Tax Lesson 5

Question 1

Selection process for entities includes consideration of factors:

Answer 1

Ease & cost of formation
Complexity of management & governance
How transferability & dissolution are achieved
Liability protection for owners’ personal assets
Reporting requirements & taxation

Question 2

Entities almost always formed under

Answer 2

State law

Question 3

Proprietorships & general partnerships

Answer 3

Less complex, inexpensive, easy to form

Question 4

Requirements for registration may include:

Answer 4

Initial registration with state
Annual filing requirements
State imposed operational requirements

Question 5

Proprietorships can be dissolved

Answer 5

At election of owner with no formal steps

Question 6

Liability protection

Answer 6

Not available for proprietorships, general partnerships, nor general partners of limited partnership & only to limited extent for LLPs

Question 7

For limited liability protection to continue

Answer 7

Entity must alert public to limited liability status in clear & identifiable manner
Failure to identify status pierced the veil & could result in personal liability of owners
To avoid piercing the veil: keep business & personal books/records separate, follow corporate formalities, address content in contracts/correspondence from view point of business entity not owners
Also maintain reasonable amount of liability insurance & be vigilant in meeting formalities

Question 8

Sole Proprietorships

Answer 8

1 individual
No filings, filing fees, transfer of assets
Formation easy & inexpensive
If collecting sales tax, register with state or local taxing authority
100% ownership interest, easy to self if find a buyer
Dissolution by discontinuing business & paying creditors or death
Capital limited to resources of proprietor
Unlimited legal liability
No guarantee of continuity

Question 9

Sole Prop Tax

Answer 9

Add schedule c to 1040
Use SSN unless employees then need EIN
No unemployment taxes on self, only employees
Does pay self-employment tax (15.3%) on own earnings & 1/2 SS taxes for employees
Can deduct all ordinary & necessary business expenses from gross income (deductions part 2 of schedule c)
Profit/loss from schedule c carried over to 1040
May make qualified contributions to retirement plan
To calculate self employed contribution to Keogh plan, use formula

Question 10

Keogh Contribution

Answer 10

1) self employment income x 92.35%
12.4% of $147k
Plus 2.9% all income
Equals self employment tax

Self employed contribution rate = contribution to others/1+ contribution to others

2) net self employment income - 1/2 self employment taxes = adjusted net self employment income x contribution rate = self employed contribution

Question 11

25% compensation limit for

Answer 11

Deductible employee contributions

Question 12

Advantages of sole prop

Answer 12

Easy to form
Simple to operate
Easy to sell business assets
Few admin burdens
Income passed through schedule c 1040

Question 13

Disadvantages of sole prop:

Answer 13

Limited sources of capital
Unlimited liability
No guarantee of continuity
Business income subject to self-employment tax

Question 14

General Partnerships

Answer 14

Joint
Not required to register with Secretary of State
Each general partner participate fully in management & act with full authority
Equal ownership/profits/loss unless specified
Usually have voting power proportionate to interest
Difficult to dispose of interest
Dissolution either voluntary or judicial (when don’t agree - most likely to arise when required unanimous)
Should have written agreement about interests & distributive share of profits/losses
Unlimited liability
Relaxed formalities
Employees able to receive tax free fringe benefits; not true for partners (can participate in qualified plan subject to limitations of sole prop)

Question 15

General Partnership Taxation

Answer 15

Not taxed at entity level
Form 1065 schedule k
Net income subject to self employment tax (15.3%)
Required to obtain EIN
Can deduct all ordinary & necessary business expenses from income
Can deduct losses against ordinary income to extent of investment/at risk amount
For contributions of services partner must recognize ordinary compensation income for value of services; amount recognized becomes basis
Basis adjusted each year (increased by income, decreased by losses, non deductible expenses, distributions)
Withdrawals not taxable but do reduce basis; additional withdrawals beyond basis considered capital gain

Question 16

Advantages of Partnerships

Answer 16

More sources of initial capital
More management resources available
Fewer admin burdens
Income/losses passed through for tax purposes

Question 17

Disadvantages of Partnerships

Answer 17

Transfer of interests more difficult
Unlimited liability
Income tax & basis adjustment results complex
Business net income subject to self employment tax
Partners entitled to few tax-free fringe benefits

Question 18

Limited Partnerships

Answer 18

2 or more
If limited participate in management become general
Usually at least one general partner
File partnership agreement - establishes who limited & who general
Dissolution same as general partnership
Transfer of limited difficult
Easier to raise capital because of liability shield for limited partners
General partners still have unlimited liability

