Cfp 503 Section 2

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3 Considerations when choosing an an accounting method

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1. Requirement by law

2. Nature of the business may dictate which is most appropriate

3. Taxpayer's personal situation

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Cash Basis Method (Definition)

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Require to report as income all cash and property actually or constructively received during the taxable year.

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Items to include under Cash Basis Method

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1. Interest over accounts you control

2. Checks when received

3. Checks when delivered (mailed)

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Cash Basis Advantages

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1. Taxes generally are not paid until income is received

2. Taxpayers control each year's income and deductions

3. Taxpayer's can keep simple records

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Cash Basis Disadvantages

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Taxpayers have to pay tax on income they have constructively received

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Accrual Basis Method

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Income is recognized (reported) for the year in which the "all events" test is satisfied and when the amount can be estimated with a reasonable level of accuracy.

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All Events test definition

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Satisfied when the taxpayer's right to receive the income becomes fixed; when it is not contingent on the occurrence of a future event.

Ex: lawsuit, security deposit (if it isn't last months rent)

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Accrual Basis Method - "Economic Performance"

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When the property or service to which the accrual relates is actually provided or used.

Must occur within shorter between the close of the tax year or 8.5 months are the close that year.

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Accrual Basis Method - Before "Economic Performance" Deductions

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1. Recurring in nature

2. Treated as incurred in the tax year in which the all events test is satisfied

3. Not be a material item

4. Present a proper matching of income and expense

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3 Rules when selecting a method

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1. Must treat items consistently and must clearly reflect the taxpayer's income

2. Draw distinction between expenses that are currently deductible and expenses that are required to be capitalized

3. Must maintain adequate books and rescords

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Accounting Method Rules of Thumb

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If using cash transactions only, may use cash accounting.

Inventories usually requires Accrual Accounting.

C Corp with >$5M must use Accrual.

Tax shelters must use Accrual.

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Small Business Account Method Exceptions

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Taxpayers withaverage annual gross receipts of $1 million or less for each of the three priortaxable years do not have to account separately for inventories, or use the accrualmethod of accounting.

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Hybrid Method of Accounting

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Using both cash and accrual by same tax payer. Accrual is used for sales and purchases, and cash for all other income and expenses.

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Percentage-of-Completion Method of Accounting

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For taxpayers dealing with long term contracts greater than 12 months or a unique item. Compares total cost to total estimated cost.

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Lookback Method of Accounting

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For use in conjunction with a long term contract. After any long term project is complete, tax payer will have to pay or will receive interest. Taxpayer compares amount of tax paid in previous years with the amount that should have been paid.

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Lookback Method Exclusions

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Lookback method does not apply to any contract that meets both of the following:

1. Gross proceeds cannot exceed $1M or 1% of the average annual gross receipts for 3 years.

2. Contract must be completed within two years of commencement date.

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How to change the method of accounting selected

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Once chosen, must continue to use until:

1. IRS requires a change

2. A request is made to IRS and is granted

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Specific Identification (Inventory)

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Keep track of the cost of each specific item in inventory and to take into cost of good sold when the item is sold.

For use with small businesses that have few high value items in inventory.

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First In, First Out (FIFO Inventory)

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Cost of oldest items in inventory used in COGS. Lower COGS in inflationary periods, which means higher tax burden. Inventory shown on balance sheet is actually what it costs to replace.

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Last In, First Out (LIFO Inventory)

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Cost of newest items in inventory used in COGS. Higher COGS in inflationary periods, which means lower tax burden. Inventory cost shown is not representative of cost to replace.

Harder to maintain due to "LIFO layers."

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Sole Proprietorship

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Individuals engaged in a business without the help of associates or a corporate charter. Most prevalent and easiest to setup: just start doing business. Most flexible form, as can change what you are doing.

No separate tax form required. Report on Schedule C, Form 1040.

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Non tax Disadvantages of Sole Proprietorship

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The lack of distinction between the affairs of the sole proprietorship and its owner. Owner's personal assets are liable.

Capital structure limited as harder to get financing to expand.

Lacks continuity of business life.

