Accounting for Different Business Entities

– Sole Proprietorship– C-Corporations– S-Corporations– Partnerships– Limited Liability Companies

November 15, 2012

Irma Miller MBA, CPAE-mail: info@irmamillercpa.com

Disclaimer:

• The views expressed in this presentation are my own and not necessarily those of the Kentucky Society of Certified Public Accountants, the American Institute Certified Public Accountants and the Internal Revenue Service.

• The information is not a substitute for consultation with an expert and the creator is not liable for problems arising from following the advice on the site.

• The laws and regulations are subject to change over time and recent changes after the date of this presentation may not be reflected on this presentation

Sole Proprietorship (legal)

• is a type of business entity that is owned and run by one individual and in which there is no legal distinction between the owner and the business.

• IRS (US federal tax authorities) defines a sole proprietorship as someone who owns an unincorporated business by himself or herself. However, if you are the sole member of a domestic limited liability company (LLC), you are not a sole proprietor if you elect to treat the LLC as a corporation. If there is only one member in the company, the sole proprietor or single member LLC is treated as a “disregarded entity” for tax purposes.

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Sole-Proprietorships

Sole Proprietorship (legal)

• The owner receives all profits (subject to federal, state and local taxation specific to the business).

• The owner is responsible for submitting estimated tax payments (quarterly) to federal, state and other agency.

• The sole proprietor is personally liable for all debts and actions of the business.

• Purchasing insurance to cover the risks of running the business is recommended.

• If more than one owner, form a partnership.• Sole Proprietor is less recommended for

Attorney Business / Law Firm

Sole Proprietorship (legal)

Advantages:• no formal filing• less government rules,

regulations, & compliance• less administration and

formalities• does not pay a separate

income tax at the business entity level, no double taxation

Disadvantages:• unlimited liability, a sole

proprietor is personally liable for all the debts and obligations of the business

• lack of continuity, and succession planning

• more difficult in raising capital• commingle with personal

information (married filing joint return on Federal 1040 with Schedule C, Profit or Loss from Business)

Formation of legal entity with secretary of state

The state law governs the default rules of each of legal entity formation and operation. Please check each of the 50 state website.

If the selected entity formation and operation chooses not to follow the default state law regulation, the opt-out of default state law regulation has to be in writing on the legal paperwork such as: article of organization, article of incorporation, operating agreement, bylaws, resolutions.

Please consult with business attorney !

C-Corporation (tax)

• C-Corporation refers to any corporation that, under United States federal income tax law, is taxed separately from its owners. (double taxation)

• Formation: Corporations are formed under the law of (50) states. Corporations are issued a “certificate of incorporation” or “articles of incorporation” by most states upon formation. Additional optional governing rules called “bylaws”.

• Guide to office of secretary of states http://smallbusiness.findlaw.com/incorporation-and-legal-structures/state-guide-corporations-offices.html

• Distributions: any distribution from the earnings and profit of a C-Corporation is treated as a dividend for US income tax purposes. (Publication 542 Corporations, Internal Revenue Services)

C-Corporation (tax)Advantages• may become public corporation,

shares being bought and sold through stock market or “over the counter”

• unlimited number of shareholders• unlimited classes of stocks/shares,

either voting or non-voting rights• limited liability, stockholders

generally not liable for debts of corporation

• flexible access of outside capital or financing

• eligible for dividends-received deduction under US Federal Income tax law (for 20% of more of ownership of certain corporation stocks)

Disadvantages• “double taxation”, dividend is

taxable on corporate level and end-user level

• not a pass-through entity , cannot pass through either loss or income to investors / shareholders

• higher administrative expense from being publicly traded than privately held corporation

C-Corporation (tax)

• C-Corporation files the Form 1120 business tax return to IRS (federal) annually.

• IRS Website for C-Corporation:

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Corporations

Reasonable Compensation in closely-held C-Corporation:

Corporate payments to a shareholder/employee are salaries or are dividends, which have different tax consequences.

