We are often asked which entity is the best for start-ups, what is the difference, advantages, and loopholes. Where it’s always best to set up a consulting meeting with a professional – here are some general notes below.
A sole proprietor is a business of one individual and is the same as the individual in all tax means. This business form is the simplest to manage and operate but leave you fully liable for all business debts and accidents. You will fill out form C or C-EZ for taxes to be included in their 1040. The biggest disadvantage to this business structure is the self-employment taxes, 15.3% of your income up to 118,500 is a tax(2016). You do get to deduct half of that on your 1040 but deduction only reduces your adjusted gross income. A Partnership is designed for 2 or more people to do business and is automatically formed if two or more people do business together.
Upon formation, it’s a good idea having the terms of the partnership formally written up for legal protection of all parties. A schedule K-1 will be distributed to all partner stating the flow through to their individual 1040 of the partnership’s losses, gains, and tax treatment of individual items. The individual has no choice how to treat items on his taxes. A corporation is costly in comparison to the other two and has the effect of double taxation on the business and individual. The main reason for a corporation is the separation of legal responsibility from the individuals. Hybrids like LLC’s and S-corps provide the best of both worlds often for new companies in that they are a corporation but are taxed like partnerships. These are often the best choice for new companies.
A business uses a calendar year for tax purposes. depending on the type of business it may use a fiscal year other than 1/1/xx. There are two types of accounting: cash and accrual bases. Inventory can be evaluated using many different methods for the accounting period including LIFO, FIFO, and Average Cost.
When debt is cancelled like home foreclosure or auto repossession the amount you are relieved in debt is income. So say your home forecloses and you owed 300K and they sold it for 200K, that 100K difference is income to you. Often there are laws forgiving you of the debt in your taxes or you can be considered insolvent but without meeting those provisions you will be responsible to pay taxes on that relieved debt. Certain assets you can depreciate over time to reduce your tax liability. When you sell those assets the gains will be treated as ordinary or capital gains depending on the recapture rules for the asset.
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A like kind exchange is the exchange of similar assets like a building for a building or a car for a car. What it does is defer the recognition of gain by adjusting the basis in the new asset down or losses by adjusting the basis up. The theory is that you are not recognizing the gain or lose because you really are just continuing the same business activity with a new asset. 1231 assets are tangible assets held for one year. Under 1231, upon disposal, a gain is recognized as long term capital gains and a loss is recognized as ordinary. The one exception is the 5 year rule, which makes you report the gain as ordinary if you had previous losses in the last 5 years.
Section 162 discusses the availability of deductions. In order to be deductible an expense must be ordinary and necessary that was paid or incurred during the taxable year in carrying on a trade or business activity. You must first determine of the activity is for profit. Only for profit activities can have losses be in excess of gains. An activity is determined to be for profit if it is conducted in a business like manner, that time and effort is put into it, and it is your livelihood. a business is presumed to be for profit if it makes a profit 3 out of the last 5 years.
Often leases are used as a form of sales contract. It is important to the IRS that the proper accounting is used by the lessor and lessee. The main goal is to determine the who in the end will own the property. A sales contract the lessee will own the property so they account for the property as a purchase and the lessor as a financier. A leveraged lease can go either way but the key determination is property ownership. The cost of getting a lease should be amortized over 15 years. When you make improvements to a property the cost should be amortized over the life of the property under MACRS but currently, until 2014 you can use 15-year MACRS to amortized those costs. There are also many other small rules for different types of property uses.
Section 163 permits the deduction of all interest on indebtedness. The most questioned common expense is mortgage interest. You may deduct your mortgage interest, penalties, and loan origination fees. You can not deduct commissions, recording fees, and abstract fees. We often borrow money to make an investment. The cost of interest on this money can only be deducted up to the gains on the investment. Any excess must be carried forward.
Real estate taxes are deductible as long as they are not an assessment for improvements. State and local income taxes are a deduction for business as an expense and for individuals on your 1040 Schedule A. The home office deduction is available when you use a specific room of your home for business purpose. Research and experimentation cost can either be expensed or amortized, but you must choose one or the other.
Depreciation and amortized are methods of spreading the expense of a cost over a period of time. These range from 5 years for cars, computer, etc. to 39 years for property. Section 197 intangibles are excess value paid for items because of their future benefit like patients, goodwill, and copyrights. These assets are typically amortized over 15 years.
Cost depletion determines the cost per unit by estimating the total units/expenses. For each unit sold, a cost is applied. Percentage depletion determines cost by a percentage of gross income. Both are acceptable methods under GAAP.
MARCS places assets into 6 recovery classes for depreciation ranging from 3 years to 20 years. When the property is sold any gain that were depreciated or Section 179 expensed are treated as ordinary (Section 1245). Any gains after are Section 1231 rules, which is capitals gains. Section 1250 is similar to 1245, but it only required the recapture of gains over straight line depreciation compared to accelerated on real property.
Under common law, anyone who performs services that is subject to the will and control of an employer is an employee.
When an employer provides a vehicle to an employee, the employer can deduct the value of that vehicles personal use as compensation. The employee must report it as income.
The standard mileage method currently depreciates at 23 cents a mile. It is simple, but doesn’t take into account the use of multiple vehicles.
Meals and entertainment are deductible at 50% as long as they are for business purposes and are “ordinary and necessary”. Meals and entertainment for company events like regional meetings are 100% deductible.
ERISA and TEFRA will dictate what must be reported, how a plan is funded, and the guidelines for any deferred compensation plans.
A trust must have three things: corpus (property), a trustee, and a beneficiary. Under the ratio test, a plan must benefit 70% of the employees compared to the highly compensated employees.
Vesting is the timing of when you gain rights to your benefits. Some plans have immediate and full vesting, some require 5 years of service, and some phase in the benefits over a time period.
A defined benefit plan specifies benefits and contributions are determined by actuarial calculations. The employer bears the risk of investment. A defined contribution plan is funded for each employee. The most common plans are profit sharing where the employee shares the profits of the organization. A money purchase plan is a pension plan that the employee contributes a fixed percentage of their income. The most common is the 401(k) plan which an employee contributes to tax free (with limits) and is fully vested.