Question 19

Income Tax for Limited Partnerships

Answer 19

Limited partners not subject to self employment tax

Form 1065 & schedule k1

Question 20

Advantages of Limited Partnerships

Answer 20

Pass through tax status
Flexibility in structuring interests
Limited partners not personally liable as long as don’t engage in management

Question 21

Disadvantages of Limited Partnerships

Answer 21

Must file with state to register
General partners liable for debts/obligations
Losses generally passive losses for limited partners

Question 22

Limited Liability Partnerships

Answer 22

Typically licensed professionals practicing together
Limited liability except for personal liability & malpractice
File with state to register; likely annual filings
Dissolution same for partnership (can be difficult due to finding similarly licensed professional)
Amount of capital contributed determines interest
Not personally liable for acts of other partners
Treated as partnership for tax
Flow through - not taxed at entity level

Question 23

Advantages of LLP

Answer 23

Pass through taxation
Flexibility in structuring ownership interests
Partners can insulate selves from acts of other partners

Question 24

Disadvantages of LLP

Answer 24

Required to file with state to register

Unlimited liability for own acts of malpractice

Question 25

``` Example Exam Question: Basis in LLP was $150j. Receive k1 from partnership showing the following: Cash withdrawal $30k LLP income $17500 Dividend income $5000 STCL $1400 Charitable contributions $2900 What is new basis? ``` A. $31400 B. $76400 C. $138200 D. $150000

Answer 25

C

Question 26

Family Limited Partnerships

Answer 26

Primary purpose of transferring to younger generations using annual exclusions & valuation discounts for minority interests & lack of marketability Usually transfer highly appreciated property that is expected to continue appreciating in return for small general & large limited partnership interests No income or gift tax consequences upon creation Owner values limited partner interests Usually transferability restrictions Usually valued 20-40% discount from FMV for calculating gift tax payable Original owner/transferor can maintain control Often a series of transfers Individual who transfers to FLP needs to be financially secure without transferred property from net worth & cash flow perspective Can help protect assets from creditors & in case of divorce

Question 27

Taxation of FLPs

Answer 27

Keep within 10-40% discount & keep FLP as separate books from personal Run it like a business Taxed as partnership Form 1065 k1 to general & limited partners General partner may be individual or corporation Limited partners passive & not subject to employment tax

Question 28

Advantages of FLPs

Answer 28

Control retained by senior family member Valuation discounts available for minority interests Annual exclusion gifts generally used to transfer interests Some creditor protection Restrictions can be placed on transferability of limited partnership interests of junior family members Commonly used as estate planning strategy

Question 29

Disadvantages of LLP

Answer 29

Attorney setup fees & costs Periodic valuation costs Operational requirements Potential IRS challenges regarding valuations & discounts

Question 30

Limited Liability Companies

Answer 30

1 or more meeting state statutory requirements Register with Secretary of State Articles of Organization Resident agent Annual filings Contributions usually determine ownership Disposal/transfer can be difficult & May be restricted - clarified in operating agreement Easier to raise capital No limit on number or type of members Limited liability unless pierce the veil Management determined by operating agreement (not filed with state) May have simple majority, super majority, or unanimous votes Not legally required to have operating agreement / governed by state laws

Question 31

Taxation on LLCs

Answer 31

Single owner schedule c on 1040; like sole prop More than 1 owner: elect partnership, s corp, or c corp Tax status will dictate self employment tax & fringe benefits No gain recognized on distribution of appreciated property unless exceeds basis Usually taxed as partnerships (except rental real estate income, & LLC members not managing member)

Question 32

Advantages of LLCs

Answer 32

Limited liability Number of members unlimited Single member LLC disregarded entity for tax purposes Income passed through to members k1 Double taxation avoided in partnership elected Members can participate in managing LLC Distributions do not have to be directly proportional to ownership interests Can have multiple classes of ownership Can elect tax status

Question 33

Disadvantages of LLCs

Answer 33

May have limited life Transfer of interests is difficult & sometimes limited by operating agreement Some industries/professions not permitted to use LLC status Laws vary from state to state Laws are relatively new; less precedent from prior court cases Complex partnership rules for tax purposes Members not meeting exceptions subject to self employment tax on all earned income if partnership status

Question 34

C Corporations

Answer 34

Chartered legal entities File charter document with state Articles of incorporation disclose name, number of shares, purpose of corp (May be broad or specific) Required to name registered agent Shares may be easy to transfer if there is a market, May be restrictions through shareholder agreement May be all one class or several classes of stock shares Easily raise capital Limited liability to invest capital Managed by one or more officers appointed by board of directors Board is governing body - appoints various offices Board should operate very formally

Question 35

C Corp Taxation

Answer 35

Form 1120 Pay taxes on own income Owner/employees treated as employees for payroll tax purposes Entity withholds 7.65% for SS & matches withholding for SS tax Owner/employees comp not subject to self employment Distributions in capacity as shareholder considered dividends C corp not allowed to take deductions for dividends but shareholders must include in income Double taxation Non-cash distributions of appreciate property: gain must be recognized at corporate level as though had been sold & cash proceeds distributed Gain recognized at corporate level

Question 36

Corporation Income Tax Rates

Answer 36

Corporate tax is flat rate of 21%

Question 37

Dividend Received Deductions (DRD)

Answer 37

Ownership <20%: 50% Between 20-80%; 65% 80%+: 100%

Question 38

Example Exam Question: C corp owned 15% of company. Company paid dividend to corp of $45000. Does not receive dividends from any other corp. How much will corp’s drd be? A. $6750 B. $22500 C. $36000 D. $45000

Answer 38

B

Question 39

C corp net operating loss

Answer 39

Carried forward indefinitely

Question 40

Personal Service Corporation

Answer 40

C corp Services of Health, law, engineering, architecture, accounting, actuarial service, consulting & substantially all stock owned by employees Taxes at 35%

Question 41

Tax C Corp

Answer 41

Double taxation of dividends 15% for taxpayers typically Owners who take significant salary may have IRS reclassify salary as dividend income

Question 42

Advantages of C Corps

Answer 42