Reasonable compensation factors involving analyzing if: (1) the amount of the salary is reasonable, and (2) the payment is “purely for services” .

C-Corporation (tax)

Reasonable Compensation in closely-held C-Corporation:C corporation income is double taxation – once when earned at the corporate level and again when paid as dividends at the shareholder level. To avoid this result, closely held C corporations tend to pay large salaries, or large year-end bonuses, reducing taxable income on corporate level, and resulting in only one level of taxation, at the shareholder level.IRS may disallow large compensation deductions to owners of closely-held C corporations, challenging the payments as “disguised dividends”. Treating a dividend as salary is less likely to be attempted in a publicly held corporation.

Menard, Inc. v. Comm., ((7th Cir) 2009 No. 08-2125

Pediatric Surgical Associates v. Comm. (TC Memo 2001-81)Multi-Pak Corp. v. Comm., TCM 2010-139

“Check the box”

• refers to “electing out” of the “default” classification• A new eligible entity that does not want the classification

provided by the “default” provisions or an existing eligible entity that wants to change its classification must file Form 8832, Entity Classification Election. The effective date may be specified in the election but may not be more than 75 days prior to the date that the election is filed.

• Eligible entities are able to choose whether to be taxed as a disregarded entity (sole proprietor/partnership) or corporation for federal tax purposes. An entity is not required, but may elect, to be classified as a corporation. (IRC Section 301.7701-1 to 301.7701-3)

S-Corporation (tax)

• S-Corporation are merely corporation that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes. (IRC Section 1361-1379)

• S-Election (IRC Section 1361(b)), a small business corporation must:– be a domestic corporation– have no more than 100 eligible shareholders– have only shareholders who are individuals, estates, certain

exempt organizations, or certain trusts– have only one class of stock

S-Corporation (tax)

• Ineligible shareholders:– non resident aliens– foreign trusts– IRAs (also Roth IRAs, Taproot Court Case)– C-Corporations– Partnerships– LLCs

• IRS Website for S-Corporation:http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/S-Corporations

S-Corporation (tax)

• Election to be an S-Corporation:A corporation elects to be treated as an S corporation by filing Form 2553, Election by a Small Business Corporation, at the appropriate IRS Service Center. An S corporation election is effective for the current year if it is filed on or before the fifteenth day of the third month of that year. Elections made after that date are effective for the following year. Each shareholder who owns stock at the time the election is made must consent to the election.

• Form 2553 can be filed with the first year Form 1120S S-Corporation Tax Return.

S-Corporation (tax)

• Formation: file with secretary of state either articles of organization or article of corporation depending on choice of legal form of entity allowed by state regulation. Additional optional governing rules call either “bylaws”, “operating agreement” or “business resolutions”.

S-Corporation (tax)

Advantages• The S-Corporation is not taxed

on its profit, the shareholders of an S-Corporation are taxed on their proportional shares of S-Corporation’s profit.

• The loss from S-Corporations flow through shareholders can be deducted limited to the shareholder’s basis. The shareholder’s basis must first be determined. (IRC Section 1366)

Disadvantages• Built-In Gains: when shifting

from C-Corporation to S-Corporation, the gain on appreciation would have been to recognize the same way as if the company has been a C-Corporation.

• The Sting Tax: a tax imposed on certain passive activity income when shifting from C-corporation to S-Corporation.

S-Corporation (tax)

Built-In Gains:

The Built-In Gains tax does not apply to a corporation that meets any one of the following:

• It made an S election prior to 1987 and has retained that election since.

• It made an S corporation election and has never been a C-corporation

• It has been an S corporation continuously for the 10 years preceding liquidation.

The built-in gains (BIG) tax was enacted to prevent corporations from making an S election solely to avoid double tax at liquidation.

S-Corporation (tax)

Built- In Gains:IRC Section 1374 requires the corporation to pay a corporate level tax

on certain property sales made in the 5-year (in 2011), 7-year (in 2009 and 2010) or 10-year (prior to 2009) recognition period following an S election by a C corporation.

