ACC 430 Chapter 10

Chapter 9

Chapter 10 - Sole Proprietorships, Partnerships, LLCs, and S Corporations

Chapter 10

Questions and Problems for Discussion

1.A sole proprietorship is not a legal entity but merely a business activity carried on by an individual. The proprietor is personally liable to the business creditors. The net profit or loss from the activity is part of the proprietors taxable income. Because a sole proprietorship has no separate identity from its proprietor, it cant be described as a passthrough entity.

2.Mrs. Liu should use the marginal rate applying to the next dollar of taxable income on Form 1040.

3.If the $17,000 business loss exceeds the total of Mr. Pitts other income items for the year (salary, dividends, interest, etc.), the excess qualifies as a net operating loss, which he can carryback as a deduction to his two prior taxable years.

4.Firm Q remitted $13,400 employer payroll tax (which it deducted as a business expense) and $13,400 employee payroll tax withheld from the compensation paid to its employees during the year.

5.The employee payroll tax is extremely convenient because the responsibility for computing and paying the tax is on the employer, not the employee. However, the payroll tax rate structure is regressive: 7.65 percent on a base amount of annual compensation + 1.45 percent on compensation in excess of the base. In 2007, the employee payroll tax on $50,000 compensation is $3,825 for an average rate of 7.65 percent. The employee payroll tax on $200,000 compensation is $8,945 for an average rate of 4.47 percent. Thus, the employee payroll tax is often criticized as vertically inequitable.

6.The self-employment tax is based on net earnings from self-employment, which is essentially the profit that sole proprietors earn from their business. Individuals pay their self-employment tax at the same time and in the same manner as they pay income tax.

7.The income tax deduction for one-half of self-employment tax corresponds to the employers deduction for employer payroll tax. The nondeductible one-half of self-employment tax corresponds to the nondeductible employee payroll tax.

8.a.General partners have unlimited personal liability for all recourse debts of their partnership.

b.Limited partners have no personal liability for the debts of their partnership. However, Tom, Angela, and Peter all cannot be limited partners because a limited partnership must have at least one general partner.

c.The members of an LLC have no personal liability for the debts of their company.

d.The shareholders of an S corporation have no personal liability for the debts of their corporation.

9.Any item recognized by a passthrough entity that is subject to a special rule, limitation, or treatment in the computation of individual or corporate taxable income or tax liability must be separately stated. This separate accounting allows each owner to apply the special rule, limitation, or treatment to that owners share of the item.

10.Each partner in Soya Partnership must combine its share of Soyas Section 1231 loss with all other Section 1231 gains and losses realized during the year to determine that partners net Section 1231 gain or loss. The rule that a net Section 1231 loss is deductible as an ordinary loss and a net Section 1231 gain is treated as a capital gain can be applied only at the partner (rather than the partnership) level.

11.The different uses of cash have no effect on the federal income tax liabilities of Mr. A and Mr. Z. Both will pay tax on the income generated by their sole proprietorships, regardless of the amount of cash flow generated or the use to which the owners put such cash flow.

12.a.As a shareholder, Mr. Bates has limited liability for creditor claims against UPF. In other words, the creditor cannot demand repayment of the corporate debt from Mr. Bates.

b.The creditor can demand repayment of the entire $120,000 debt from Mr. Bates. If Mr. Bates pays the debt, he can seek restitution from the other general partners for their proportionate shares.

c.As a limited partner, Mr. Bates has limited liability for creditor claims against UPF.

d.As a member of a LLC, Mr. Bates has limited liability for creditor claims against UPF.

13.a.Mr. Yangs basis in his sole proprietorship is the aggregate basis of the tangible and intangible assets used in the business activity.

b.Mr. Yangs basis is his adjusted basis in his intangible partnership interest, which equals his initial basis (contributed cash and property or cost basis of a purchased interest) adjusted for increases and decreases in his investment over time.

c.Mr. Yangs basis is his adjusted basis in his corporate stock, which equals his initial basis (contributed cash and property or cost basis of purchased stock) adjusted for increases and decreases in his investment over time.

14.Corporation ABC must compute its adjusted basis in its interest in KK Partnership as of the date of sale. This adjusted basis must include ABCs share of partnership items attributable to the portion of KKs taxable year during which ABC was a partner (January 1 through October 9). The partnership may not be able to compute such share until after the closing of the year on December 31.