``` Relative ease of raising capital Limited liability of shareholders Unlimited life of entity Ease of transfer of ownership interests Generally more management resources Shareholder/employees May receive full array of employer provided tax free fringe benefits ```

Question 43

Disadvantages of C Corps

Answer 43

``` Potential for double taxation Admin burdens More difficult to form Dissolution can cause taxable gains Borrowing may be difficult Requires registered agent Requires federal tax id number ```

Question 44

S Corporations

Answer 44

First forming c corp then filing s election with IRS Cannot have more than 100 eligible stockholders Ownership restricted to US citizens/residents, estates, certain trusts, & charitable organizations (ESBT trust can) Corp must be eligible created under laws of US or any state Insurance companies, domestic international sales corporations (discs), & certain financial institutions not eligible for s status One or more officers from bird of directors Only allowed 1 class outstanding stock Stock can have shares with & without voting rights Ownership evidenced by shares of stock Easier to raise capital IRC allow close family members to be treated as single stockholder Limited liability unless: Lender requires loan guarantee Pierce the veil (fraud, circumvent law, illegal purposes) If not maintained as separate entity

Question 45

S corp taxation

Answer 45

Pass through income Owner/employees considered employees 7.65% SS tax withheld Not considered self employment income Distributions beyond reasonable compensations treated as dividends not subject to payroll tax In kind distributions of appreciated assets treated as sale/capital gain to all shareholders in proportion to ownership even if only distributed to one shareholder Form 1120s schedule k1 Not required to pay tax at entity level Taxable basis adjusted each year Increased by distributive share of both taxable & non taxable s corp income Decreased by share of losses, non deductible expenses, & distributions Distributions non taxable up to basis

Question 46

Example Exam Question: Purchased 24 share of s corp’s 200 shares of common stock outstanding. Held for 219 days in taxable year. If S corp reported taxable income of $300000, what amount included on personal tax return? A. $21600 B. $36000 C. $43200 D. $72000

Answer 46

A

Question 47

Advantages of S Corps

Answer 47

Income passed through to shareholders Taxes at individual level which may be lower than applicable corporate rate Limited liability Distributions exempt from payroll tax system assuming adequate compensation to shareholder/employees

Question 48

Disadvantages of S Corps

Answer 48

Limited to 100 shareholders Only 1 class of stock Cannot have corporate, partnership, certain trust, or nonresident alien shareholders Shareholder employees owning more than 2% of company must pay taxes on range of employee fringe benefits that would be tax free to shareholder/employee of c corp Tax rate on individual May be higher than corporate tax rate Borrowing may be difficult without stockholder personal guarantees

Question 49

Personal Holding Company

Answer 49

Both: Personal holding income test: at least 60% of corp’s AGI from dividends, interest, rent, & royalties Stock ownership requirement: any time during last half of tax year more than 50% in value of outstanding stock owned directly/indirectly by 5 or fewer individuals

Question 50

If you have significant personal income & expect business to have a loss

Answer 50

Flow through entities

Question 51

If want to be able to allocate income/losses in percentages different than ownership

Answer 51

LLC taxed as partnetship

Question 52

Concerned about liability

Answer 52

Avoid sole prop & general partnerships

Question 53

If significant income expected from business

Answer 53

Consider c corp

Question 54

