Chapter 10
Sole Proprietorships
and
Flow-Through Entities
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Flow-Through Entity
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An operating business whose net income
(and certain other items) pass directly
through to the owners
The items passed through are included with
the owners’ other income/loss items for
taxation
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Flow-Through Entities
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Sole proprietorship
General partnership
Limited partnership
Limited liability company (LLC)
Limited liability partnership (LLP)
S corporation
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Sole Proprietorship
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One owner business that is easy to form
Owner (sole proprietor) must be an individual
Sole proprietor has unlimited liability
Business uses same tax year as owner
Owner has no capital account and no basis in
the business as a whole
Basis of personal assets contributed is lesser
of their adjusted basis or FMV
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Owner must establish that the business is
legitimate and not a hobby
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Sole Proprietorship
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Owner uses Schedule C (or C-EZ) to report
proprietorship income and expenses
Some transactions are not included in
business operating income
Investment income and expenses
Capital gains and loses
Section 1231 gains and losses
Charitable contributions
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Sole Proprietorship
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Proprietor maintains an office in the home
Allocated space must be used exclusively and
on a regular basis for the business
Deduction is limited to taxable income from
business after deducting all other business
expenses
Expenses related to use are separately
reported on Form 8829
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Sole Proprietorship
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Sole proprietor does not receive a salary
 Taxed on the entire net income (or deducts the
loss) from Schedule C on Form 1040
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Sole proprietor is not eligible for tax-free
employee fringe benefits
 Can deduct own health insurance premiums for
AGI
 Can deduct contribution to own retirement
account for AGI
 Can hire spouse as employee and spouse can
then participate in fringe benefits
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Self-Employment Taxes
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Self-employed individuals (sole proprietors,
general partners, and managing members of
LLCs) must pay self-employment taxes
(Social Security and Medicare)
Deduction allowed for 50% of selfemployment tax for AGI
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Partnerships
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A partnership is a relationship between 2 or
more individuals (or other entities) to operate a
business and share profits
No limit on number of partners
There are no restrictions on who can be a
partner (any type of entity, including an
individual, another partnership, a corporation,
an estate, or a trust)
Most LLCs are partnerships for tax purposes
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General Partnership
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General partnerships have only general partners
 General partners are personally liable for all
debts of the partnership
 General partners have an active role in
management
 General partners have the authority to bind the
partnership with respect to third parties
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Limited Partnership
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Limited partnerships have at least one general
partner and at least one limited partner
 Limited partner’s liability is limited to invested
capital
 Limited partners are not permitted to have an
active role in the management of the
partnership
 Limited partners do not have the authority to
bind the partnership with respect to third parties
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Limited Liability Partnership
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The LLP is a general partnership that
conducts a business providing professional
services
Partners in an LLP are fully liable for the
general debts of the partnership
This entity protects partners from liability for
malpractice of other partners
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Limited Liability Company
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An LLC is a separate entity from its owners
(members)
LLCs provide members with limited liability
LLCs can choose to be taxed as partnerships or
corporations for federal tax purposes (singlemember LLC cannot be taxed as partnership)
Ownership structure allows different classes of
ownership with different voting rights
Forming an LLC is a more formal process than
forming a partnership and may be more costly
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PLLC
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The professional limited liability company is
a professional service organization using the
LLC form
PLLCs protect members from liability for
malpractice of other members
PLLCs also protect members from general
liabilities of the business (similar to corporate
shareholders)
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Partners Cannot Be Employees
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General partners, managing LLC and other
active LLC members are considered selfemployed individuals and required to pay selfemployment tax on net income passed through
to them
Limited partners and LLC members who are only
investors do not pay self-employment tax
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Partners and LLC members cannot be
employees and are not eligible for tax-free
employee fringe benefits
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Entity vs. Aggregate Concept
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Entity concept – views the partnership as
separate from the partners
Partner can sell property to partnership and
recognize gain or loss on sale
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Aggregate or conduit concept – views the
partnership as an extension of the partners
Partners are liable for debts of the partnership
Partners share gains and losses from operations
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Partner’s Capital Account
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Each partner’s capital account will show the
partner’s claim on the net book value of the
partnership assets.