A Keogh plan is a self employment retirement plan available to sole proprietors and partnerships. A Roth IRA is the contribution of already taxed money by an individual that will be non taxable upon distribution when retired. A traditional IRA is money that is contributed tax free now and taxed when distributed at retirement. A SIMPLE 401(k) is a employer contribution for small business under 100 employees. In a SIMPLE 401(k) an employer contributes a matching percentage or a non matching contribution. The maximum contribution changes each year and should be set up by a professional.
Coverage must not constitute permanent insurance (Reg.§1.79-1(b))
Disability insurance cannot be included
Coverage can apply only to employees, although spouses and dependents can be covered up to $2,000
Excess benefits are taxable under the tables (Reg. §1.79-3(d)(2))
The plan must be written
There must be a formula for determining coverage based upon age, years of service, compensation, or position
The plan must cover a group of employees which is usually defined as at least 10 or more employees, although there are special rules for groups less than 10
The plan may not discriminate in favor of the key employees
The retired lives reserve fund is an extension of a group term insurance plan in retirement. A reserve fund is required to be set up and actuarially determined contributions are made to the fund. These funds are then used to buy term life insurance protection for the employee during retirement.
Under the uniform capitalization rules, the direct costs and part of the indirect costs for certain production or resale activities are capitalized, not expensed. These costs must be included in the basis of property produced or purchased for resale, rather than claimed as a current deduction. The costs are recovered through depreciation, amortization, or cost of goods sold when the property is used, sold, or otherwise disposed of. Indirect costs include premiums for insurance on a plant or facility, machinery, equipment, materials, property produced, or property acquired for resale.
The marital deduction is a deduction from the gross estate of the value of property that is included in the gross estate but that passes, or has passed, to the surviving spouse. A marital deduction generally is denied for property passing to a surviving spouse who is not a citizen of the United States. A marital deduction is permitted, however, for property passing to a qualified domestic trust of which the noncitizen surviving spouse is a beneficiary. A qualified domestic trust is a trust that has as its trustee at least one U.S. citizen or U.S. corporation. No corpus may be distributed from a qualified domestic trust unless the U.S. trustee has the right to withhold any estate tax imposed on the distribution.
Generally, a marital deduction is not allowed for a life estate that passes from a decedent to a surviving spouse, because the surviving spouse’s interest terminates when he or she dies. However, a marital deduction may be elected for all or part of this interest if it meets the requirements of qualified terminable interest property.
Simple wills convey your assets upon death to who you choose and are subject to any Estate taxes imposed at that time. There are a many types of trusts by in general a trust protects your assets from a lot of those estate taxes by putting those assets into them now. An Annuity is a form of estate distribution where the heirs get a preset amount on a schedule based on some factor. An example would be the annual distribution of 50% of the earned income of an estate.
A conservatorship allows a court to appoint another to handle your assets and make medical decisions for you. The court appoints a conservator of the “estate” to handle property and a conservator for the “person” to look after your personal needs, authorize medical services and have you placed in a hospital. After a conservator is appointed, he must file an inventory of the conservatee’s assets. In addition, he cannot normally sell or purchase any assets without the court’s permission.
A private annuity is where one person transfers property to another for that person’s unsecured promise to make fixed periodic payments to the other for life. The property must be transferred for full and adequate consideration. The IRS has issued proposed regs that would eliminate the income tax advantages of selling appreciated property in exchange for a private annuity. Under the new rules, the property seller’s gain would now be recognized in the year the transaction occurs rather than as payments are received.
The advantages of a sole proprietorship are that organizational costs, legal, accounting, administrative cost, as well as income taxes (state and federal) are lower. In addition to that, the administration is less complicated.
The disadvantages of sole proprietorship include personal liability, the inability to income split, the limited fringe benefits, and also self-employment tax where it consists of Social Security and Medicare taxes (the non- employee portion).
In regards to characterization of assets, each asset in a sole proprietorship is treated separately for tax purposes, rather than as part of one overall ownership interest.
The advantages of a partnership include income being taxed to the partners rather than to the partnership, income distributed is not subject to double taxation, losses and credits generally pass through to partners, and the liability of limited partners is normally limited as in a corporation.
The disadvantages of a partnership include that the liability of general partners is not limited, that partners are taxed currently on earnings (even if the earnings are not distributed), and that partners cannot exclude certain tax favored fringe benefits from their taxable income.
In regards to passive loss, a partner’s loss deduction from a limited partnership interest is disallowed. As for the at-risk rules, the rules limit the amount of loss a partner can deduct to the amounts for which that partner is considered at risk.
In regards to the husband-wife partnership, they should report income or loss on Form 1065. The spouses should include their respective shares of the partnership income or loss on separate Schedules SE (it will give each spouse credit for social security earnings).
As for limited partnership, passive and active income, credit, gain, and loss are effectively segregated for tax purposes.
For estates and trusts, the federal taxation is sort of a hybrid between partnership taxation and traditional corporate taxation. As for unincorporated associations, for federal income tax purposes they are generally treated as corporations. However, the association can also be made to parallel a partnership.
The difference between a corporation and a subchapter S corporation is that the S corporations generally avoid all federal income taxation at the corporate level. Similar partnerships, all items of income, deduction, credit, gain and loss are passed through directly to the individual shareholders on a pro rata basis.
A personal service corporation is a corporation in which the principal activity is the performance of personal services that are substantially performed by employee-owners where the (compensation costs for personal service activities is more than 50% of its total compensation costs).
Preferences and Adjustments (All Taxpayers):
· Mining Costs
· Pollution Control Facilities
· Incentive Stock Options
· Intangible Drilling Costs
· Long-term Contracts
· Tax Exempt Interest
· Appreciated Charitable Contribution Property
· Financial Institutions’ Bad Debts
· Alternative Tax Net Operating Loss Deduction
· Adjusted Basis of Certain Property
Preferences and Adjustments (Non-corporate and Some Corporations):
· Circulation Expenditures
· Farm Losses
· Passive Losses
Preferences and Adjustments (Corporations):
· Untaxed Book Income
· Earnings and Profits
· Blue Cross/Blue Shield Deduction
· Merchant Marine Capital Construction Fund
The formation of a corporation involves the transfer of money or property (or both) in exchange for stock or ownership of the company. In regards to Section 351, for this type of transaction to apply the transferor of property to a corporation must have control of the corporation immediately after the exchange, that no gain or loss is recognized when the transferors receive solely stock, or a gain (but not loss) is recognized when the transferors receive other property in addition to stock.
