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BUSINESS BOOT CAMP 1 CHAPTER 1: FUNDAMENTALS OF BUSINESS RETURNS

BUSINESS BOOT CAMP

CHAPTER 2

Introduction to Business Returns


DIFFERENCE BETWEEN INDIVIDUAL AND BUSINESS RETURNS

When doing an individual return, we enter the information and

arrive at the tax. If the tax payer has a Schedule C, you may have

financials to use for that schedule.

When doing a business return, we start with the business’s financial

statements and use those to enter the information on the tax return. Then

we reconcile the return to the statements.

DIFFERENT BUSINESS ENTITIES AND THEIR CHARACTERISTICS

SOLE PROPRIETORSHIPS

This business form is not separate from the owner. The information

is reported on a Schedule C of the owner’s Form 1040. However, the

owner should apply for an Employer Identification Number (EIN) if the

business will have employees, or will have a retirement plan.

The owner may or may not have financial statements and may or

may not keep the business bank accounts separate from the owner’s

personal bank accounts.

The rules for depreciation and other tax aspects are much the

same as for other business entities. When the owner is paid for working,

he/she doesn’t go on payroll – or receive a 1099. The bottom line of the

Schedule C is what the owner will be taxed on and it will be subject to SE

tax. The business may have other employees who will be on payroll.

The owner of a sole proprietorship has unlimited liability for both his actions and those of his employees.

If the business is not going to be conducted in the name of the

owner, a fictitious name statement must be filed. The owner needs to

search the county clerks’ records to verify that the desired name isn’t

already being used. This statement must be filed within a specified

number of days from beginning business. It must also be published in a

newspaper of general circulation in the county housing the business within

thirty days after filing. The statement will expire 5 years after filing and

must be re-filed before the expiration date. There is a fee for this and also

for the newspaper publishing.

The owner must pay estimated payments following the rules

set by the IRS and the FTB and report them under his/her SSN.


C CORPORATIONS

When a business incorporates, it incorporates as a C Corporation

under the laws of the state in which it will operate. Each state has

different rules for how corporations are governed, so if the owner is going

to do business in more than the state where the business is located – he

should research the laws in the other states.

The C Corporation is a totally separate entity from the owner and it

doesn’t die until someone chooses to close it. The corporation files its

own tax return and pays its own tax with both the IRS and, in California,

the FTB.

When a C corporation pays dividends, the recipient of the dividend

pays tax on those dividends. Since the corporation has already paid tax

on the money used to pay those dividend, this creates the “double

taxation” often complained about with C corporations.

Many states require corporations to hold at least an annual

meeting, keep minutes and copies of resolutions passed. Failure to do

this may “break” the corporate seal – meaning that the officers and

directors will have trouble filing or protecting themselves in court.

A copy of the corporation’s Articles of Incorporation must be filed

with the Secretary of State in the state where the corporation will be doing

business. www.sos.ca.gov is the website where all the pertinent

Secretary of State forms can be found.

In California, corporations must create bylaws covering stockholder

meetings, director meetings, and the number of officers and their

responsibilities.

A Statement of Information must be filed annually with the Secretary of State. Failure to do this can result in substantial fines.

Before a corporation can register with the Secretary of State, it

must make application to the Secretary of State to reserve the desired

business name. A business search to determine if there is already a

similar existing corporate name on the records of the CA SOS. The SOS

will also challenge the name if it feels the name is misleading to the public.

Like the sole proprietorship, a corporation needs to follow the rules for Fictitious Business Names of the county in which it is incorporating.

A corporation must appoint a Registered Agent for service of

process. This must be an individual or other corporation who agrees to

accept legal papers on behalf of the corporation and who is physically


present in CA. The corporation may not serve as its own agent for process.

The corporation needs to set up a corporate records book to keep

all its important papers, including minutes, stock certificates, and stock certificate stubs.

The person who incorporated the business appoints the initial

corporate directors to serve on the board until the first annual meeting of

shareholders. At the first annual meeting, the shareholders elect board members to serve.

At the first meeting of the board of directors, they elect officers,

adopt bylaws, select the corporation’s bank, authorize issuance of shares

of stock, set the corporation’s fiscal year, and adopt an official stock

certificate form and the corporate seal. The directors’ actions must be

recorded in corporate minutes. In addition, in California, securities must

be either exempted or qualified. Most small corporations will want to be

exempt when they form and must therefore file a Limited Offering

Exemption Notice.

OTHER TAX RELATED REQUIREMENTS

The corporation must apply for an Employer Identification Number (EIN).

Officers of corporations that are being paid to work for the

corporation, must be on payroll. Directors of a corporation who aren’t

working for the corporation but who receive a stipend for being on the board are subject to the 1099 reporting rules.

Business entities registered in California to do business in

California must pay the annual minimum tax “for the privilege of doing

business in California”. This tax is currently $800. If the corporation is newly formed, the minimum franchise tax is not due in their first year.

