Chapter 10
Sole Proprietorships, Partnerships,
LLCs, and S Corporations
McGraw-Hill/Irwin
Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
10-2
Objectives
Explain effect of a sole proprietorship on an individual tax
return
Compute FICA taxes and self-employment taxes
Differentiate between partnership distributive income versus
cash flow
Apply basis limitation on deduction of partnership losses
Explain federal tax treatment of Limited Liability Companies
(LLCs)
Compute partnership adjusted basis
Determine eligibility for S Corporation status
Contrast basis limits for S Corporations versus partnerships
10-3
Business Organizations
Taxpayer = owner(s) of flow-through entities
Sole proprietorship
Partnerships
LLCs
S Corporations
Taxpayer = corporation
C Corporation is taxed first, then shareholders may be
taxed on distributions, resulting in double taxation
10-4
Sole Proprietorship
Business income and expenses are reported on
Schedule C, filed with the individual form 1040
Net income or loss on Schedule C is ordinary income or
loss; combine this net amount with other items of gross
income on page 1 of form 1040
If the Schedule C business loss
is greater than other sources of
income, the NOL (net operating
loss) can be carried back 2 years
and forward 20 years
10-5
Sole Proprietorship
Special reporting rules
Interest, dividends and rent income related to owner’s
investments are not reported on Schedule C; see
Schedules B and D instead
Dispositions of business assets are reported on Forms
4797 and Schedule D
Interest expense on business debt is
deducted on Schedule C. Non-business
interest expense may be deductible if it
is for investments or home mortgages.
More on these issues in Chapters 15 and 16
10-6
Home Office Deduction
 A portion of the taxpayer’s personal residence may be
allowable as a Schedule C deduction if
 The office is used exclusively on a regular basis as
1) the principal place of business
operated by the homeowner, OR
2) a place to meet with patients,
clients or customers
 A home office used exclusively for administrative or
management activities qualifies if the taxpayer
has no other fixed location where such
activities are conducted
10-7
Home Office Deduction
If the home office qualifies
Allocate expenses between business and personal use
Utilities
Home mortgage interest and taxes
Insurance
Repairs
Depreciation
Home office deduction cannot exceed taxable income of the
business before this deduction
10-8
Employment Taxes
Employer portion:
FICA = 6.2% Social Security tax on wages up to $113,700 (2013) +
1.45% Medicare tax on all wages
Employee portion:
FICA = 6.2% in 2013 (4.2% for 2011 and 2012) Social Security tax on
wages up to $113,700 (2013) + 1.45% Medicare tax on all wages
Employers withhold income taxes and
the employee’s share of FICA taxes
Employers must remit the withheld
taxes to the federal (and state if
applicable) governments
10-9
Employment Tax Example
In 2013, ABC Co. paid Ms. Smith $119,000 in salary and
withheld $21,800 for federal income taxes. How much
cash was disbursed to Ms. Smith and to the US Treasury
on her behalf?
Ms. Smith’s Social Security W/H = (.062 x $113,700) = $7,049
Ms. Smith’s Medicare W/H: (.0145 x $119,000) = $1,726
Cash disbursed to Ms. Smith = $119,000 - $21,800 - $7,049 $1,726 = $88,425
ABC’s employer FICA = (.062 x $113,700) + (.0145 x $119,000) =
$8,775
Cash disbursed to US Treasury = $21,800 + $7,049 + $1,726 +
$8,775 = $39,350
10-10
Self-Employment (SE) Tax
Self-employed persons pay SE tax on net earnings from
self employment
Tax base = 92.35% of net profit reported on Schedule C
Tax rates
 Social security tax =12.4% in 2013 (10.4% in 2011 and
2012) of earnings up to $113,700 (2013)
 Medicare tax = 2.9% of earnings
Self-employment tax is paid via estimated tax payments rather
than through withholding
50% of self-employment tax (2013) on Form
1040 as deduction for AGI
10-11
Additional Medicare Tax on Wages
Beginning in 2013, 0.9% additional Medicare tax
on wages above a threshold amount
$250,000 MFJ ($125,000 MFS)
$200,000 single and H of H
In 2013, Mr. Fox earned wage income of $220,000
and Mrs. Fox earned wage income of $115,000
On their joint return, they will owe additional Medicare tax
of $765 (0.009 × ($220,000 + $115,000 - $250,000))
10-12
Partnerships
The partnership agreement states the rights and obligations
of partners, and the % of profits and losses allocable to
each partner. Such agreements permit flexibility
General partnership: all partners have
unlimited liability - joint and severable
Limited partnership: one or more limited partners are only
liable for their contributed capital. Legally, all limited
partnerships have at least one general partner
10-13
Limited Liability Partnership
Limited liability partnership (LLP) used for
professional services. General partners are not
liable for malpractice of other partners but are
personally liable for other debts of the LLP
10-14
Initial Tax Basis in Partnership Interest
Cash plus adjusted basis of property contributed
+ Share of partnership debt for which partner could be
responsible
Two individuals, Jay and Kay, each contributed $25,000
cash to a new partnership. What is Jay’s basis in his
partnership interest assuming that the partnership takes
out a $10,000 loan and
The partnership assets secure the loan?
($25,000 + (.5 × $10,000)) = $30,000
Jay personally guarantees the loan?