The requirements to qualify as Section 1244 stock includes: the stock must have been issued for money or other property and not for stock; the stock must be in a domestic corporation; 5 years prior to the loss, the corporation must have been primarily an active business; and at the time of the stock issuance, the total amount paid in for stock can’t exceed $1,000,000.
A start-up expense is one paid or incurred for creating an active trade or business, or for investigating the possibility of creating or acquiring an active trade or business. Organizational expenses are those incurred directly for the creation of the corporation that would be chargeable to the capital account.
In general, when a corporation carries on any business it will be recognized as a separate entity. However, when a corporation does virtually nothing other than to obtain limited liability for the shareholder, the corporation status will be ignored.
A corporation can only deduct capital losses only up to its capital gains. If the loss is not completely used up, it is carried forward 1 year (2 years back) and then 1 more year (1 year back).
In regards to dividends received, a corporation is allowed a deduction for a percentage of certain dividends received. It may deduct 70% of the dividends received if the corporation receiving the dividend owns less than 20% of the distributing corporation and a deduction for 80% of the dividends received or accrued if it owns 20% or more.
To qualify for the deduction, the contribution must be made to or for the use of community chests, funds, foundations, corporations, or trusts organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals, or other charitable organizations. A corporation cannot deduct contributions that total more than 10% of its taxable income and can be carried over to each of the following five years.
Before the Bush Tax Cuts, Section 341 converted capital gain on the sale or liquidation of a corporation into ordinary income.
To avoid the penalty tax of from Section 541 a corporation that would be defined as a personal holding company must distribute to its shareholders all of its personal holding company income.
To avoid liability for accumulated earnings tax (Section 531), if the corporation accumulates earnings beyond its reasonable business needs, the corporation must show that tax avoidance by its shareholders is not one of the purposes of accumulation.
In regards to accounting periods, a regular accounting period is classified as either a calendar tax year or a fiscal tax year. A calendar year period must maintain records and report its income and expenses for the period from January 1 through December. A fiscal tax year is 12 consecutive months ending on the last day of any month (except December).
As for accounting methods, it can be classified as cash method, accrual method, special methods, or combination (hybrid). Under the cash method, you only report income when it is received, and deductions are not allowed until paid. The accrual method requires reporting income when it is earned and expenses when all events have occurred that fix the amount of liability for an expense item.
Three methods of identifying items in inventory include specific identification, first-in first-out (FIFO), and last-in first-out (LIFO). The two common valuation methods are cost method and lower cost or market method.
Tax advantages of multiple corporation include being able to divide corporate taxable income among several corporations, being able to avoid the tax on unreasonable accumulation of earnings, being able to provide additional exemptions in computing the alternative minimum tax, excluding certain groups of employees from retirement plan and fringe benefit coverage, facilitating a future sale of part of the business by selling one of the corporations, and being able to adopt different accounting methods and periods.
The tax consequence for corporate liquidation and distributions is that it may involve double taxation, one tax at the corporate level, and another one at the shareholder level.
Form 941 is for employers to report social security and Medicare taxes and withholdings of income tax. Form W-4 is used to determine how much income tax to withhold (based on the employee’s income and number of withholding exemptions claimed). Form W-2 show the total wages and other compensation paid, total wages subject to social security taxes, total wages subject to Medicare taxes, the amounts deducted for income, social security, and Medicare taxes. Form W-3 is a form that employers must file annually to transmit Forms W-2 to the Social Security Administration.
FICA is levied on both the employer and the employee. It has different tax rates and wage bases. As for FUTA, the employers pay it and it is not deducted from the employee’s wages.
The employee labor laws covers minimum wage requirements, overtime, fair employment laws, child labor laws, immigration laws, workers compensation insurance, state disability insurance, and OSHA.
The 20 factors indicating whether an individual is an employee or an independent contractor are:
· Services rendered personally
· Hiring assistants
· Continuing relationship
· Set hours of work
· Full-time work.
· Work done on premises
· Order or sequence set
· Tools and materials
· Profit or loss
· Works for more than one person or firm.
· Offers services to general public
· Right to fire
· Right to quit
The danger of unreasonable compensation is that if the compensation is disallowed, the company loses its deduction and has made a nondeductible dividend distribution instead. To avoid this, the compensation has to be deemed as reasonable based on a number of different factors including employee qualifications, size of the business, etc.
An example of how a corporation can be a valuable income-splitting device can be seen through the use of gifts to children. A distribution of stock is considered a dividend, but if it is classified as gift to minor children the result in the payment of dividends will be lower since children are presumably in a lower tax bracket than their parents.
A buy sell agreement is an arrangement for the disposition of a business interest at some earlier time (owner’s death, disability, divorce, retirement).
One of the differences between an entity and a cross purchase plan is in regards to tax advantages. A tax advantage of a cross purchase plan over an entity purchase plan is that the remaining shareholders will receive a stepped-up cost basis on the acquired stock.
Recapitalization is a restructuring of the existing capital structure of the corporation. One of potential uses of a recapitalization is to achieve what is known as an estate freeze where it is used for the avoidance or limitation of estate tax, gift tax, and federal income tax.
Section 61 defines gross income as all income from whatever sources derived and specifies that it include compensation for services.
Before, there were two basic types of fringe benefits. A statutory benefit that specifically permitted by statute and a non-statutory type that had specific basis in the Code. After 1984, all of the fringe were scrapped other than faculty housing. The ruling did this by providing statutory rules for excluding certain fringe benefits from an employee’s income (no-additional-cost, de minimis, etc.)
The no-additional-cost services are certain costs that employers provide employees on top of what is considered reasonable. These costs are excludable from gross income.
Non-investment or non-real property items that employers sell to employees that are of the same type ordinarily sold to the public.
