Principles of Taxation
Chapter 9
Sole Proprietorships,
Partnerships, and S
Corporations
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Objectives
Slide 9-2
 Explain effect of sole proprietorship on individual
tax return.
 Describe requirements for home office deductions.
 Compute FICA taxes and self-employment taxes.
 Distinguish general and limited partnerships.
 Differentiate between partnership distributive
income versus cash flow.
 Compute partnership adjusted basis.
 Determine eligibility for S Corporation status.
 Contrast basis limits for S Corporations versus
partnerships.
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Business Organizations
Slide 9-3
 Taxpayer = owners = passthrough entities
 sole proprietorship
 partnerships
 LLCs
 S Corporations
 Taxpayer = corporation
 C Corporation is taxed first, then
shareholders may be taxed on distributions
(double taxation).
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Sole Proprietorship
Slide 9-4
 Business income and expenses are reported
on Schedule ____, filed with the individual
form 1040.
 Net income or loss on Schedule C is ordinary
income or loss; combine this net with other
items of gross income.
 If the Schedule C business loss > other sources
of income, the NOL (net operating loss) can
be carried back ___ years and forward ___
years.
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Sole Proprietorship
Slide 9-5
 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. See
Chapters 15 and 16.
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Home Office Deduction
Slide 9-6
 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
 1) as the...
 or
 2) as a place to meet with____________
____________or ____________.
 A home office used exclusively for administrative
or management activities qualifies as a principal
place of business under what conditions?
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Home Office Deduction
Slide 9-7
 If the office qualifies under above rules:
 Allocate expenses between business and
personal use. What are some examples?
 Home office deduction cannot exceed taxable
income of the business before this deduction.
See AP2.
 IR3, 4
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Employment Taxes
Slide 9-8
 FICA = _______% Social Security tax (on wages up to
$________ in 2001) + _____% Medicare tax on all
wages. Both employer and employee must pay this
tax.
 Employers withhold income taxes and the employee’s
share of FICA.
 Employers must remit the withheld taxes to the federal
(and state if applicable) governments.
 Self-employed taxpayers must pay SE (selfemployment) tax, equal to 2 x FICA, or ______% of net
earnings from self-employment. (See footnote 20 for
details). _______ of SE tax is deductible on Form 1040.
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Partnerships
Slide 9-9
 Are partnership agreements flexible?
 General partnership: All partners have unlimited
liability.
 Limited partnership: One or more limited partners
are only liable for their contributed capital.
Legally, all limited partnerships have at least one
general partner.
 Limited liability company (LLC): Treated as a
partnership for tax purposes but every owner has
limited liability.
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Partnership Reporting
Slide 9-10
 The partnership files an information return,
Form 1065.
 Included with the Form 1065 are Forms
______, which show EACH partner’s share of
income and deductions.
 EACH partner reports his or her share on
partnership income on Schedule E, as part of
his or her Form 1040. Certain items are
separately stated. Q9
 Does the partnership pay tax?
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Guaranteed Payments
Slide 9-11
 A guaranteed payment is a special allocation
of ordinary income to the partner receiving it
- similar in nature to a salary.
 The receiving partner reports as ordinary
income BOTH:
 1) His guaranteed payment.
 2) His share of partnership income after
the guaranteed payment.
 Other partners report their shares of
partnership income after the guaranteed
payment.
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Guaranteed Payment
Example
Slide 9-12
 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 1/3 each.
 RJJ earns $85,000 during the year.
 Robert reports $_________ of partnership
income ($25,000 + 1/3 x $60,000).
 John and Joseph each report $________ of
partnership income (1/3 x $60,000).
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Self-Employment Income
From Partnership
Slide 9-13
 SE tax must be paid on
 Guaranteed payments +
 ____________ partners do NOT pay SE tax on
share of ordinary income.
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Partnership Basis
Slide 9-14
 These things increases basis:
 Contributions (initial and ongoing): cash +
______ ________ contributed.
 + Positive income (taxable and taxexempt).
 + Share of partnership liabilities for which
partner is liable. (Also allow nonrecourse
real estate loans for limited partners.)
 These things decrease basis:
 Distributions.
 Losses and deductions (and shares of
nondeductible expenses).
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Partnership Losses Limited
to Basis
Slide 9-15
 Partners CANNOT deduct losses in excess of
________ . See AP13, 14.
 Excess losses are carried forward indefinitely
until additional basis is restored
 by additional contributions or additional
positive income.
 This rule applies to EACH partnership
separately.
 AP11, 12
 Are there questions about examples in the
text? This can be complicated.
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Other Entities
Slide 9-16
 Limited Liability Company
 Treated as a corporation for liability
purposes, but as a partnership for federal
tax purposes.
 Limited Liability Partnership
 A partnership in which each partner’s
liability is limited to his or her own actions.
Used by professional service firms.
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S Corporations
Slide 9-17
 Legally a corporation under state law.
 An S Corporation is a passthrough entity for
tax purposes.
 Income and loss items are allocated among
shareholders based on what?
(This allocation is not flexible like partnership
agreements.)
 Passthrough items retain their character on
the individual tax return (e.g. ordinary
income, capital losses, charitable
contributions, etc).
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S Corporation Eligibility
Slide 9-18
 What kinds of taxpayers can be shareholders?
 The number of shareholders (not including
spouses) is limited to ____.
 The corporation may only have one class of
outstanding common stock.
 Shareholders must unanimously elect S Corp
status.
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Shareholder Basis
Slide 9-19
 Initial basis = cash + adjusted basis of
contributed property.
 How do loans affect shareholder’s basis?
Contrast this to partnerships. See AP19, 20
 Like partnerships, basis is increased by
contributions and income items. Basis is
decreased by distributions and loss items.
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S Corporation Operation
Slide 9-20
 Shareholders can be paid a salary. The salary
is subject to payroll taxes and reduces
ordinary income of the S Corporation.
 Is ordinary income subject to selfemployment tax?
 Allocable share of loss items can only be
deducted up to BASIS, like with partnerships.
What happens to losses in excess of basis?
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