$25,000 + $10,000 = $35,000
10-15
Partnership Reporting
The partnership files an information return, Form 1065
Included with Form 1065 are Forms K-1, which show
each partner’s ‘distributive share’ of income and
deductions
“Non-ordinary” items are separately stated and retain their
character on the partner’s return
Examples: muni interest, capital gains and losses
Each partner reports his or her share of partnership
income on Schedule E, as part of his or her Form 1040
10-16
Partnership Reporting
Because the partnership does not pay tax, the
partnership is referred to as a ‘flow-through’ or
‘pass-through’ entity
Publicly Traded Partnerships
Partnership interests traded on an established securities
market
Generally taxed as corporations
10-17
Guaranteed Payments
A guaranteed payment is a special allocation of ordinary
income to the partner receiving it; similar to a salary, except
that FICA and income tax are not withheld
Partnership is allowed a deduction for the guaranteed
payment
The receiving partner reports as ordinary income
His guaranteed payment and
His share of partnership income after the guaranteed payment
Other partners report their shares of partnership income
after the guaranteed payment
10-18
Example: Guaranteed Payment
Robert, John and Joseph form the RJJ partnership. Robert
will do most of the work, so he will receive a guaranteed
payment of $25,000 per year. The partners agree to share
any remaining income one-third each
The partnership earns $85,000 during the year
Robert reports $45,000 of partnership income ($25,000 + 1/3 x
$60,000)
John and Joseph each report $20,000 of partnership income (1/3 x
$60,000)
10-19
Self-Employment Income From Partnership
SE tax must be paid by a general partner on
Guaranteed payments +
Distributive share of ordinary business income from partnership
Limited partners do not
pay SE tax on their share
of ordinary income
10-20
Adjusting Partnership Basis
A partner’s tax basis in his/her partnership interest is
adjusted annually to reflect share of partnership items and
changes in investment
These items increase basis
Contributions (initial and ongoing): cash + adjusted basis of property
contributed
Positive income (taxable and tax-exempt)
Share of partnership liabilities for which
partner is liable (Also allow nonrecourse
real estate loans for limited partners)
10-21
Adjusting Partnership Basis
These items decrease basis
Distributions
Losses and deductions (and shares of nondeductible
expenses)
10-22
Partnership Losses Limited to Basis
Partners cannot deduct losses in excess of basis
Excess losses are carried forward indefinitely until additional
basis is restored either by additional contributions or
additional positive income
This rule applies to each partnership separately
10-23
Example: Partnership Losses
Mr. Q is a 1/3 partner in QRS Partnership. His basis in the
partnership at the beginning of the year is $3,000. The partnership
had ordinary income of $30,000; capital gain of $4,500; and
guaranteed payments to Mr. Q of $45,000 for the current year
Mr. Q’s share of the operating loss is (1/3 * ($30,000 - $45,000) =
$5,000), but the current year deduction is limited to basis
What is Mr. Q’s basis as of Dec. 31?
Beg. of Year Basis
$ 3,000
Share of capital gain
1,500
Share of operating loss
( $4,500)
End of Year Basis
$
0
10-24
Limited Liability Company
LLCs are an alternative to a general or limited partnership.
All members of an LLC have limited liability for LLC’s debt
Treated as a corporation for liability purposes, but as a
partnership for federal tax purposes
Relatively new organizational form - less legal precedence
Every state (and DC) permits LLCs
Still unclear when LLC income is subject to SE tax
10-25
S Corporations
Legally a corporation under state law, an S Corporation is a
flow-through entity for tax purposes
Income and loss items are allocated among shareholders based on
their % ownership of stock; this allocation is not flexible like
partnership agreements
Flow-through items retain their character (e.g. ordinary income,
capital losses, charitable contributions, etc)
Distributions to S corporation shareholders are generally treated as
non-taxable recoveries of investment, similar to partnership
distributions
Not treated as dividends (C corporation treatment)
10-26
S Corporation Eligibility
Only individuals, estates and some trusts
may be shareholders – not nonresident aliens, other
corporations, or partnerships
The number of shareholders is limited to 100; all family
members may be counted as 1 shareholder
The corporation may only have one class of outstanding
common stock
Shareholders must unanimously elect S Corp status; the
election is permanent unless shareholders owning a
majority of the stock revoke the election
10-27
Shareholder Basis
Initial basis = cash + adjusted basis of contributed property
Loan from a shareholder to S Corp increases basis for that
shareholder. Any other debt of the S Corp does not
increase shareholder basis (E.g., a bank loan guaranteed by
shareholder does not increase basis for any shareholder,
even the one that guaranteed the loan)
Like partnerships, basis is increased by contributions and
income items; basis is decreased by distributions and loss
items
10-28
S Corporation Operation
Shareholders can be paid a salary
Salary is subject to payroll taxes and reduces ordinary
income of the S Corporation
S Corp can use corporate employee benefit plans for
shareholder/employees
Share of ordinary income is NOT subject to SelfEmployment tax
10-29
S Corporation Operation
Allocable share of loss items can only be deducted
up to basis, as with partnerships
If the shareholder loans money to the S
corporation, additional loss equal to the basis of
debt may be taken
Losses in excess of basis
are carried over until the
shareholder has basis again
10-30
Example: S Corporation Loss
Assume that Mr. Q owns 1/3 of the stock in an S Corporation and that
the basis in his stock on Jan. 1 is $3,000. In addition, Mr. Q loaned the S
corp. $1,000 during the year. The S Corp. had ordinary income before
salary payments to Mr. Q of $30,000; capital gain of $4,500; and salary
payments to Mr. Q of $45,000 for the current year.
Stock
Loan
Beg. of Year Basis
$ 3,000
$1,000
Share of capital gain
1,500
Share of operating loss
( $4,500)
($ 500)
End of Year Basis
$
0
$ 500
10-31