``` Example Exam Question: Which provides limited liability for all owners? 1. Limited partnership 2. Corporation 3. S corporation ``` A. 3 B. 1,2 C. 2,3 D. 1,2,3

Answer 54

C

Question 55

Example Exam Question: Doctor investing in new business. Experience losses in first year. Concerned about protecting personal assets. Which entity do you recommend? A. Sole prop B. S corp C. C corp D. Partnership

Answer 55

B

Question 56

Example Exam Question: Owns 100% ph inc. ph inc owns 80% rm inc. rm inc pays dividends. Which would benefit most from rm dividend payments? A. S corp B. C corp C. Sole prop D. LLC

Answer 56

B

Question 57

Deduction for qualified business income

Answer 57

20% for partnership, s corp, sole prop As well as aggregate qualified real estate investment trust dividends, qualified cooperative dividends & qualified publicly traded partnership income Not allowed in computing AGI but is an allowable deduction reducing taxable income Limitation based on w2 income $170,050 (single) phaseout

Question 58

Lesson 5 Review: CPA performed services from partnership & in lieu of normal fee accepted 15% unrestricted capital interest in partnership with FMV of $10k. How much income should be reported on tax return? A. $0 B. $1500 C. $10000 D. $66667

Answer 58

C

Question 59

``` Lesson 5 Review: S corp had following info for tax year: Net income: $60k Salary to employee: $18k Rental income: $22k Rental expenses: $29k Net income: $35k 40% owner in s corp performs services What is self employment income from corporation abject to self employment tax? ``` A. $0 B. $2670 C. $35000 D. $60000

Answer 59

A

Question 60

Lesson 5 Review: During year purchase 5 shares of s corp’s 100 shares. Held for 146 days during tax year. If s corp reported taxable income of $300k, what amount must be included on personal tax return? A. $0 B. $6000 C. $15000 D. $120000

Answer 60

B

Question 61

``` Lesson 5 Review: Partnership basis was $100k. Received following information: Cash withdrawal: $60k Partnership income: $35k Dividend income: $10k STCL: $2800 Charitable contribution: $5800 What is new basis? ``` A. $31400 B. $76400 C. $100000 D. $145000

Answer 61

B

Question 62

Lesson 5 Review: C corp owns 25% company. Company paid dividend of $30k to c corp. Assuming does not receive dividends from any other corp, how much will dividends received deduction be? A. $0 B. $10k C. $19500 D. $30k

Answer 62

C

Question 63

Lesson 5 Review: S corp showed following income/distributions each year: Yr 1: taxable income $55k, distributions $35k Yr 2: ti $60k, d $25k Yr 3: ti $50k, d $35k Yr 4: ti $40k, d $50k Company has had single shareholder since beginning & basis was $10k. What is basis at end of year 4? A. $5k B. $10k C. $70k D. $215k

Answer 63

C

Question 64

``` Lesson 5 Review: Received 70% capital interest in general partnership by contributing: Land: basis 60 fmv 100 Debt on land: fmv -50 Inventory: basis 10 fmv 8 Services: fmv 2500 What is basis after contribution? ``` A. $20k B. $57,500 C. $70k D. $110,500

Answer 64

B

Question 65

Lesson 5 Review: General partner in general partnership. Received k1 which contained: Taxable income: $200k Dividend income: $2500 LTCG: $6000 How much self employment tax will have to be paid? A. Not required B. $14,130 C. $17,707 D. $23,584

Answer 65

D

Question 66

Lesson 5 Review: Which is not requirement of a corp status? A. Must have at least 2 classes of stock B. May not have more than 100 shareholders C. Nonresident alien not an eligible shareholder S corp must be created under laws of US or any state

Answer 66

A