Examples of working conditions fringe benefits are company provided cars, uniforms, etc. Exceptions include to working condition benefits are parking and any business expense that does not go over 2% of the employees AGI.
As for de minimis fringe, the exclusions include coffee or doughnuts, occasional theater or sporting event tickets, etc.
Section 74 states that the fair market value of prizes and awards is includible in gross income. As for Section 79, employers can deduct group term life insurance premiums paid/incurred on policies covering the lives of employees if the employer is not the beneficiary under the contract.
Requirements for Section 129 is that it must be a written plan, it may not discriminate in favor of highly compensated employees, it is no more than 25% of the amounts paid or incurred by the employer for dependent care assistance during the year may be provided for shareholders or owners owning more than 5% of the company, a notice of availability and terms of the plan must be provided to eligible employees, and
a written statement must be given to each employee showing the amounts paid under their plan to that employee during the calendar year.
A cafeteria plan is written program that permits employee- participants to select among cash and qualified tax-free benefits.
Section 119 excludes from gross income of an employee the value of any meals or lodging furnished to him, his spouse, or any of his dependents by the employer for the convenience of the employer.
Section 105 is an arrangement provided by an employer to reimburse employees for medical and dental expenses.
Under Section 127, an individual cannot deduct education unless such expenses are incurred to maintain or improve skills of their existing employment.
The valuation methods for automobile valuation are the general valuation, annual lease value, cent per mile, and commuting value method.
Interest free or low interest loan involves employers lending money to an employee who is required to pay no interest or a rate of interest below the market place.
For Section 217, direct moving expenses are completely deductible, however, there is a $3,000 dollar limit of indirect expenses.
Section 132 exclusions do not apply with respect to highly compensated employees.
Under Section 67 and 121, fees incurred for tax or investment advice are deductible by the employee.
For Section 132, the athletic facility need not be in the same location as the business premises, but must be located on property owned by the employer.
For section 280, home office deductions are not allowed to the extent they create or increase a net loss from the business activity to which they relate.
For S Corporations, the affected plans are the $5,000 exclusion under 101(b), accident and health insurance plans under 105 and 106, group term life insurance under 79, and meals or lodging furnished under 119.
The requirements for ERISA are that employers must prepare a Summary Plan Description (SPD) for distribution to all employees covered by a welfare plan within 120 days after the plan is first adopted, new employees must be given a copy of the SPD within 90 days after becoming a participant in the plan, and employers must also make available plan documents for inspection by employees. Copies must be furnished upon request.
Entertainment is defined as amusement or recreational activity and includes entertaining guests at such places as nightclubs, country clubs, theaters, sporting events, and on yachts, or on hunting, fishing, vacation, and similar trips.
Lavish or extravagant entertainments are expenses that go beyond a reasonable threshold in entertainment.
Entertainment must be directly related to the conduct of the business, associated with the conduct of the business, and covered by one of the statutory exceptions.
The statutory exceptions provide a reasonable basis for the classification of entertainment expenses.
For ticket purchases, the deduction for the cost of a ticket is to the face value of the ticket, which includes any amount of ticket tax on the ticket.
Meals and entertainment deductions are reduced by 50% except if it’s a reimbursement, or treated as compensation, etc.
There is a 2% floor on miscellaneous itemized deductions. This means that expenses that fall within this category are deductible only to the extent that, in the aggregate, they exceed 2% of adjusted gross income.
An “entertainment facility” is one used in connection with an entertainment, amusement, or recreation activity (yachts, hunting lodges, etc.).
If the employee does receive reimbursement or an allowance for such expenses, they must generally include these payments on their tax return. Use Form 2106 and attach it to Form 1040 to determine the amount of the unreimbursed employee business expenses subject to the 2% limitation on miscellaneous itemized deductions.
For self-employed people, they must report their income and expenses on Schedule C. The items in the schedule include travel, meals, business expenses, etc.
As for the employers, if they are under the cash method of accounting, business expenses are deducted in the tax year they are actually paid, even if they were incurred in an earlier year. But if they are under the accrual method of accounting, business expenses are deductible when the taxpayer becomes liable for them, whether or not paid in the same year. In addition, for employers, business expenses are generally not deductible until economic performance occurs.
The popularity and application of business life insurance plans and
identifying common coverage and premiums provided to employees
Five corporate uses for life insurance including estate, travel and accident uses and the tax treatment, reporting requirements, and discrimination rules for business insurance particularly the eight requirements for qualifying group term life insurance under §79
The benefit of not needing a medical examination as a prerequisite to purchasing a plan. A retired lives reserve and split dollar life insurance explaining their mechanics, taxation regulation, and advantages and disadvantage
The mechanics of employer paid health, medical and disability income insurance including the impact of medical examination requirements
In regards to life insurance, the group term life insurance is very popular because it can offer the employee so much, and cost the employer so little. The application starts when the insurance company issues a master group policy to the employer. The each employee receives a certificate of insurance specifying his amount of coverage. The usual group policy provides pure term insurance and the premiums are generally paid on an annual renewable term basis.
The requirements for qualifying group term life insurance are that the coverage must not constitute permanent insurance, that the disability insurance cannot be included, the coverage can apply only to employees, although spouses and dependents can be covered up to $2,000, the excess benefits are taxable under the tables, the plan must be written, there must be a formula for determining coverage based upon age, years of service, compensation, or position, the plan must cover a group of employees which is usually defined as at least 10 or more employees, although there are special rules for groups less than 10; and the plan may not discriminate in favor of the key employees.
Since group life insurance is generally issued without a medical examination, it is beneficial especially to people who would otherwise be deemed uninsurable.
The retired lives reserve fund is an extension of a group term insurance plan where under such plan a reserve fund is set up and contributions are made to the fund. At retirement, the fund uses the contributions to buy term life insurance protection for the employee. The employees are not taxed on the current contributions to the reserve fund. However, the cost of coverage in excess of $50,000 is taxable. The advantage is that highly paid executives often need continual insurance benefits for purposes of maintaining continuation of income. The disadvantage concerns the coverage of employees, amounts of insurance, and federal tax consequences.
