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Non-Corporate Forms of BusinessSole ProprietorshipPartnershipLLCS corporation

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Sole ProprietorshipTrade or business conducted by one individual

in an unincorporated formOperating income and expenses reported on

Schedule C of individual Form 1040 Net loss deductible against other income

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What is a Trade or Business? Term is never defined in the Code or Regulations Criteria:

Profit motive Continuous, regular involvement in the activity Livelihood, not a hobby

If an activity is a hobby, not a trade or business, related expenses are deductible only against income from the activity Business presumption if activity shows a profit in 3 of 5

consecutive years

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Home Office Deduction Qualification

Part of home used regularly and exclusively as principal place of business or to meet with clients, customers or patients

Use for administrative activities qualifies if taxpayer has no other location for such activities

For employees, use must be for convenience of employer and required as a condition of employment

Amount of deduction Allocable portion of expenses of maintaining home (mortgage

interest, taxes, insurance, utilities, repairs, depreciation) Deduction limited to net income earned from

the home office activity

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Employee/Employer Payroll TaxesEmployees and employers each pay:

Social security tax = 6.2% of compensation up to $87,000 (2003)

Medicare tax = 1.45% of compensation Employee portion is withheld and remitted by

employer Employer portion is deductible for income tax

purposes, employee portion is not deductible

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Self-Employment (SE) TaxSole proprietors pay SE tax on net earnings

from self employment tax base = 92.35% of net profit tax rate:

• Social security tax =12.4% of earnings up to $87,000 (2003)

• Medicare tax = 2.9% of earnings

Self-employment tax is paid via estimated tax payments rather than through withholding

50% of SE tax deductible for income tax purposes

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Example: Tax Treatment of Conduit Entities and their Owners

Conduit entity X is owned in equal shares by Bob and Martha. In year 1, X earns taxable income of $100,000. All of this income is retained by X to develop the business; Bob and Martha receive no distributions in year 1. In year 2, X earns taxable income of $200,000 and distributes $100,000 in total to its owners. In year 3, X earns $100,000 and distributes $150,000 in total to its owners.

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Example continued How much income will Bob and Martha report in

years 1, 2, and 3 as a result of their ownership of X?• Year 1: $50,000 income per owner

Year 2: $100,000 income per ownerYear 3: $50,000 income per owner

Critical point:• The owners are taxed when the entity earns income,

regardless of when or if such income is distributed to the owners

• The amounts distributed to each owner are not included in taxable income

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PartnershipsA ‘syndicate, group, pool, joint venture, or other

unincorporated organization’ carrying on a business, financial operation or venture

General partner: Typically involved in partnership management, has unlimited liability for partnership debts

Limited partner: Cannot be active in partnership management, liability limited to investment in partnership

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Partnerships continuedTaxation of partnership income

Partners are taxed on their ‘distributive share’ of partnership income

• Reported to each partner on Schedule K-1

• Partners are taxed when income is earned by the partnership, regardless of when or if any cash is distributed to the partners

• ‘Special allocations’ are permitted, as specified in the partnership agreement, to reflect differences in partner contributions and liability

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Partnerships continuedTaxation of partnership income continued

Special items of income and deduction retain their character at the partner level

• Examples: muni interest, capital gains and losses

Publicly Traded Partnerships Partnership interests traded on an established

securities market Generally taxed as corporations

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Partnerships continuedTax basis of partner’s interest in a partnership

Initial tax basis = cost if acquired by purchase, or carryover basis + gain recognized if acquired in a non-taxable exchange (Chapter 8)

Adjusted annually to reflect activity of partnership• Ending Adjusted tax basis = Beginning adjusted basis

+ allocable share of partnership income or gain - allocable share of partnership loss or deduction + additional capital contributions - distributions +/-changes in share of partnership debt

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Debt As Investment BasisPartners may include their allocable share of

partnership debt as basis Determination of ‘allocable share’ is complicated

when both general and limited partners exist and depends on recourse vs. nonrecourse nature of the debt

• General rules– recourse debt allocated to general partners

– nonrecourse debt allocated to all partners

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Importance of Basis CalculationBasis determines gain/loss on disposition of

partnership interestPartners may not deduct allocations of losses in

excess of tax basisDistributions in excess of tax basis result in

taxable gain

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SE Tax Assessments on PartnersSelf-employment earnings include

General partners’ distributive share of net partnership earnings

• Limited partners not subject to SE tax

Guaranteed payments from the partnership• Fixed distributions of earnings, usually as compensation

for time and effort expended in the partnership business

• Partners cannot be regular employees of partnership, so not subject to payroll taxes

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Limited Liability CompanyAn unincorporated business entity, usually

taxed as a partnershipPrimary advantage of an LLC

Provides the limited liability not available to general partners, without the participation restrictions of limited partners

Potential disadvantage of an LLC Relatively new form, with undeveloped case law

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S CorporationsRequirements for election

No more than 75 shareholders Shareholders must be individuals, estates or certain

trusts; no nonresident alien shareholders Must be an eligible domestic corporation with only

one class of stock issued and outstanding All shareholders must consent to the election, which

is binding until revoked or terminated

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S Corporations continuedAdvantages of S Corporation treatment

S corporation income avoids the double taxation of the corporate income tax system

S corporation income, gains and losses are passed through and taxed to its shareholders

S corporations are not subject to the corporate alternative minimum tax, the accumulated earnings tax or the PHC tax

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S Corporations continuedTaxation of S Corporation income

Shareholders are taxed on their prorata share of S corporation income or loss

Special items of income and deduction retain their character at the shareholder level

S corporation is subject to certain special taxes at the entity level

• Examples: Built-in gains tax, excess net passive income tax

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S Corporations continuedTax basis of shareholder’s investment in S

corporation stock adjusted annually in same manner as partner’s basis in partnership interest Exception: shareholder’s basis in S corporation

stock does not include share of debt• Loans from shareholder to S corp. create basis in debt

Distributions to S corporation shareholders• Generally treated as non-taxable recoveries of

investment, in manner similar to partnership distributions

• Not treated as dividends (C corporation treatment)

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S Corporations continuedBasis limitations

S corporation shareholders may not deduct losses in excess of both basis in stock and basis in loans from shareholder to corporation

Distributions in excess of basis result in taxable income

Shareholder compensation S corporation shareholders can be employees Earnings not subject to SE tax