The Sting Tax:If an S Corporation had ever been a C corporation and that C

corporation carried over subchapter C earnings and profits, the S corporation is subject to a corporate tax on its passive income that exceed 25% of gross receipts. (Internal Revenue Code Section 1375)

The sting tax can be avoided if the corporation has always been an S Corporation.

S-Corporation (tax)

Reasonable Compensation in S-Corporation:

FICA and FUTA taxes are imposed on compensation paid by an S corporation.

Dividend and undistributed income not subject to payroll taxes.

David E. Watson, P.C. v. USA, (S.DC Iowa) 4:08-cv-442, May 27, 2010, 2010 USTC

David E. Watson, a CPA created DEWPC, an S-Corporation. DEWPC agreed to provide accounting services exclusively to LWBJ Financial, a CPA, consulting and venture capital firm. In 2002, DEWPC paid $ 24,000 as salary to David even though it received over $ 203,000 from LWBJ. The rest was distributed as S corporation dividends. In 2003, David received $ 24,000 of salary.

S-Corporation (tax)Continued ……David E. Watson, P.C. v. USA, (S.DC Iowa) 4:08-cv-442, May 27, 2010, 2010 USTC

The IRS employment tax examiner recharacterized $ 130,730 of the 2002 dividend payments as wages subject to employment taxes and $ 175,470 of the 2003 dividend payments as wages subject to employment taxes. At court, the IRS reduced their characterization, arguing that only $ 67,044 of the dividend distributions should be recharacterized as wages for each of 2002 and 2003. DEWPC (David) asked for summary judgment against the IRS’ position. The Iowa District Court denied the summary judgment.

V.R. DeAngelis M.D., P.C. v. Comm., CA-2 2009-2 USTC July 28, 2009

Note: Supreme Court Denies Review of Case, May 17, 2010

Partnerships (legal)

“partnership” includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate (IRC Section 761(a))

Intent of subchapter KSubchapter K is intended to permit taxpayers to conduct joint business (including investment) activities through a flexible economic arrangement without incurring an entity-level tax. Please see the detail requirement on IRC Section 1.701-2(a)

IRS Website for Partnerships:http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Partnerships

Partnership that chooses to be treated as a disregarded entity file Form 1065 Annual Tax Return.

Partnerships (legal)

• A partnership is a for-profit business association of association of two or more persons. Because the business component is defined broadly by state laws and because “persons” can include individuals, groups of individuals, companies, and corporations.

• Creation, organization, and dissolution of partnerships are governed by state law. Many states have adopted the Uniform Partnership Act.

Partnerships (legal)

• General Partner share equal rights and responsibilities in management. Each individual partner assumes full responsibility for all the business’s debts and obligations. If the partnership opt for an unequal distribution, the percentage assigned to each partner must be documented in the partnership agreement.

• Limited Partner allows each partner to restrict his or her personal liability the amount of his or her business investment.

• At least one participant must accept general partner status, exposing himself or herself to full personal liability for the business’s debts and obligations.

• General Partner retains the right to control the business, while the limited partner(s) do(es) not participate in management decisions.

• Both general and limited partners benefit from business profits.

Partnerships (legal)

Advantages• Not required to file with the state for

simple general partnership arrangement. When there is a limited partner, prefer to file with the state.

• Even though no formal written agreement is required for general partnership, written partnership agreement is strongly recommended to avoid unresolved dispute between partners.

• No double taxation, pass-through entity.

• Joint venture possibly works for business to business project arrangement, not perpetual. This will require advance bookkeeping administration techniques / skills.

Disadvantages• Unlimited liability.• Partners cannot transfer ownership

without unanimous consent.• Profit sharing between partners.

