it needn’t be purchased in the business name.

Question 70

What are the special rules for a greater than 2% shareholder in an S corporation wrt health insurance deduction?

Answer 70

If the company pays for the premium, or reimburses the employee for the premium, then the insurance plan is said to be in the company name. The reimbursements are reported as income and are subject to income tax.

Question 71

How is the home office deduction calculated with the simplified method? How does it differ from the regular one?

Answer 71

The simplified method uses a standard $5 per square foot in the home, whereas the regular method uses a more complicated percentage of the total home calculation. The simplified method has a maximum of $1500.

Question 72

What is the “ordering rule” for the home office deduction?

Answer 72

Before any home deductions are considered, business expenses must be deducted first. Then, mortgage interest and taxes, and finally utilities and depreciation. If this meets (or exceeds) your business income, you may not create a loss with this deduction. Expenses may be carried forward.

Question 73

What is the main stipulation of the hobby rule? What is generally presumed not to be a hobby?

Answer 73

The only expenses that are generally permitted are cost of goods sold. Profits from the activity in any three of the previous five consecutive tax years. Only income - cost of good sold is reported.