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Tax Characteristics of Sole Proprietorship

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Never a taxable event because owner and business are one. Unfavorable if owner has other income sources. Favorable is business produces a loss. Net income subject to self employment tax.

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Sale of Sole Proprietorship

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Treated as a sale of an individual asset. Inventory treated as ordinary income. If sale price exceeds FMV, then counted as goodwill and taxed as capital gain.

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Self-Employed Health Insurance Deduction (Sole Proprietorship)

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A sole proprietor may deduct 100% of the amount paid for health insurance andqualified long-term care insurance for the sole proprietor and his spouse,dependents, and any child of the taxpayer who is under age 27 at the close of thetax year.

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Partnership

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An association of two ormore persons to carry on a business as co-owners for profit.

The partnership may be recognized as an entity forsome purposes, but it may be treated as an aggregation of individuals in regard toother matters.

The partnership is a conduit, in that certain items ofincome, deduction, and credit are passed through (or flowed through) to thepartners.

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Tax Characteristics of Conduit Taxation (Partnerships)

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Advantagein situations where the partnership is producing losses, deductions, or tax creditsthat can be used by the partner to offset income from other sources.

Disadvantage if the partnership is producing a largeamount of income that is subject to tax at the highest marginal rate of theindividual partners.

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Tax Advantages of Partnerships

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No recognized income in the formation of the partnership.

Conduit taxation in operation (flow through).

Adjustment in basis if income is not received directly (no retained earnings in partnership).

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Tax Disadvantages of Partnerships

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1. If partnership formed with 80% value from appreciated securities, not tax free. So rich people can't start partnerships and remove their individual basis.

2. Taxation can be formed when a service partner is included. Someone who gets major interest by brining talents, shares will be taxed a FMV.

3. In formation of partnership where it assumes an individual's debt. Amount of debt assumed will be income.

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Non tax Advantages of Partnerships

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Easily organized and no formal agreement required. No state approval needed. Free from annual reporting requirements and don't have to pay taxes.

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Non tax Disadvantages of Partnerships

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Unlimited liability of the partners. Each partner is liable for the acts of all the other partners. This includes financial liability.

Lack of continuity in the life of the partnership. Difficult time raising capital.

Management deadlock.

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Sale of a Partnership

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Sale for partnership asset, same as sole proprietorship.

Sale of interest in partnership, same as capital asset. Accounts receivable, etc. may be counted as ordinary income.

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3 Reasons to use Limited Partnerships

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1. Used for the pass through of losses in tax advantaged investments.

2. For people who want to invest in a business, but have their personal resources protected from a potential business failure.

3. Can be used by management to lock investors out of the management venture.

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Limited Partnerships

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Structure that permitsthe limited partner to invest in the venture without being subjected to personalliability for obligations of the business.

Has at least one general partner that has unlimited liability.

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Non tax Disadvantages of Limited Partnerships

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More formal: requires written partnership agreement. State approval and annual reports.

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C Corporations

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Can be used from one person to large corporations with millions of shareholders. Limited liability of owners and shareholders. Structure was to encourage new capital formation and risky ventures to drive development.

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Non tax advantages of C Corporations

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Limited personal liability for the owner's. Shareholder's liability limited to the capital contributed.

Unrestricted right to transfer ownership.

Potential perpetual life.

Transfer of ownership has no affect on the operations of the business.

Separation of management and ownership.

Capital more easily accessible.

Some constitutional rights.

Choose state of incorporation for tax purposes.

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Non tax disadvantages of C Corporations

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1. If formalities not follow, courts can pierce corporate veil and make someone liable.

2. Shareholder's will be liable if company not properly insured, etc.

3. Shareholder's liable for watered stock

4. Officer's may be held liable in Ultra Vires, or in excess of authorized corporate powers.

5. Copious paperwork.

6. More expensive to run.

7. Majority shareholders can suppress the minority.

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C Corporation Tax Advantages

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1. Offers the ability to create a new taxpayer with which income can be split

2. Allows business to have retained earnings at potentially lower marginal tax rates

3. Can have tax free incorporation

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3 Examples of when incorporation is not tax free

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1. Contributing appreciated securities for the stock of an investment company.