The difference between the partner’s capital
account and partner’s tax basis is due to the
unrecognized (deferred) gain or loss on
property contributed
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Partner’s Interests
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A partner has a proportionate interest in the
partnership assets
A partner has a right to share in a
percentage of the partnership's profits and
losses
 Share of income or loss is determined by
the provisions of the partnership agreement
 If no provision is specified, partners are
assumed to share profits and losses equally
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Partnership Tax Year
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Profits and losses flow through to partners on
the last day of the partnership’s tax year
 Partners report their share on their tax return in
the year in which the partnership tax year ends
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Partnership tax year is one of following
 Tax year of its partners who own majority
 Year of all the principal partners (owning more
than 5% interest)
 Month that provides least aggregate deferral of
income
 Natural business year (no more than 3-month
deferral of flow-through items)
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Operating Results
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Form 1065, information return, includes
Schedule K (and K-1 for each partner) which
shows separately stated items and aggregate
income or loss
Separately stated items are those that cannot
be aggregated into net income because they
are subject to some special treatment or
limitation at the owner level
Partnership net income is the aggregate of all
items that are not separately stated
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Separately Stated Items
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Capital gains and losses
Section 1231 gains and losses
Dividends and interest (and related expenses)
Section 179 deductions
Charitable contributions
Medical and dental expenses paid by
partnership for partners
Passive income
AMT preferences and adjustment items
Self-employment income
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Operating Results
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Partners must report their share of
partnership income even if they receive no
distributions from which to pay taxes
Partners who need money to pay taxes on
income that is passed through should make
sure partnership agreement permits
withdrawals of cash for this purpose
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Partner's Basis
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Basis determines the
 Maximum amount a partner can withdraw
tax-free from the partnership
 Limit on the amount of loss a partner can
deduct
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A partner's basis in his partnership interest
begins with his contribution to the
partnership
 If property is contributed, partnership
interest basis equals the adjusted basis of
the property contributed
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Partner's Basis
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The partner's basis is increased by:
Recourse debt—creditor can look only to
general partners for repayment on default
Partner's share of income (including taxexempt income)
Nonrecourse debt—creditor can look only to
collateral for repayment on default
Partner’s share of liabilities
General partner's share in all partnership
liabilities
Limited partner’s share in nonrecourse
liabilities only
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Partner's Basis
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The partner's basis decreased by
Reduction in liabilities
Partner's share of loss
Distributions made to partner
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Partner can never have negative basis
To prevent negative basis, partner
recognizes gain equal to the amount by
which a cash distribution exceeds basis
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General Loss Limitation
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If a partner’s share of losses exceeds the
partner’s basis
 Partner can only deduct losses to the
extent of basis
 Excess losses are carried forward
(indefinitely) to future years until there is
sufficient basis against which to deduct the
unused losses
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At-Risk Rules
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Limit losses by recognizing partners are not
at-risk for nonrecourse debt
At-risk rules limit deductibility of losses to
partner’s basis reduced by nonrecourse
debt
 Losses are carried forward until partner has
sufficient at-risk basis
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Passive Income and Losses
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Passive losses can only be deducted by
owner/recipient to the extent there is passive
income from a prior year or from another
passive activity
Passive losses may be deducted against
nonpassive income in year activity is
completely disposed of
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Types of Income and Losses
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Active: salary and wages of an employee and
income earned from a business in which the
owner/recipient materially participates
Portfolio: interest and dividends
Passive: tax shelter income, income passed
through to limited partners, and income from
other businesses in which owner/recipient
does not materially participate
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Material Participation
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Current activity level
 500 hours or more participation during year
 Participation is substantially all the activity by all
persons
 At least 100 hours and no one else participates
more
 At least 100 hours in more than one activity and
aggregate of activities exceeds 500 hours
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Prior activity level
 Materially participated in 5 of preceding 10 years
 Materially participated in 3 prior years in personal
service activity
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Rental Real Estate Relief
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Taxpayers can qualify for up to $25,000
deduction for rental real estate losses
Taxpayer must own at least 10% and actively
participate in management
Set rents, qualify renters, approve repairs
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Deduction phases out for AGIs between
$100,000 and $150,000
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Real Property
Business Exception
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Taxpayers must spend more than half their
time in real property businesses in which they
materially participate and time spent equals
or exceeds 750 hours
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Partner’s Guaranteed Payment
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A fixed or guaranteed payment (or salary)
made to a partner for services or use of
capital is treated as a business expense
deduction by the partnership and ordinary
income to the partner receiving it
If the payments are dependent upon
partnership operations, they are not
guaranteed payments
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Nonliquidating Distributions
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Distributions are generally tax-free to
partners
Distributions reduce the partner’s basis
 Reduce basis first for cash received then
for basis of other property distributed
(partner takes partnership’s basis for
property)
 If cash distribution exceeds partner’s basis,
the partner recognizes gain for the excess
 Loss is never recognized on nonliquidating
distributions
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Liquidating Distributions
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Gain recognized only if cash received
exceeds partner’s basis (same as
nonliquidating distribution)
A partner may recognize loss only if the total
basis of cash and ordinary income property
received is less than his partnership basis
 If partner receives any other property, the partner
allocates basis remaining in the partnership
interest to that property (and loss is not
recognized)
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Sale of Partnership Interest
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Any gain or loss recognized on sale of
partnership interest is normally capital gain or
loss
 If partnership owns ordinary income assets (hot
assets), the sale must be partitioned between
the hot assets and all other assets to prevent
the partner from converting gain on sale of
ordinary income assets to capital gains
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Any reduction in liabilities is treated as cash
received
Partnership tax year closes for selling partner
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S Corporations
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Qualifying corporations that elect S
corporation status use conduit (flowthrough) concept to achieve only one level
of tax
Profits and losses allocated to
shareholders according to the number of
shares of stock owned on each day of the
tax year
Afford shareholders the limited personal
liability of a regular corporation
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S Corporation Requirements
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Must be a domestic corporation
Have only one class of stock outstanding
Have no more than 75 shareholders (husband
and wife are considered one shareholder)
Can have only individuals, estates and certain
trusts as shareholders
Individual shareholders must be either U.S.
