Accounting for Different Business Entities

Accounting for Different Business Entities

– Sole Proprietorship
– C-Corporations
– S-Corporations
– Partnerships
– Limited Liability Companies
November 15, 2012

Irma Miller MBA, CPA
E-mail: info@irmamillercpa.com

Disclaimer:

• The views expressed in this presentation are my own
and not necessarily those of the Kentucky Society of
Certified Public Accountants, the American Institute
Certified Public Accountants and the Internal Revenue
Service.
• The information is not a substitute for consultation with
an expert and the creator is not liable for problems
arising from following the advice on the site.
• The laws and regulations are subject to change over
time and recent changes after the date of this
presentation may not be reflected on this presentation

Sole Proprietorship (legal)

• is a type of business entity that is owned and run by one
individual and in which there is no legal distinction
between the owner and the business.
• IRS (US federal tax authorities) defines a sole
proprietorship as someone who owns an
unincorporated business by himself or herself. However,
if you are the sole member of a domestic limited liability
company (LLC), you are not a sole proprietor if you elect
to treat the LLC as a corporation. If there is only one
member in the company, the sole proprietor or single
member LLC is treated as a “disregarded entity” for tax
purposes.

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Sole-P


• The owner receives all profits (subject to federal, state
and local taxation specific to the business).
• The owner is responsible for submitting estimated tax
payments (quarterly) to federal, state and other agency.
• The sole proprietor is personally liable for all debts and
actions of the business.
• Purchasing insurance to cover the risks of running the
business is recommended.
• If more than one owner, form a partnership.
• Sole Proprietor is less recommended for
Attorney Business / Law Firm

Advantages: Disadvantages:
• no formal filing • unlimited liability, a sole
• less government rules, proprietor is personally liable
regulations, & compliance for all the debts and
• less administration and obligations of the business
formalities • lack of continuity, and
• does not pay a separate succession planning
income tax at the business • more difficult in raising capital
entity level, no double taxation • commingle with personal
information (married filing joint
return on Federal 1040 with
Schedule C, Profit or Loss
from Business)

Formation of legal entity with secretary of
state

The state law governs the default rules of each of legal
entity formation and operation. Please check each of the
50 state website.
If the selected entity formation and operation chooses not
to follow the default state law regulation, the opt-out of
default state law regulation has to be in writing on the
legal paperwork such as: article of organization, article of
incorporation, operating agreement, bylaws, resolutions.

Please consult with business attorney !

C-Corporation (tax)
• C-Corporation refers to any corporation that, under
United States federal income tax law, is taxed separately
from its owners. (double taxation)
• Formation: Corporations are formed under the law of
(50) states. Corporations are issued a “certificate of
incorporation” or “articles of incorporation” by most
states upon formation. Additional optional governing
rules called “bylaws”.
• Guide to office of secretary of states
http://smallbusiness.findlaw.com/incorporation-and-legal-struc
• Distributions: any distribution from the earnings and
profit of a C-Corporation is treated as a dividend for US
income tax purposes.
(Publication 542 Corporations, Internal Revenue Services)

C-Corporation (tax)
Advantages
• may become public corporation,
Disadvantages
shares being bought and sold • “double taxation”, dividend is
through stock market or “over the taxable on corporate level and
counter”
• unlimited number of shareholders end-user level
• unlimited classes of stocks/shares, • not a pass-through entity ,
either voting or non-voting rights cannot pass through either
• limited liability, stockholders
generally not liable for debts of loss or income to investors /
corporation shareholders
• flexible access of outside capital • higher administrative expense
or financing
• eligible for dividends-received from being publicly traded than
deduction under US Federal privately held corporation
Income tax law (for 20% of more
of ownership of certain corporation
stocks)

C-Corporation (tax)
• C-Corporation files the Form 1120 business tax return to IRS
(federal) annually.
• IRS Website for C-Corporation:
http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Corporations

Reasonable Compensation in closely-held C-Corporation:

Corporate payments to a shareholder/employee are salaries or are
dividends, which have different tax consequences.