Application Problems

1.a.Schedule C would reflect net profit of $26,800 as shown on the following Schedule C:

b.Schedule SE would reflect $3,787 of SE tax, as shown on the following Schedule SE:

2.a.Rheas home office deduction is computed as follows.

Annual rent$48,000

Housekeeping service5,200

Renters insurance 2,000

Total apartment expense$55,200

Percentage of square footage used as office .15

Expenses allocated to office$8,280

Rheas home office deduction is $8,280.

b.Rheas home office deduction is limited to $4,000 (net profit before the deduction).

3.a.Colins home office deduction is computed as follows.

Annual housing expenses$19,055

Percentage of square footage used as office .10

Expenses allocated to office1,905

MACRS depreciation (10% [$185,000 ( 39 years]) 474

Home office deduction$2,379

Net profit before home office deduction$75,000

Home office deduction (2,379)

Net profit$72,621

b.Net profit before home office deduction$1,800

Home office deduction (limited to profit before deduction)(1,800)

Net profit-0-

4.a.BDFs 2007 payroll tax is $4,590 ($60,000 7.65%).

b.BDFs 2007 payroll tax is $8,945 ([$97,500 6.2%] + [$200,000 1.45%]).

5.a.BDFs 2008 payroll tax would be $4,590 (no change from 2007).

b.BDFs 2008 payroll tax would be $9,224 ([$102,000 6.2%] + [$200,000 1.45%]).

6.a.Mrs. Singers 2006 self-employment tax is $7,271, and her income tax deduction is $3,635

b.Mrs. Singers 2006 self-employment tax is $6,859, and her income tax deduction is $3,430.

c.Mrs. Singers 2006 self-employment tax is $340, and her income tax deduction is $170.

7.a.Only the $120,000 profit from operations is subject to self-employment tax.

b.Self-employment tax = $14,895 = $94,200 * 12.4% + $120,000 * 92.35% * 2.9%

c.Net profit from operations$120,000

Ordinary gain on asset sale17,000

Interest income on working capital 960

Before-tax income from bookstore activities$137,960

One-half self-employment tax (7,448)

Taxable income from bookstore activity$130,5128.a.Net profit from JCs practice$32,000

One-half self-employment tax (2,261)

Taxable income from practice$29,739

Tax rate .25

Income tax$7,435

Before-tax income$32,000

Self-employment tax(4,522)

Income tax (7,435)

After-tax income$20,043

b.JCs self-employment tax is 38 percent of the federal tax burden on her business income ($4,522 SE tax ( $11,957 total tax).

9.a.Social Security tax ($33,000 ( 6.2%)$2,046

Medicare tax ($33,000 ( 1.45%) 479

Employer payroll tax on Bens salary$2,525

b.Salary payment to Ben$33,000

Employer payroll tax on salary 2,525

Unemployment tax 400

Janes before-tax cost of salary/tax payments$35,925$35,925

Income tax savings from deduction ($35,925 35%)(12,574)

Reduction in Janes SE tax$962

Income tax cost of reduced deduction for 50% SE tax

($481 35%)(168)

Net tax savings from SE tax reduction (794)

Janes after-tax cost of hiring Ben$22,55710.a.As equal general partners, AB and YZ each include half the partnerships recourse debt in their initial bases.

ABs contributed cash$500,000

ABs share of recourse debt125,000

ABs initial basis in its partnership interest$625,000

YZs basis in contributed land$430,000

YZs share of recourse debt125,000

YZs initial basis in its partnership interest$555,000

b.Because YZ is a limited partner, it is not responsible for any of the partnerships recourse debt. As the general partner, AB is responsible for repayment (i.e. has unlimited liability) and consequently can include the entire partnership debt in basis.

ABs contributed cash$500,000

ABs share of recourse debt250,000

ABs initial basis in its partnership interest$750,000

YZs basis in contributed land$430,000

YZs share of recourse debt -0-

YZs initial basis in its partnership interest$430,00011.FGH Partnerships $600,000 ordinary business income is allocated equally to Triad LLC and Beta. However, since these two partners are both passthrough entities, the $300,000 allocated to each is passed through and reported by the following taxpayers.