citizens or resident aliens
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Electing S Status
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File Form 2553 by 15th day of the 3rd month
of the year in which election is to be
effective
 File by March 15, 2005 for calendar year
2005
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Prospective election (effective for following
tax year) can be made any time
IRS has authority to accept late filing if
corporation can show reasonable cause
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Affirmative Termination
of the S Election
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A retroactive revocation must be made by the
15th day of 3rd month by a simple majority of
the shareholders
A prospective termination can be made at
any time for any future date specified by a
simple majority of the shareholders
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Inadvertent Termination
of the S Election
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If the S corporation fails to satisfy any of the S
corporation requirements at any time, the
election is terminated as of the day before the
disqualifying event occurred
If termination inadvertent, IRS can allow
corporation to continue as S corporation
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S Corporation Operations
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Determination of net income and separately
stated items is similar to partnerships
S corporation net income not subject to selfemployment taxes
 Employment taxes paid only on salaries
 Shareholder cannot participate in employee fringe
benefits if ownership is greater than 2%
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Form 1120S reports operations
 Income and loss allocated on number of days
ownership and number of shares owned
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Loss Limitations
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Limitations on loss deductions for
shareholders similar to those for partners
 Shareholder must have basis
 Shareholder must be at-risk
 If losses are passive, passive rules apply
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Liability treatment very different from
partnership
 No basis increase for any corporate liability
 Shareholder can deduct loss to the extent of basis
in debt for money loaned directly to corporation
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Stock Basis
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Each shareholder must keep track of stock
basis similar to tracking a partnership basis
Basis begins with contribution to capital or
purchase of stock
Increased for income and gains and reduced
first for distributions and then for deductions
and losses (including nontaxable income and
expenses), but not below zero
Distributions are tax-free if they do not exceed
basis; gain recognized if distribution exceeds
basis as if stock is sold for excess
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AAA
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Accumulated adjustment account – a
corporate account that tracks a corporation’s
undistributed but previously taxed earnings
The positive balance in AAA is the measure of
the value of cash and property that can be
distributed to shareholders without additional
tax
Unlike basis, AAA may be negative from
losses (but distributions cannot make AAA
negative)
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Property Distributions
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Corporation recognizes gain on distribution of
appreciated property
Loss on depreciated property not recognized
Shareholders increase their stock basis for
the gain recognized (unrecognized loss does
not reduce basis)
Basis is then reduced for FMV of distributed
property
Shareholders use FMV for basis of all
property received
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Schedules M-1 and M-2
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Schedule M-1 reconciles book to tax income
and is similar to C corporation’s M-1 without
contribution carryovers or taxes paid
Schedule M-2 reconciles AAA account at
beginning of year to balance at end of year
OAA reconciles items that don’t affect AAA
(tax-exempt income and expenses)
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S Corporation Taxes
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Under normal circumstances, an S
corporation does not pay taxes
If it was previously a C corporation, it may
pay taxes in a few special cases for
 Built-in-Gains
 Excess Net Passive Investment Income
 LIFO Recapture
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Redemptions and Liquidations
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S corporations follow C corporation rules
In a redemption of stock for property, S
corporation recognizes gain on distribution of
appreciated property (but not loss)
Recognized gain flows through to shareholders
and increase basis
In liquidation both gains and losses are
recognized; these gains (losses) flow through
and increase (decrease) stock basis
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The End
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