Reasonable compensation factors involving analyzing if: (1) the amount
of the salary is reasonable, and (2) the payment is “purely for
services” .

C-Corporation (tax)
Reasonable Compensation in closely-held C-Corporation:
C corporation income is double taxation – once when earned at the
corporate level and again when paid as dividends at the shareholder
level. To avoid this result, closely held C corporations tend to pay
large salaries, or large year-end bonuses, reducing taxable income
on corporate level, and resulting in only one level of taxation, at the
shareholder level.
IRS may disallow large compensation deductions to owners of
closely-held C corporations, challenging the payments as “disguised
dividends”. Treating a dividend as salary is less likely to be
attempted in a publicly held corporation.
Menard, Inc. v. Comm., ((7th Cir) 2009 No. 08-2125
Pediatric Surgical Associates v. Comm. (TC Memo 2001-81)
Multi-Pak Corp. v. Comm., TCM 2010-139

“Check the box”
• refers to “electing out” of the “default” classification
• A new eligible entity that does not want the classification
provided by the “default” provisions or an existing
eligible entity that wants to change its classification must
file Form 8832, Entity Classification Election. The
effective date may be specified in the election but may
not be more than 75 days prior to the date that the
election is filed.
• Eligible entities are able to choose whether to be taxed
as a disregarded entity (sole proprietor/partnership) or
corporation for federal tax purposes. An entity is not
required, but may elect, to be classified as a
corporation. (IRC Section 301.7701-1 to 301.7701-3)

S-Corporation (tax)
• S-Corporation are merely corporation that elect to pass
corporate income, losses, deductions, and credit through
to their shareholders for federal tax purposes.
(IRC Section 1361-1379)
• S-Election (IRC Section 1361(b)), a small business
corporation must:
– be a domestic corporation
– have no more than 100 eligible shareholders
– have only shareholders who are individuals, estates, certain
exempt organizations, or certain trusts
– have only one class of stock

S-Corporation (tax)
• Ineligible shareholders:
–non resident aliens
–foreign trusts
–IRAs (also Roth IRAs, Taproot Court Case)
–C-Corporations
–Partnerships
–LLCs
• IRS Website for S-Corporation:
http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/S-Corporations

S-Corporation (tax)
• Election to be an S-Corporation:
A corporation elects to be treated as an S corporation by
filing Form 2553, Election by a Small Business
Corporation, at the appropriate IRS Service Center. An S
corporation election is effective for the current year if it is
filed on or before the fifteenth day of the third month of
that year. Elections made after that date are effective for
the following year. Each shareholder who owns stock at
the time the election is made must consent to the
election.
• Form 2553 can be filed with the first year Form 1120S
S-Corporation Tax Return.

S-Corporation (tax)
• Formation: file with secretary of state
either articles of organization or article
of corporation depending on choice of
legal form of entity allowed by state
regulation. Additional optional governing
rules call either “bylaws”, “operating
agreement” or “business resolutions”.

S-Corporation (tax)
Advantages Disadvantages
• The S-Corporation is not taxed • Built-In Gains: when shifting
on its profit, the shareholders from C-Corporation to S-
of an S-Corporation are taxed Corporation, the gain on
on their proportional shares of appreciation would have been
S-Corporation’s profit. to recognize the same way as
• The loss from S-Corporations if the company has been a C-
flow through shareholders can Corporation.
be deducted limited to the • The Sting Tax: a tax imposed
shareholder’s basis. The on certain passive activity
shareholder’s basis must first income when shifting from C-
be determined. corporation to S-Corporation.
(IRC Section 1366)

S-Corporation (tax)
Built-In Gains:
The Built-In Gains tax does not apply to a corporation that meets any
one of the following:
• It made an S election prior to 1987 and has retained that election
since.
• It made an S corporation election and has never been a C-
corporation
• It has been an S corporation continuously for the 10 years
preceding liquidation.

The built-in gains (BIG) tax was enacted to prevent corporations from
making an S election solely to avoid double tax at liquidation.