Mr. T (40% $300,000)$120,000

Mrs. U (35% $300,000)105,000

V Inc. (25% $300,000)75,000

Ms. B300,000

$600,00012.a.Rochelles taxable income will increase by the $25,000 of ordinary income. Rochelle will combine the $3,000 Section 1231 loss with any Section 1231 gains or losses from other sources. Ultimately, the loss will reduce her taxable income by $3,000. The nondeductible expenses and cash distribution will have no impact on her taxable income. Thus, the net impact of the partnership activity on Rochelles taxable income is an increase of $22,000.

b.Tax cost = $22,000 * 35% = $7,700 cash outflow. Cash distribution of $5,000 is a cash inflow. Net cash outflow of $2,700 ($5,000 - $7,700).

13.Gross receipts from sales$670,000

Cost of goods sold(460,000)

Operating expenses(96,800)

50% meals and entertainment (3,120)

KLMNs ordinary business income$110,080KLMNs Section 1231 loss on the equipment sale and charitable contribution are separately stated items.

14.a.Mr. T has the following shares.

Ordinary business income$11,008

Separately stated items:Section 1231 loss(1,350)

Charitable contribution(150)

Nondeductible expense

(312)

b.Mr. Ts adjusted basis at beginning of year$45,000

Increased by ordinary business income11,008

Decreased by:Cash distribution(1,000)

Section 1231 loss(1,350)

Charitable contribution (150)

Nondeductible expense (312)

Mr. Ts adjusted basis at end of year$53,196

c.Mr. Ts adjusted basis would increase to $55,996 ($53,196 + 10% [$28,000 increase in partnership debt]).

15.a.Ordinary income = $270,000 = $500,000 - $200,000 - $30,000

Separately stated items:

Long-term capital gain $9,000

Nondeductible expenses 2,000

Distributions100,000

b.Ordinary income, $135,000; Long-term capital gain, $4,500; Nondeductible expenses, $1,000; Distributions, $50,000

c.$139,500 = $135,000 ordinary income + $4,500 capital gain

d.$123,500 = $25,000 beginning basis + $135,000 ordinary income +$4,500 capital gain - $1,000 nondeductible expenses - $50,000 distribution +$10,000 share of debt increase

16.Schedule K:

b.Jayanthis Schedule K-1:

17.

Partner XPartner Y

Initial basis in partnership interest$50,000$10,000*

Deduction for $21,000 share of loss(21,000)(10,000)

Adjusted basis at beginning of next year$29,000-0-

* Adjusted basis of contributed business assets

18.AVs net Section 1231 loss is computed as follows.

Section 1231 loss on sale of equipment$(17,000)

Share of LLC Section 1231 gain 4,000

Net Section 1231 loss

$(13,000)

AVs net capital loss is computed as follows.

Capital loss on sale of securities$(5,000)

Share of LLC capital loss(1,200)

Net capital loss

$(6,200)

Without the items from the LLC, AV has a $17,000 deductible Section 1231 loss and a $5,000 nondeductible capital loss. With the items from the LLC, it has a $13,000 deductible Section 1231 loss and a $6,200 nondeductible capital loss. Thus, the LLC items increased AVs taxable income by $4,000.

19.a.Ordinary income before guaranteed payments$95,000

Deduction for guaranteed payments(48,000)

Ordinary business income

$47,000

Bonnies and Georges 50% share$23,500

b.Bonnies self-employment income is $71,500 ($48,000 guaranteed payment + $23,500 share of ordinary business income). Georges self-employment income equals her $23,500 share of ordinary business income.

c.Ordinary income before guaranteed payments$32,000

Deduction for guaranteed payments(48,000)

Ordinary business loss

$(16,000)

Bonnies and Georges 50% share$(8,000)

Bonnies self-employment income is $40,000 ($48,000 guaranteed payment $8,000 share of business loss), while George has no self-employment income.

20.

Zeldas adjusted basis at beginning of 2006$95,000

Increased by:60% share of dividends and interest8,760

60% share of capital gain 3,720

Basis before loss deduction$107,480

a.Decreased by limited deduction for

60% share of business loss(107,480)

b.Zeldas adjusted basis at end of 2006-0-

c.If Zelda received a $5,000 cash distribution from the partnership, her basis before the loss deduction would be only $102,480, and the deduction for her share of the business loss is limited to $102,480.