As for split-dollar, it is an arrangement for purchasing a life insurance where the employee and the employer split the premium and death benefit. There is no deduction for any portion of the premium that the employer pays.
The mechanics of the medical insurance provided by employers has given the opportunity for employees to receive these benefits for lesser to no cost to them. In regards to medical examination, since these benefits are given to employees, the need for examination is no longer required. Which means that it is very good for people that could not afford medical insurance as well as for people that might not qualify for one in the first place.
Under the over-$50,000 disallowance rule, if a policy that was bought with the understanding and intention of borrowing against cash values are purchased after June 20, 1986, the interest on any portion of a loan over $50,000 is disallowed. This may reduce the attractiveness of some purchases and has impacted both the purchasers and the life insurance industry.
A key person life insurance can be used to protect the surviving shareholders and their estates from liability.
COBRA requires many group health plans to offer benefits to certain terminated employees or their beneficiaries. Nonetheless, the coverage is limited in duration and is elective since the beneficiary must agree to pay for it.
VEBA is a type of plan where it provides medical benefit (sick pay, accidents, etc.) for members of the employees or their dependents.
To be considered a qualified deferred compensation plan, it must satisfy a number of requirements including a minimum participation standards, a nondiscrimination standards (i.e., the plan cannot discriminate in favor of highly compensated employees), a minimum vesting standards, a minimum funding standards (particularly, for defined benefit plans), and
a specified limits on benefits and contributions.
One of the major benefits of qualified plans is that they are a significant wealth building devices.
The current advantages for a corporate plan are that employers obtains a current deduction for the amounts paid to the qualified plan, while for the employee does not recognize income currently on contributions made by the employer. One of the disadvantages of a corporate plan is that it is a cost to the employee. I addition, as a result of the Tax Equity and Fiscal Responsibility Act of 1982 maximum benefits were reduced, the early retirement age was raised, restrictions were established (for top heavy plans).
In regards to fiduciary responsibilities, any person who exercises any discretionary control or authority over the management of a plan is liable for losses if they violate their fiduciary duties. Several prohibited transactions that fiduciaries are forbidden to engage in with party-in-interest include the sale, exchange, or lease of property between the plan and a party-in-interest, a loan or other extension of credit between the plan and a party-in-interest, etc.
The Profits Sharing Plan cannot provide determinable benefits (defined) because the amount of contribution to the plan is determined by profits. The Money Purchase Pension Plan is a plan where the employer contributes a fixed amount each year based upon a percentage of each employee’s compensation. The Cafeteria Compensation Plan is where an employee can select from a package of employer provided benefit. The Thrift Plan is a mixed breed where, in general, the employee contributes some percentage of their compensation to the plan; the employer then matches their contribution dollar for dollar. A 401(k) Plan is an arrangement whereby an employee will not be taxed currently for amounts contributed by an employer to an employee trust.
Cash basis self-employed can now take advantages of accrual basis taxpayers for purposes of making their contributions to Keogh plans. When a self-employed person has controls more than one business, they must treat the controlled businesses as one for purposes of figuring the maximum contribution that they can make for themselves. There are also some limitations such as that a beneficiary of a deceased self-employed person or owner- employee will generally be taxed in the same manner as the deceased would have been taxed.
Individuals can set up and make contributions to a traditional IRA if they received taxable compensation during the year, and if they were not age 70 1/2 by the end of the year.
Requirements for an SEP plan includes that the employer contributes for each employee who has attained age 21 and who has performed any service for the employer during three of the preceding five years, contributions must not discriminate, each plan participant must own the IRA account or annuity and employer contributions must not be conditioned upon the retention in such plan of any amount so contributed, etc.
Employers can set up a SIMPLE IRA plan if they meet the employee limit, and they do not maintain another qualified plan unless the other plan is for collective bargaining employees.
Roth IRA is a special tax-free nondeductible individual retirement plan where contributions to a plan are not deductible, however, distributions from the plan are tax free.
Identifying nonqualified plan advantages and the ways to design the plans
Understanding the five deferred compensation patterns set forth in R.R. 6031 analyzing the taxability of each
Contrasting unfunded with funded plans
An advantage of nonqualified deferred compensation is that the employer is not restricted by all of the rules and regulations accompanying qualified plans.
The first situation is to the use of crediting a reserve for benefits to employees until a certain vesting period (not taxable because it was not received by the taxpayer). A deferred compensation program constructive receipt determines when an item of income comes within the control of the taxpayer and thus is subject to income tax, while economic benefit concepts basically determines the amount of income that can be determined as taxable.
An arrangement where the employee is able to defer receiving payments until a certain period (termination, part-time, etc.). This is not taxed because the benefit has not yet been received.
A deferred compensation program where the benefit is not currently paid to the participants but is set aside on the company’s books until retirement.
A royalty agreement where no more than $100 is received in any one calendar year. The agreements were entered into before the royalties were earned and prior to the time the services were performed.
Using an escrow account where an agent agreed to pay this sum plus interest to the taxpayer in installments. The taxpayer was taxable in the year the employer unconditionally paid the amount over to the escrow agent.
A partnership agreement between the partners where one of the partner’s share of profits will be distributed at a later date. This does not defer tax on such share until the later date because income is taxable to a partner when it is received by the partnership.
The employer may, under limited circumstances, designate some of its own assets as a deferred compensation fund as long as the assets remain solely the property of the employer.
The segregated asset plan is governed by section 83 where it states that funds covering the payment of future obligations are transferred to an outside account are not subject to the claims of the employer’s creditors and still be able to avoid employee taxation.
The tax consequences of a nonqualified plan include; employees to include contributions to gross income, employer deductions are limited, plan trusts owes income tax on the trust earnings, and no rollovers.
Some of the advantages of an S Corporation include the avoidance of double taxation, losses are currently deductible by shareholders, and S corporation is specifically exempted from the accrual method.
Some of the disadvantages of an S Corporation include no opportunity to accumulate corporate earnings in a lower corporate tax bracket, the 80% dividends received deduction is lost, and other non-deductible fringe benefits for the shareholders cannot be paid for by lower taxed corporate funds.