2. Contributing services to the corporation in exchange for stock (ordinary income).

3. When a corporation relieves a shareholder of debt.

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C Corporation Tax Disadvantages

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1. Double taxation (corporate and dividend)

2. Personal Service Corporations to entice owner's to pay themselves a salary

3. Personal Holding Company tax

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Exclusion of Gain from Small Business Stock

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Taxpayers other than C Corporations who hold qualified small business stock for more than five years may exclude a portion or all of the gain on the sale of the stock. Max exclusion of 50%.

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Sale of a C Corporation

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1. Sale of the stock (easy)

2. Sale of an asset (complex)

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S Corporations

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A corporation that has elected to be taxed as a conduit entity under Subchapter S of the IRS Code.

Still limited liability for shareholders. All tax benefits flow through to shareholders.

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S Corporation Requirements

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1. Domestic Corporation

2. No more than 100 shareholders

3. Shareholder must be citizen or resident of United States

4. Only one class of stock

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Sting Tax

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Tax on passive investment income earned by the S Corporation.

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S Corporation Advantages

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1. Advantageous to new businesses that experience losses initially

2. Shareholders have greater ability to be involved in management

3. Limited liability not subject to paperwork

4. Stock is freely transferrable

5. Not subject to self employment tax

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S Corporation Disadvantages

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1. Basis of shareholder calculated differently than basis or a partner

2. Basis can be exhausted stopping tax flow through benefit.

3. Limit on the deductibility of passive losses.

4. Fringe benefits might be reduced

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Three taxes an S Corporation may be liable for

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1. Built in gains tax

2. LIFO Recapture tax

3. Net passive income penalty tax

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Limited Liability Company

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Combines the limited liability of corporations with partnership treatment for federal income tax purposes. Perpetual life.

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Limited Liability Partnership

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General partnership with at least a partial liability protection for the partners. May be taxed as partnership or corporation decided by the members. Generally liable for own torts but not other partners.

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Domestic Production Activities Deduction

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Equal to 9% of the lesser of:

1. the qualified production activities income of the taxpayer for the taxableyear, or

2. the taxable income (determined without regard to the deduction itself) for thetaxable year.

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Deduction for Energy Efficient Commercial Buildings

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The maximum energy efficient commercial building deduction is equalto $1.80 per building square foot less the total amount of this deduction allowed for thebuilding in prior years.

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Tax Credit for Contractors Building New Energy Efficient Homes

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A contractor can claim either a $2,000 or $1,000 credit (depending onthe type of home and the energy reduction standard it meets) for each qualifiednew energy efficient home they build that is then acquired by a person for use asa residence.

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Formation of Sole Proprietorship

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Any individual who operates any business of any sortwithout consciously selecting a business form will be operating as a soleproprietorship. No special documents need to be prepared to form a soleproprietorship.

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Formation of General Partnership

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If two or more individuals operate a business withoutconsciously selecting a business form, the business will be a general partnershipby default. No special documentation required.

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Formation of C Corporation

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State law governs the formation of any corporation. Laws mayvary from state to state, but in every state a taxpayer is required to file some typeof form, often known as articles of incorporation, to form a corporation.

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Formation of S Corporation

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An S corporation is formed under state law in the same mannerand is subject to all of the same requirements as a C corporation.

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Formation of LLC or LLP

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An LLC (or LLP) is formed under state law in essentially the samemanner as a limited partnership. Articles of Organization must be filed with theSecretary of State office in the state in which the LLC is formed.

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Risk of Sole Proprietorship

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With a sole proprietorship, there is no legal distinctionbetween the owner as an individual and the business enterprise. The owner isindividually and personally liable for all of the debts of the business.

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Risk of General Partnership

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Each partner is “jointly andseverally” liable for the debts of the business. This means that each general partnermay be held individually and personally liable for all of the partnership’s debts.