21.a.Zelda can deduct her $18,520 loss carryforward from 2006. Consequently, she will report a $14,320 business loss ($4,200 2007 income - $18,250 loss carryforward) and $10,800 dividend and interest income on her 2007 Form 1040.

Zeldas adjusted basis at beginning of 2007-0-

Increased by:60% share of business income4,200

60% share of dividends and interest10,800

60% share of partnership debt12,600

Basis before loss deduction$27,600

Decreased by deduction for 2006 loss carryforward

($126,000 ( $107,480)(18,520)

b.Zeldas adjusted basis at end of 2007$9,080

22.a.Ms. Ps initial cost basis in her partnership interest$20,000

Increased by share of partnership debt12,000

Decreased by share of ordinary loss(28,000)

Ms. Ps adjusted basis on January 1, 2008$4,000

Ms. P can deduct her entire $28,000 share of loss on her 2007 return.

b.Amount realized on sale ($2,000 cash + $12,000 debt relief)$14,000

Adjusted basis

(4,000)

Gain recognized on sale of partnership interest$10,00023.a.Leo can deduct $23,000 of his $30,000 allocated share of BLSs 2005 operating loss.

BLS StockBLS Note

Leos initial basis$15,000$8,000

Decreased by limited loss deduction(15,000)(8,000)

b.Adjusted basis at end of 2005-0--0-

24.a.Leo is allocated $20,400 of 2006 income from BLS, so he can deduct his $7,000 loss carryforward from 2005. Consequently, he will include $13,400 S corporation income in 2006 taxable income.

BLS StockBLS Note

Leos basis at beginning of 2006-0--0-

Increased by 2006 income allocation12,4008,000

Decreased by 2005 loss carryforward(7,000)_____

b.Adjusted basis at end of 2006$5,400$8,000

c.In this case, Leo is allocated $11,000 of 2006 income from BLS, only $4,000 of which is included in his 2006 taxable income.

BLS StockBLS Note

Leos basis at beginning of 2006-0--0-

Increased by 2006 income allocation3,0008,000

Decreased by 2005 loss carryforward(3,000)(4,000)

d.Adjusted basis at end of 2006-0-$4,00025.Because his adjusted basis in the note surrendered in only $4,000, Leo must recognize a $4,000 capital gain on the receipt of the $8,000 repayment.

26.a.Evans cash withdrawal from the S corporation is not taxable to him, nor it the payment deductible by the S corporation.

b.If the payments are recharacterized as salary, the S corporation is permitted a deduction, lowering its taxable income. Evan must report salary income. The net effect on Evans taxable income and income tax liability should be zero, since he is the sole shareholder of the S corporation.

c.If the $50,000 per year is treated as salary, both the S corporation and Evan have unpaid payroll tax of $3,825 per year, for a total potential underpayment of $22,950 ($3,825 * 2 * 3 years).

Issue Recognition Problems

1.Will the marginal tax rate on Ellie and her husbands joint return for next year (and the rate applying to Ellies business profits) increase because Ellies husband will earn a salary?

2.Does Javier owe employee payroll tax on his entire salary plus self-employment tax on his entire net earnings from self-employment? Does Javier have an annual base amount of compensation subject to either Social Security tax or self-employment tax (but not both), or does he have an annual base amount subject to both Social Security and self-employment tax?

3.Is Mrs. Chou also considered to be self-employed so that some of the net profit from the business should be attributed to her for self-employment tax purposes?

4.Does Travis use of his home office to house the family library violate the exclusive use test for a home office deduction?

5.Should AF Partnership allocate a portion of its capital gain to Lola, even though she was not a partner on the date the gain was realized? How does AF Partnership allocate 15 percent of its income between Lola and R Corporation? What is Lolas adjusted basis in her partnership interest on April 12?

6.Did Fred adjust his basis in the limited partnership interest for his share of annual partnership income? Has Fred received cash distributions equaling the total partnership income on which he paid tax for the last nine years?

7.Is the exchange of a partnership interest for an interest in a newly formed LLC a taxable or nontaxable exchange?

8.Does the state of incorporation (and every other state in which the corporation will conduct business) treat an S corporation as a nontaxable passthrough entity for state income tax purposes?