Number of shareholders, type of shareholders, one class of stock, specific tax years, and domestic status.
A corporation’s status as an S corporation may be terminated by revoking the election by the shareholders, the organization ceases to qualify as an S corporation, or it violates the passive investment income restrictions on S corporations with pre-S corporation earnings and profits.
The treatment of S corporation income and expenses, pass-through
items, built-in gain, passive income, tax preference items, LIFO recapture tax and
capital gains tax and their impact on the taxation of S corporations
S corporation owner compensation and distribution options, reasonable compensation requirements, related party rules, S corporation distribution taxation, tax year choices, fringe benefits, and when the Form 1120S must be filed
For income, loss, expenses of S Corps, they are divided into two categories as separately stated items where and non-separately stated items. Separately stated are those items that, when separately treated on the shareholder’s income tax return could affect the shareholder’s tax liability. Non-separated items are items that are excluded from separately stated. If an S corporation has a net recognized built-in gain, a tax is imposed on the income of the S corporation for that tax year. S Corps must pay corporate income tax on the excess net passive income. Some of the tax preference items are reduced by 20% (section 1250 capital gain, percentage depletion, etc.). The LIFO recapture tax is figured for the pre-S corporation’s last tax year and is paid in four equal installments.
The reasonable compensation applies when the S corporation employs a family member. Losses realized on sales or exchanges of property between related parties generally may not be deducted. When an S corporation has earnings or profits, distributions are tax-free return of capital to the shareholders, to the extent they do not exceed the amount of net income accumulated since becoming an S corporation. In regards to filing Form 1120S, If an S corporation’s income tax return is made on a calendar year basis, the return must be filed by March 15 following the close of the tax year. If an S corporation is using a fiscal year as its tax year, its return must be filed by the 15th day of the 3rd month following the close of its fiscal year.
How organizational costs, startup costs and syndication costs are incurred and what expenditures they include and how they are treated
Five advantages of purchasing an existing business over starting a new business, listing six ways to find a business that is for sale, and noting the tax and practical considerations of such an acquisition
Reorganization under §368(a)(1), and the seven types of transactions that qualify as nontaxable reorganizations
The factors that determine the corporate tax attributes of an acquired corporation that carry over to the acquiring or successor corporation
Organization costs are incurred in creating an entity such as a corporation or a partnership, a start-up costs are incurred in connection with the establishment of a new business after the entity has been formed but before operations begin, and syndication costs are incurred in connection with the issuing and marketing of interests in a corporation or partnership-type entity.
Advantages of buying an existing business include the chance to start out with an established customer base, the possibility of a regular draw or salary right from the start, having less risk of business failure, the opportunity to have the seller stay on for a transitional period, and the ability to focus more attention on service and operations. Some ways of finding an existing business can be done through brokers, advertisements, customers, suppliers, attorneys, accountants, chamber of commerce, and direct approach. When a business is held in corporate form, the acquisition transaction can be nontaxable, partly taxable, or fully taxable to the sellers.
Types of reorganization include merger and consolidation; an acquisition in exchange solely for all or part of its voting stock, of stock in another corporation if, immediately after the reorganization, the acquiring corporation has control of the other corporation; an acquisition in exchange solely for all or part of its voting stock, of substantially all of the property of another corporation; a transfer by a corporation of all or part of its assets to another corporation; recapitalization; a change in identity, form or place of organization; and a transfers incident to a bankruptcy or receivership proceeding.
Some factors that determine the corporate tax attributes include the degree of the change in ownership, whether the acquired corporation’s business is continued, the value of the acquired corporation, the long-term tax-exempt rate; and whether there is a tax-avoidance motive.
Sole proprietors are the easiest form of business and the cost is very low. You retain the advantages of an individual when it comes to taxes but this also means you pay self-employment taxes. You also are fully liable for any company mistakes which means any assets like your home are available to creditors and lawsuits. Startup expenses are deducted up to $5000 and then amortized over 15 years for the remaining. Withdraws have already been taxed to you so they are not affected when you withdraw them.
If your business is not for profit you will be limited by the IRS to what you can deduct and not allowed losses. This applies to all business types except corporations. A business activity is presumed to be for profit if it makes money 2 out of the last 5 years. Schedule C-EZ is a simple form to file taxes but your business must be very small and has minimal profits and expenses under $5000. If a taxpayer cannot file their return on time, the Form 4868 may be used to request an automatic 4-month extension.
Sole Proprietors have to pay self-employment taxes which is a higher rate than if you were employed by someone else. You must also make estimated tax payments so that you don’t pay penalties. There is little opportunity for income splitting with a sole proprietorship unless a child or other family member is employed by the sole proprietorship or assets are leased to business by such parties.
Employment of a family member permits the sole proprietor to retain profits in the family and still receive a deduction under §162(a) for paying a salary. a sole proprietorship’s assets pass under the terms of the sole proprietor’s will or applicable intestate statute. Thus, the proprietorship’s assets will receive a step up in basis under §1014 to their date of death value.
A Partnership is any two or more persons with a relationship to carry on business. Cotenancies does not make a partnership until you provide services to tenants. A partnership can be a public partnership and traded on an exchange. Another benefit of a partnership is a family partnership which can help funnel income to lower tax bracket family members but there are many rules to stop any tax avoidance activities. The most important reason you may form a partnership is to limit liability, gain basis on losses, and still have tax flow through to the individual. Some disadvantages are that general partners are not limited in liability and you are taxed on the money now even though you may not take it out of the partnership.
A partnership only files an information return and then Each partner is give a K-1 for the partnership to show their share of gains, losses, and tax benefits. A partner’s share of income, gains, losses, deductions, or credits is usually determined by the partnership agreement. However, the partnership agreement or any modification will be disregarded if the allocations to a partner under the agreement do not have substantial economic effect. An allocation has substantial economic effect if: (1) There is a reasonable possibility that the allocation will substantially affect the dollar amount of the partners’ shares of partnership income or loss independently of tax consequences; and (2) The partner to whom an allocation is made actually receives the economic benefit or bears the economic burden corresponding to that allocation (§704(b)).