S-Corporation (tax)
Built- In Gains:
IRC Section 1374 requires the corporation to pay a corporate level tax
on certain property sales made in the 5-year (in 2011), 7-year (in
2009 and 2010) or 10-year (prior to 2009) recognition period
following an S election by a C corporation.

The Sting Tax:
If an S Corporation had ever been a C corporation and that C
corporation carried over subchapter C earnings and profits, the S
corporation is subject to a corporate tax on its passive income that
exceed 25% of gross receipts.
(Internal Revenue Code Section 1375)
The sting tax can be avoided if the corporation has always been an S
Corporation.

S-Corporation (tax)
Reasonable Compensation in S-Corporation:
FICA and FUTA taxes are imposed on compensation paid by an S
corporation.
Dividend and undistributed income not subject to payroll taxes.

David E. Watson, P.C. v. USA, (S.DC Iowa) 4:08-cv-442, May 27, 2010, 2010 USTC
David E. Watson, a CPA created DEWPC, an S-Corporation.
DEWPC agreed to provide accounting services exclusively to LWBJ
Financial, a CPA, consulting and venture capital firm. In 2002,
DEWPC paid $ 24,000 as salary to David even though it received
over $ 203,000 from LWBJ. The rest was distributed as S
corporation dividends. In 2003, David received $ 24,000 of salary.

S-Corporation (tax)
Continued ……
David E. Watson, P.C. v. USA, (S.DC Iowa) 4:08-cv-442, May 27, 2010, 2010 USTC
The IRS employment tax examiner recharacterized $ 130,730 of the
2002 dividend payments as wages subject to employment taxes and
$ 175,470 of the 2003 dividend payments as wages subject to
employment taxes. At court, the IRS reduced their characterization,
arguing that only $ 67,044 of the dividend distributions should be
recharacterized as wages for each of 2002 and 2003. DEWPC
(David) asked for summary judgment against the IRS’ position. The
Iowa District Court denied the summary judgment.

V.R. DeAngelis M.D., P.C. v. Comm., CA-2 2009-2 USTC July 28, 2009
Note: Supreme Court Denies Review of Case, May 17, 2010

Partnerships (legal)
“partnership” includes a syndicate, group, pool, joint venture, or other
unincorporated organization, through or by means of which any business,
financial operation, or venture is carried on, and which is not, within the
meaning of this title, a corporation or a trust or estate (IRC Section 761(a))

Intent of subchapter K
Subchapter K is intended to permit taxpayers to conduct joint business
(including investment) activities through a flexible economic arrangement
without incurring an entity-level tax. Please see the detail requirement on
IRC Section 1.701-2(a)

IRS Website for Partnerships:
http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Partnerships

Partnership that chooses to be treated as a disregarded entity file Form 1065 Annual
Tax Return.


• A partnership is a for-profit business association
of association of two or more persons. Because
the business component is defined broadly by
state laws and because “persons” can include
individuals, groups of individuals, companies,
and corporations.
• Creation, organization, and dissolution of
partnerships are governed by state law. Many
states have adopted the Uniform Partnership Act
.


• General Partner share equal rights and responsibilities in
management. Each individual partner assumes full responsibility for
all the business’s debts and obligations. If the partnership opt for an
unequal distribution, the percentage assigned to each partner must
be documented in the partnership agreement.
• Limited Partner allows each partner to restrict his or her personal
liability the amount of his or her business investment.
• At least one participant must accept general partner status,
exposing himself or herself to full personal liability for the business’s
debts and obligations.
• General Partner retains the right to control the business, while the
limited partner(s) do(es) not participate in management decisions.
• Both general and limited partners benefit from business profits.


• Not required to file with the state for • Unlimited liability.
simple general partnership • Partners cannot transfer ownership
arrangement. When there is a limited without unanimous consent.
partner, prefer to file with the state. • Profit sharing between partners.
• Even though no formal written
agreement is required for general
partnership, written partnership
agreement is strongly recommended
to avoid unresolved dispute between
partners.
• No double taxation, pass-through
entity.
• Joint venture possibly works for
business to business project
arrangement, not perpetual. This will
require advance bookkeeping
administration techniques / skills.