9.What happens to Mr. Yangs carryforward of his DK loss when he sells his entire interest in the partnership? Can Mr. Yang deduct $7,500 of his loss carryforward because he recognized a $7,500 gain on the sale of the partnership interest? Does the loss carryforward transfer to the purchaser of the partnership interest?

10.Which share of loss (ordinary or capital) does Paula deduct first? Because Paula can deduct only $6,200 of her partnership losses, how does she allocate the deduction between her shares of ordinary loss and capital loss?

11.Does Marcus recognize his final monthly 2007 guaranteed payment as taxable income in 2007 or 2008? Does the partnership deduction for the payment depend on the year in which Marcus recognizes the payment as income?

12.Can David increase the basis in his DES stock by his $8,900 allocation of tax-exempt interest so that he can deduct his entire $4,700 ordinary loss allocation?

13.How should WW account for the $21,000 payment made on its shareholders personal behalf? Should Mr. and Mrs. West treat the corporate payment on their personal behalf as taxable compensation from WW or as a nontaxable cash distribution that reduces the basis in their WW stock?

14.Can the other six individuals prevent a termination of NSs S corporation election? Is the NS stock subject to a buy-sell agreement or similar restriction that prevents the individual from giving shares to a nonqualifying shareholder?

15.Can BR recognize the $125,000 loss realized on the sale of land to a partnership in which it is a partner? Are BR and the limited partnership related parties for purposes of the loss disallowance rule? Does BR indirectly own a 100 percent interest in the partnership because all other partners are BR shareholders?

16.In which taxable year does Corporation L report its $100,000 share of JKL Partnerships 2006 business income? Is Corporation Ls $100,000 share allocated between the corporations fiscal year ending on June 30, 2006, and its fiscal year ending on June 30, 2007?

17.Can FG deduct a $15,500 ordinary abandonment loss because it relinquished its equity interest in the limited partnership?

Research Problems

1.Rev. Rul. 66-95, 1966-1 CB 169, provides the authority for the solution to this research problem. The first step is the computation of Don Ferriss guaranteed payment, which the partnership can deduct in the computation of taxable income.

Taxable income before deduction of guaranteed payment$107,200

.50

Don Ferriss share before guarantee$53,600

Minimum guarantee$75,000

Share(53,600)

Guaranteed payment$21,400

The second step is the computation of F&Ls taxable income.

Taxable income before deduction of guaranteed payment$107,200

Guaranteed payment(21,400)

Taxable income$85,800

The last step is the computation of Don and Lous shares of taxable income.

Don FerrisLou LindbergTotal

Taxable income$53,600$32,200$85,8002.This research problem is based on the facts in Tracy Lee Milian v. Commissioner, TC Memo 1999-366, in which the court held that a police officer was liable for self-employment tax on his earnings as an off-duty security guard. The police officer was acting as an independent contractor rather than a police department employee, even though he wore his police uniform and used police equipment. As a security guard, he was not under policy department control, even though the policy department approved his off-duty work. Because the facts of Max Coens situation so closely resemble the facts in the Milian case, the IRS would certainly conclude that Maxs $4,100 wages from the school district are net earnings from self-employment.

3.According to Section 1362(d)(2), Herolds S election terminated on October 10, 2006. Per Section 1362(e)(1), the corporation must file its final Form 1120S for the period January 1-October 9 (S short year) and its first Form 1120 for the period October 10-December 31 (C short year). Section 1362(e)(2) requires that Herolds 2006 taxable income be pro rated between the two returns based on the number of days in each short year. Here is the pro ration.

(282 days [Jan. 1-Oct. 9] 365) $592,030 = $457,404 income on Form 1120S

(83 days [Oct. 10-Dec. 31] 365) $592,030 = $134,626 income on Form 1120

Section 1362(e)(5) requires that the corporate tax on Herolds C short year income be computed on an annualized basis. Thus, the corporate tax rates are applied to $592,030 annual income to result in a full years tax of $201,290. This amount is then multiplied by the ratio of the number of days in the C short year to the number of days in the full year. Based on this annualization, Herolds tax for its C short year is $45,773 ([83 365] $201,290. 4.Because Sandy has a zero adjusted basis in her worthless note, Section 166(b) provides that her bad debt deduction is zero. Because she also has a zero adjusted basis in her worthless stock, Section 166(g)(1) provides that her capital loss realized on the deemed sale of this stock is also zero. Reg. Sec. 1.1366-2(a)(5) provides that if an S corporation shareholder disposes of all of her stock, any loss carryforward attributable to the Section 1366(d) basis limitation is permanently disallowed. Thus, Sandy can never deduct her $7,400 ordinary loss carryforward. In summary, Sandy has no 2006 tax consequences from the worthlessness of her investment in Lindlee Inc. Tax Planning Cases