When a partnership terminates it closes the year. A partnership terminates when more than 50% of the ownership changes within 12 months. A partnership does not automatically terminate by the death of a partner, change of partner, or liquidation on one partner. When you close a partnership you must file a final return so the taxing agency knows this is the end of the partnership.
Code 707 provides that a sale is disguised as a contribution when it is followed by an allocation or distribution to the partner which in substance is payment for the property and therefore must be treated as a sale, not a contribution.
A transaction may be treated as an exchange of property between partners on which gain or loss is recognized if a partner contributes property to a partnership and within a short period other property is distributed to the contributing partner or the contribution, the contributed property is distributed to another partner. Code 721 says that no gain or loss is recognized to the partnership or the partners upon a contribution of property to the partnership in exchange for a partnership interest (§721). This nonrecognition provision is based on the idea that the formation of a partnership is not an appropriate time to tax the partner on gain or loss on the assets contributed to the partnership. This rule applies to a partnership in the process of formation and to one that is already operating.
A LLC is a non-corporate business that provides its members with potential tax and legal benefits including limited liability, a single tax, and the option to participate actively in the entity’s management. A LLC is most often a partnership, an association taxable as a corporation, or a trust. The advantages of an LLC are: Special allocations available, Good asset protection, Separate legal entity, No restriction on number of members, Tax consequences flow thru, Members can employ managers, Valuation discounts, Tax free liquidations, Pass through of entity debt. The biggest advantage of a LLC over a C Corporations is the C corporation pay an entity level federal and state income tax. The distributed income of a C corporation may be taxed twice as the shareholder is also taxed on dividends received from the C corporation. Perhaps the biggest benefit of the LLC over the C corporation is that the LLC is subject to one level of tax which is paid by the members of a LLC that is characterized as a partnership. C corporation can also not receive tax free property exchanges for ownership and can also not distribute losses to shareholders.
An LLC has many advantages over all types of business structures. Compared to an S corporation an LLC is allowed to have as many members it wants of any type from any country with as many classes of stock if desired. None of these can be done by an S corporation. In a limited partnership, there must always be a general partner who has 100% liability.
An LLC shields the liability to inside the LLC. However, one must consider the following issues: Uncertainty of self-employment taxes, Restricted to certain business, California has a special tax for LLCs, Must use the calendar year, Cancellation of indebtedness may stick to member.
Professional firms may benefit from conducting business as a LLC, particularly, by limiting malpractice liability for other professionals with whom one practices. However, LLCs do not protect a professional from liability for their own acts. An LLC allows the venture capitalist to combine the desired elements of management control with the flow through benefits of the partnership. Now the venture capitalist can control events that will trigger sale of assets or other rights without inheriting the duties of a corporate director. A LLC also provides preferential tax treatment where two or more corporations plan to form a joint venture. If the corporations formed a corporate subsidiary then distributions would be eligible for the dividends received deduction, which provides tax relief for 70% or 80% of the dividend payment dependent upon the ownership interest in the subsidiary.
The LLC on the other hand, offers limited liability with only one level of taxation. A common practice in estate planning is to consolidate family wealth in a partnership or S Corporation and then spread that wealth among family members by transferring ownership interest in the entity. This is much easier to accomplish with an LLC than with a partnership or S Corporation. Because there are normally no limitations as to the number or types of LLC owners, complex trusts may be members of an LLC. Restrictions with respect to access to, and allocation and distribution of, income and principal can be placed in the trust agreement without considering the S corporation rules.
Trusts of all kinds can be LLC members, while only very specific types of trusts may hold S corporation stock. LLCs can use a flexible “master” trust with multiple beneficiaries as opposed to qualifying S corporation trusts that are limited to a single beneficiary. This significantly simplifies the structure and reduces administrative costs. Additionally, modifications of existing estate plans to ensure compliance with the restrictions governing S shareholders on death of a shareholder are avoided completely as there is no restriction on the number or type of members which are permitted. LLC’s can also be beneficial for foreign investment, real estate ventures, and charitable investments.
A California LLC is required to pay the $800 minimum franchise tax similar to that of limited partnerships. The tax is required to be paid each year until the LLC formally dissolves. In addition to the minimum tax of $800, the LLC is subject to an annual fee based on total income from all sources earned in California. The fee is progressive and escalates with the level of gross receipts.
A corporation is an associations, joint stock company, or insurance company. For purposes of federal income taxes, the corporation is recognized as a separate tax paying entity.
A personal service corporation generally is a corporation in which the principal activity is the performance of personal services that are substantially performed by employee-owners. A corporation is a qualified personal service corporation if at least 95% of the value of its stock is held by employees or their estates or beneficiaries, and Its employees perform services at least 95% of the time in certain fields. A small business investment company (SBIC) is one that is licensed and operated under the Small Business Investment Act of 1958.
Forming a corporation involves a transfer of money, property, or both by prospective shareholders in exchange for capital stock in the corporation. If money is exchanged for stock, the shareholder or corporation realizes no gain or loss. The stock received by the shareholder has a basis equal to the money transferred to the corporation by the shareholder.
Normally stock losses will generally be treated as a capital loss. Section 1244 allows an original shareholder’s loss to be treated as an ordinary loss. An individual can deduct, as an ordinary loss, a loss on the sale, exchange, or worthlessness of small business stock. This ordinary loss is reported on line 10, Part II of Form 4797. The gain on this stock, however, is a capital gain if the stock is a capital asset and is reported on Schedule D, Form 1040.
A corporation, other than an S corporation, can deduct capital losses only up to its capital gains. In other words, if a corporation has a net capital loss, the loss cannot be deducted in the current tax year. It is carried to other tax years and deducted from capital gains that occur in those years. A corporation may deduct, with certain limitations, 70% of the dividends received if the corporation receiving the dividend owns less than 20% of the distributing corporation. Thus, if a corporation owns stock in another domestic corporation subject to federal taxation, it may deduct from its gross income 70% of the dividends that it receives from the other corporation.
Section 341 converted capital gain on the sale or liquidation of a corporation into ordinary income. However, this provision was repealed by the 2003 Bush Tax Act. Section 541 imposes an additional 15% penalty tax on corporations where five or fewer individuals own more than 50%, and 60% or more of its adjusted ordinary gross income is personal holding company income.