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Risk of C Corporation

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One benefit of the corporate form of organization is that thecorporation is viewed as a legal entity separate from its individual owners. Because of this, the owners, absent some specific guarantee of the corporate debt,will not be personally liable for the debts of the corporation.

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Risk of S Corporation

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The risks are generally the same as those of a C corporation.

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Risk of LLC or LLP

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The members of an LLC generally enjoy limited liability, muchlike shareholders in a corporation.

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Transferability of Sole Proprietorship

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An interest in a sole proprietorship can be transferred onlythrough a sale of the assets of the sole proprietorship.

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Transferability of General Partnership

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While the interest in a partnership may certainly be sold, the partnershipagreement will often require the approval of the other partners before apartnership interest may be transferred or divided.

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Transferability of C Corporation

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Absent a restrictive agreement between the stockholders, aninterest in a C corporation generally is easily transferred.

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Transferability of S Corporation

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A buy/sell agreement is essential with an S corporation, becausegreater restrictions should be placed on the ability of a shareholder of an Scorporation to transfer her shares.

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Transferability of LLC or LLP

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Interests in an LLC or LLP may certainly be divided, and/or sold.The owners may encounter issues similar to partners in a partnership, in that theoperating agreement may restrict the sale or transfer of all or part of the interest.

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Continuity of Sole Proprietorship

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Unless a sole proprietor can find a family member oroutside party willing to purchase the business, a sole proprietorship’s businesswill end with the death or retirement of the owner.

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Continuity of General Partnership

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The death or bankruptcy of a partner may result in thetermination of the partnership from both a legal and practical standpoint. Thecreditors of a bankrupt partner or the estate of a deceased partner may have sucha claim on the assets of the partnership that it will no longer be able to operate.

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Continuity of C Corporation

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One advantage of the corporate form is that, as a legal entityseparate from its owners, the corporation, in theory, has potentially unlimitedlife. The death or bankruptcy of a stockholder need not impact the operations ofthe corporation.

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Continuity of S Corporation

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While the election of S corporation status may be terminated by anumber of different events (and taxation would then be under Subchapter C), this does not affect the legal existence of the corporation as an entity, which, like theC corporation, is theoretically unlimited.

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Continuity of LLC or LLP

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These entities are usually established to have a perpetual life. However,the Articles of Organization may specify a limited life, such as 30 years.

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Availability of Capital for Sole Proprietorship

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The financial resources of a sole proprietorship generallyare limited to the assets and credit of its owner.

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Availability of Capital for General Partnership

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The financial resources of a general partnership generallyare limited by the assets and credit of the various general partners.

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Availability of Capital for C Corporation

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Subject to securities law registration requirements, along withmarket limitations, a C corporation has a very large potential pool of investmentcapital available to it through the issuance of stock or other types of securities.

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Availability of Capital for S Corporation

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The amount of capital available to an S corporation is somewhatlimited by the fact that the corporation may have only 100 shareholders and onlyone class of stock.

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Availability of Capital for LLC or LLP

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The financial resources of an LLC or LLP generally are limited bythe assets and credit of the various members.

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Income Tax of Sole Proprietorship

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Business revenues and expenses are reported directly onSchedule C of the individual owner’s Form 1040 and taxed in full to the owner.

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Income Tax of General Partnership

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Business revenues and expenses are allocated among thepartners, reported to them by the partnership on Schedule K–1 of Form 1065, andreported by each partner on Schedule E of Form 1040.

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Income Tax of C Corporation

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A C corporation is a separate taxable entity. The net income ofthe C corporation is reported on Form 1120 and is subject to graduated tax ratesof 15%, 25%, 34%, and 35%.

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Income Tax of S Corporation

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The income or loss from the business generally is allocatedamong the shareholders, reported by the S corporation on Schedule K–1 of Form1120S, and reported by each shareholder on Schedule E of Form 1040.

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Income Tax of LLC or LLP

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The default taxation for the entity is partnership taxation. Under thecheck-the-box regulations, the entity may elect to be treated as a corporation.

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Home Office Expense Deduction Form

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Form 8829, Expenses for Business Use ofYour Home.

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Home Office Deduction Calculation

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