1. Mr. and Mrs. Janus should clearly document that they used the $80,000 borrowed funds (plus $5,000 from their savings account) to buy the new equipment for their restaurant. By doing so, the interest on the debt is a fully deductible business expense on their Schedule C. If they used borrowed funds to buy the two automobiles, the interest paid on such funds would be a nondeductible personal expense.

2.Eve and Frank should not withdraw any funds from the partnership in 2007 because they need to keep their initial investments intact to deduct the partnerships operating loss on their 2007 Form 1040s.

Eves BasisFranks Basis

Initial cash invested in the partnership$30,000$30,000

Partnership debt included in basis25,00025,000

Basis before loss deduction$55,000$55,000

Share of 2007 operating loss(50,000)(50,000)

Basis at end of 2007$5,000$5,000

If the partners withdraw their initial cash contributions in December 2007, they can deduct only $25,000 of their share of loss. The $25,000 nondeductible loss would carry forward as a deduction against 2008 income. However, the deferral of a $25,000 ordinary deduction for one year decreases the tax savings from the deduction in NPV terms. For example, at a 7 percent discount rate, the deferral of the deduction for one year reduces the tax savings from $8,750 ($25,000 ( 35%) to $8,181 ($8,750 ( .935 discount factor). Of course, Eve and Frank must weigh the tax savings against the opportunity cost of delaying their cash withdrawals from December to January.

3.a.In each case, Amishas net cash flow from the loan in year 0 is ($26,000).

Cash loaned to Sultan($40,000)

Tax savings from deduction of loss

against debt basis ($40,000 35%) 14,000

Net cash flow in year 0($26,000)

The $49,000 share of undistributed corporate income in years 1 and 2 increased Amishas basis in her Sultan note to $40,000 and her stock basis to $9,000. The repayment of the loan in year 2 resulted in $42,470 net cash flow ($40,000 repayment + $3,800 interest - $1,330 tax cost [$3,800 interest income 35%]).

PV of year 0 net cash flow($26,000)

PV of year 2 net cash flow

($42,470 .890 discount factor) 37,798

NPV of cash flows$11,798

b.The $19,100 share of undistributed corporate income in years 1 and 2 increased Amishas basis in her Sultan note to $19,100. The repayment of the loan in year 2 triggered a $20,900 capital gain taxed at 15%. Consequently, the repayment resulted in $39,335 net cash flow ($40,000 repayment - $3,135 capital gain tax + $3,800 interest - $1,330 tax cost [$3,800 interest income 35%]).

PV of year 0 net cash flow($26,000)

PV of year 2 net cash flow

($39,335 .890 discount factor) 35,008

NPV of cash flows$9,008

c. Amishas share of corporate losses in years 1 and 2 had no effect on the zero basis in her Sultan note. Consequently, when Sultan defaulted on repayment, Mrs. NG did not realize any tax loss on the worthlessness of the note. The NPV of the cash flows associated with her loan is ($26,000).

4.Investment A:

Year 0Year 1Year 2Year 3

Purchase/Sale$(50,000)

$60,000

Dividends

$4,000$4,000 4,000

Tax on dividends

(600) (600) (600)

Tax on gain

(1,500)

Net cash flow$(50,000)$3,600$3,600$61,900

NPV at 4% = $11,819

Investment B:

Year 0Year 1Year 2Year 3

Purchase/Sale$(50,000)

$90,000

Tax on annual income$(3,500)$(3,500) (3,500)

Tax on gain

(1,500)

Net cash flow$(50,000)$(3,500)$(3,500)$85,000

NPV at 4% = $18,963

Note: tax basis of S corporation stock prior to sale is $80,000 ($50,000 +$30,000 earnings)

Based on these projections, Marla should choose Investment B, the S corporation stock.

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