To avoid this tax, all you have to do is distribute the income. Under Code 531, a penalty tax of 15% is imposed on corporations that permit earnings and profits to accumulate in excess of the greater of the accumulated earnings credit or reasonable business needs.
A regular accounting period is either a calendar tax year or a fiscal tax year. If a corporation adopts the calendar year for its annual accounting period, it must maintain books and records and report its income and expenses for the period from January 1 through December 31 of each year. Personal Service and S corporations normally need to use a calendar year.
Tax-exempt income received by a corporation increases earnings and profits. Therefore, if a corporation receives a payment of tax free life insurance proceeds, any excess over premiums paid will increase earnings and profits. Likewise, interest on state bonds and other obligations, although not taxable when received by a corporation, increases earnings and profits. The proceeds and interest then lose their tax-free nature when they are distributed to shareholders as dividends.
There are three methods of identifying items in inventory specific identification, first-in first-out (FIFO), and last-in first-out (LIFO). Specific identification is like a car where you know the value of each item individually. FIFO evaluates the inventory by selling the oldest priced inventory first. LIFO sells the last item purchased first. LIFO is not allowed by IFRS. When you evaluate an inventory, you can use the cost method or lower of cost or market methods.
Multiple corporations can provide important benefits to the owners. The tax advantages made possible by operating a business through multiple corporations can dividing corporate taxable income among several corporations, substantially reduce income tax liability, avoiding the tax on unreasonable accumulation of earnings by generating additional accumulated earnings tax credits, and providing additional exemptions in computing the alternative minimum tax.
In order to be an S corporation you must be a Domestic Corporation, can’t have more than 100 shareholders, can only have individual shareholders, can’t have foreign owners, and you can’t have more than one class of stock. A corporation’s status as an S corporation may be terminated by revoking the election, ceasing to qualify as an S corporation, or violating the passive investment income restrictions on S corporations with pre-S corporation earnings and profits.
To figure S corporation income, divide the S corporation’s items of income, loss, expense, and credit into two categories separately stated items and items used to figure nonseparately stated income or loss. The separately stated items and the nonseparately stated income or loss are collectively known as pass-through items because they are passed through to the shareholders on a pro rata basis. However, before they are passed through, some items may be reduced. The character of each “pass-through” item is preserved. Thus, an item of tax-exempt income received by the corporation is tax-exempt to the shareholders; long-term capital gain earned by the corporation is a long-term capital gain for the shareholders.
If an S corporation has a net recognized built-in gain for any tax year beginning in the recognition period, a tax is imposed on the income of the S corporation for that tax year. When an S corporation has earnings and profits from its years as a C corporation, and where its passive income exceeds 25% of its gross receipts, it must pay corporate income tax on the excess net passive income. If a corporation used the LIFO inventory pricing method for its last tax year before its S election became effective, the corporation may be liable for LIFO recapture.
The LIFO recapture tax is figured for the pre-S corporation’s last tax year. The LIFO tax is paid in four equal installments. Investment credit recapture. This tax may apply if the corporation claimed investment credit on a prior year’s corporate income tax return before it became an S corporation. If the S corporation makes an early disposition of the property, the S corporation, and not its shareholders, will be liable for payment of the tax.
Reasonable Compensation is if a family member renders services to an S corporation, there must be reasonable compensation to that individual before allocation of the remaining income to stock held by other family members. This provision prevents the use of an S corporation to split personal service income. Related Party Rules losses realized on sales or exchanges of property between related parties generally may not be deducted. If the related party who acquired the property on which the loss was disallowed later resells the property at a gain, the gain is recognized only up to the amount that is more than the disallowed loss.
An S corporation is treated as a partnership for purposes of employee fringe benefits. Any 2% or more shareholder is considered a partner. Some fringe benefits are much more favorable to taxpayers when the corporate form is employed. For example, a corporation can pay and deduct medical insurance premiums for its employees, yet these are not taxed as compensation or dividends to the employees. This is not possible in a partnership because the premiums are considered paid by partners directly. However, under the Code, the partnership fringe benefits rules apply to S corporations.
Under a 105 plan, employer reimbursements for such employee medical expenses are excludable from income. This exclusion will not apply to highly compensated employees if the 105 plan discriminates in their favor. Under a 106 medical plan employers can deduct premiums paid or incurred for health or accident insurance plans. This includes payments made under plans that reimburse premiums paid by employees on personal health insurance policies, including supplemental medical insurance. These amounts are deducted on the line titled “Employee benefit programs” on the employer’s business return and are generally not includible in the employee’s income.
Code 119 specifically excludes from gross income of an employee the value of any meals or lodging furnished to him, his spouse, or any of his dependents by or on behalf of his employer. Cafeteria plans, including flexible spending arrangements, are written plans that allow employees to choose among two or more benefits consisting of cash and qualified benefits. Generally, a plan that provides for deferred compensation is not a cafeteria plan. However, certain profit sharing or stock bonus plans, and certain life insurance plans maintained by educational institutions can be offered through a cafeteria plan even though they provide for deferred compensation.
An individual cannot deduct education unless such expenses are incurred to maintain or improve skills of their existing employment. Educational expenses paid directly by the employer are normally not taxable to the employee if business related. An employee can receive up to $5,250 of educational assistance benefits tax-free. The assistance has to be provided under a qualified written plan. The Tax Relief Act of 2001 extended the exclusion for employer provided educational assistance to graduate education and made the exclusion permanent.
Under this provision, employers may furnish railroad or airline seats or hotel accommodations to employees if customers are not displaced and no substantial additional cost is incurred.
An employer can exclude qualified transportation fringe benefits from the gross income of employees, up to certain limits. Qualified transportation fringes are transportation in a commuter highway vehicle if the transportation is between the employee’s home and workplace, a transit pass, and qualified parking. Cash reimbursements an employer makes to an employee for these expenses under a bona fide reimbursement arrangement are also excludable. Cash reimbursements for transit passes qualify only if a voucher or a similar item that may be exchanged only for a transit pass is not readily available for direct distribution by the employer to employees.