Partnerships (legal)

Randall Holdner v. Comm., William Holdner v. Comm., TCM 2010-175Father and son owned farms. Randal Holdner, the son, ran the day to day operations of the farms. William Holdner, the father and a CPA, was primary responsible for Holdner Farms’ finances and accounting. William Holdner maintained an active accounting practice in 2004-2006.On his Federal income tax returns for 2004, 2005, and 2006, William Holdner reported Schedule K-1 income from his accounting partnership, on Schedule E, $264,516, $232,156, and $263,423, respectively.

William Holdner prepared his and his son’s Federal income tax returns for 2004-2006. For 2004-2006 each reported Holdner Farms’ income and expenses from cattle sales and rental activity on Schedules F of their income tax returns, and they reported Holdner Farms’ income and expenses from timber sales on Schedules D of the returns. No partnership return for the farm was filed. Instead, each Holdner reported one-half of Holdner Farms’ gross income, treating it as a joint venture. However, Williams Holdner deducted most of Holdner Farms’ expenses in 2004-2006 on his personal income tax returns for those years, resulting net losses for 2004-2006.

The Court concluded that the Holdner Farms activity was a partnership for Federal income tax purposes in 2004-2006. The father and son had equal interests in partnership income, expenses, and other partnership items.

Limited Liability Companies (legal)

• A limited liability company (LLC) is a flexible form of enterprise that blends elements of partnership and corporate structures.

• It is a hybrid business entity having certain characteristics of both a corporation and a partnership (multiple members) or sole proprietorship (single member).

• The primary characteristics an LLC shares with a corporation is limited liability.

• The primary characteristics an LLC shares with a partnership is pass-through income taxation.

Limited Liability Companies (legal)

Income Taxation of LLC:• For US federal income tax purposes, an LLC is treated by default as a

pass-through entity.• If there is only one member in the company, the LLC is treated as a

“disregarded entity” for tax purposes. A single owner would report LLC’s income or loss on Schedule C of his or her individual tax return.

• The default tax status for LLCs with multiple members is as a partnership, which is required to report income and loss on IRS Form 1065.

• An LLC with either single or multiple members may elect to be taxed as a corporation through the filing of IRS Form 8832 (please check the eligibility of LLC formation and franchise/pass through entity tax with each of 50 states law). After electing corporate tax status, an LLC may further elect to be treated as a regular C-Corporation or as an S-Corporation.

IRS Website for LLC:

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Limited-Liability-Company-(LLC)

Limited Liability Companies (legal)

• Formation: LLCs are formed under the law of (50) states. Corporations are issued “articles of organization” by most states upon formation. Additional optional governing rules called “operating agreement”, “corporate resolution”.

• LLC management:– member - managed– manager - managed

Limited Liability Companies (legal)

Advantages• Avoid double taxation• Limited liability• Pass–through entity,

unless LLC elects to be taxed as a C-Corporation

• Flexible• Less administrative

expense and record keeping.

Disadvantages• Not publicly traded.• More difficult to raise

capital than publicly traded company.

• Franchise tax depends on each 50 state jurisdiction.

• The management structure of an LLC may be unfamiliar to third party, external party.

Choice of Entity

The business client is responsible for making the ultimate determination of

entity.

Resources:

Kreider, Sharon CPA, Hoven, Vernon CSP, CPA, “Pass-Through Entity Choices, Entity

Comparison Chart” 2007-2008, http://www.terrafirmaglobalpartners.com/Agent_Resources/Commercial/Entity%20Comparison%20Chart.pdf

Pence, Craig M., “Accounting Course Manual”, 2008

http://my-accounting-tutor.com/Financial/Modules/Module1/FinModule1-12.pdf

Rutledge, Thomas E., “Limited Liability Companies in Kentucky”, August 2012

http://www.skofirm.com/Library/142643.pdf

Rutledge, Thomas E, Franklin, Mark S., Lukinovich, Stephen, “Organizing a Professional Practice: An After-Tax Choice-of-Entity Calculus”, March 17, 2009

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1361915##