Randall Holdner v. Comm., William Holdner v. Comm., TCM 2010-175
Father and son owned farms. Randal Holdner, the son, ran the day to day operations
of the farms. William Holdner, the father and a CPA, was primary responsible for
Holdner Farms’ finances and accounting. William Holdner maintained an active
accounting practice in 2004-2006.On his Federal income tax returns for 2004, 2005,
and 2006, William Holdner reported Schedule K-1 income from his accounting
partnership, on Schedule E, $264,516, $232,156, and $263,423, respectively.

William Holdner prepared his and his son’s Federal income tax returns for 2004-2006.
For 2004-2006 each reported Holdner Farms’ income and expenses from cattle sales
and rental activity on Schedules F of their income tax returns, and they reported
Holdner Farms’ income and expenses from timber sales on Schedules D of the
returns. No partnership return for the farm was filed. Instead, each Holdner reported
one-half of Holdner Farms’ gross income, treating it as a joint venture. However,
Williams Holdner deducted most of Holdner Farms’ expenses in 2004-2006 on his
personal income tax returns for those years, resulting net losses for 2004-2006.

The Court concluded that the Holdner Farms activity was a partnership for Federal
income tax purposes in 2004-2006. The father and son had equal interests in
partnership income, expenses, and other partnership items.

Limited Liability Companies (legal)
• A limited liability company (LLC) is a flexible form of
enterprise that blends elements of partnership and
corporate structures.
• It is a hybrid business entity having certain
characteristics of both a corporation and a partnership
(multiple members) or sole proprietorship (single
member).
• The primary characteristics an LLC shares with a
corporation is limited liability.
• The primary characteristics an LLC shares with a
partnership is pass-through income taxation.

Income Taxation of LLC:
• For US federal income tax purposes, an LLC is treated by default as a
pass-through entity.
• If there is only one member in the company, the LLC is treated as a
“disregarded entity” for tax purposes. A single owner would report LLC’s
income or loss on Schedule C of his or her individual tax return.
• The default tax status for LLCs with multiple members is as a partnership,
which is required to report income and loss on IRS Form 1065.
• An LLC with either single or multiple members may elect to be taxed as a
corporation through the filing of IRS Form 8832 (please check the eligibility
of LLC formation and franchise/pass through entity tax with each of 50
states law). After electing corporate tax status, an LLC may further elect to
be treated as a regular C-Corporation or as an S-Corporation.

IRS Website for LLC:

http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Limited-Liability-Company-(LLC)

• Formation: LLCs are formed under the law of
(50) states. Corporations are issued “articles of
organization” by most states upon formation.
Additional optional governing rules called
“operating agreement”, “corporate
resolution”.
• LLC management:
– member - managed
– manager - managed

• Avoid double taxation • Not publicly traded.
• Limited liability • More difficult to raise
• Pass–through entity, capital than publicly
unless LLC elects to be traded company.
taxed as a C-Corporation • Franchise tax depends on
• Flexible each 50 state jurisdiction.
• Less administrative • The management
expense and record structure of an LLC may
keeping. be unfamiliar to third
party, external party.

Choice of Entity

The business client is responsible for
making the ultimate determination of
entity.

Resources:
Kreider, Sharon CPA, Hoven, Vernon CSP, CPA, “Pass-Through Entity Choices, Entity
Comparison Chart” 2007-2008,
http://www.terrafirmaglobalpartners.com/Agent_Resources/Commercial/Entity
%20Comparison%20Chart.pdf

Pence, Craig M., “Accounting Course Manual”, 2008
http://my-accounting-tutor.com/Financial/Modules/Module1/FinModule1-12.pdf

Rutledge, Thomas E., “Limited Liability Companies in Kentucky”, August 2012
http://www.skofirm.com/Library/142643.pdf

Rutledge, Thomas E, Franklin, Mark S., Lukinovich, Stephen, “Organizing a Professional
Practice: An After-Tax Choice-of-Entity Calculus”, March 17, 2009
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1361915##

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