Unlike the Sole Proprietorship, any losses do not flow through to

the owners’ personal tax return, but instead stay on the corporation’s tax

return. They may be limited for the current year and if so will be able to be carried over.

The due date for filing a C corporation return is the 15th day of the

4th month. An extension of time to file is generally 6 months. If a C

corporation has a June 30 year ending, the IRS may consider a 7 month extension but CA will not.


If the C corporation will owe tax, it should make estimated

payments if it expects to owe tax of $500 or more, and make the payment

under the C corporation’s EIN.

S CORPORATIONS

A corporation may choose to be treated as a flow-through entity

and therefore will need to make an “S-election”. This is known as the

“2553 election”.

:

1. Corporation must be a domestic entity;2. Corporation has no more than 100 shareholders;

3. Shareholders can only be individuals, estates, certain

exempt organizations, or certain trusts;

4. No nonresident alien shareholders;

5. Only one class of stock

6. Is not:

a. Bank or thrift institution that uses the reserve

method of accounting for bad debts

b. Insurance company subject to tax under

subchapter L of the Code

c. A corporation has elected to be treated as a

possessions corporation

d. A DISC or former DISC.

7. Has one of the following tax years:

a. 12/31

b. A natural business year

c. An ownership tax year

d. A tax year elected under section 444

e. A 52-53 week tax year

f. Any other tax year with a business purpose.8. Each shareholder consents to the election.


The corporation must make this election no more than 2 months

and 15 days after the beginning of the tax year for the election, or at any time during the tax year preceding the effective tax year.

Example: Corporation Steve begins its first tax

year on January 7. The 2-month period ends March 6

and 15 days after that is March 21. For the

corporation’s first year to be an S-corporation, Form

2553 must be filed between January 7 and March 21.

Example: Corporation Linda has been filing

Form 1120 as a C corporation but now wants to

become an S Corporation for its next tax year which

will begin on January 1. Linda’s 2-month period ends

February 28 (29 in leap years) and 15 days after that

is march 15. For Linda’s election to be effective for

the year beginning the next January 1, the corporation

must file the election during the period that begins the

first day of January of its last year as a C corporation

and ends March 15h of the year it wishes to make the

change.

There are provisions for making late S-elections. For these see Rev. Proc. 2013-20, section 4.04.

The service center will notify the corporation if its elections is

accepted and when it will take effect, or if it has not accepted the election.

The determination letter should be received generally within 60 days after

the Form 2553 is filed.

The election may be terminated by the corporation or inadvertently by failing any one of the 8 tests above.

The general formation and organization rules are the same as for a

C corporation. In fact, all corporations form as C corporations and then make an S election.

Another trade-off for the S election is that shareholder-employees

that own 2% or more of shares of the corporation are limited on the fringe

benefits they make take advantage of without paying tax on the benefit.

Health insurance that is provided by the corporation to the more

than 2% shareholder may be deductible as an above-the-line health

insurance deduction if:


S-corporation makes the payments, or

Employee/shareholder makes the payments and then is

reimbursed (after showing proof of payment) during the current tax year by the Corporation.

The premiums must also be included in gross wages on employee’s Form W-2.

This deduction is limited to the smaller of the eligible insurance premiums or net profit from the business.

BUILT-IN GAINS TAX

When a C-corporation elects to become an S-corporation and has

assets on its balance sheet which would give rise to either capital gains or

losses if sold by the C-corporation, they must be tracked by the S-

corporation for the first 5 years of S-corporation status.

The S-corporation must establish the FMV at the time of the S-

election and then track those assets for the next 5 years. When any are

sold, the BIG tax will apply. For cash basis corporations, the accounts

receivable present when the S election was made are also BIG tax items.

The BIG tax is calculated at the highest corporate tax rate – which

is now a flat 21%. Fortunately, any NOL carried over from the C

corporation will be allowed to offset the net recognized built-in-gain.

Built-in losses are also recognized in the S-corporation and can be used to net built-in gains.

OTHER TAX PROVISIONS

The S-corporation files its own tax return but the income (loss) flow

through to the shareholders on a K-1. The character of the income and

expenses are the same when recognized by the shareholder as they are

in the corporation’s books.

In California, S-corporations pay a tax of 1.5% on the net income of

the corporation. Shareholder distributions must be pro-rate to their share

ownership.


Because the sale of a shareholder’s stock results in a capital gain, the shareholder must keep track of their basis in the stock. A distribution

in excess of a shareholder’s basis will also result in capital gain.

S corporate shareholders may increase their basis by loaning money directly to the S-corporation.

PARTNERSHIPS

A partnership is when two or more people carry on a business with the intention of making a profit. There doesn’t have to be a written agreement, but even without a written agreement they will be sharing both profits and risks. That said – there should always be a written agreement to enumerate how profits/losses will be shared, how the division of labor will be done, and how they will go their separate ways at the end of the partnership.

When there is not a written agreement, in California the Revised Uniform partnership Act sets the rules for the partnership. This generally means that there will be an equal share of profits and losses and equal right to manage the business.

Partnerships need to check their name with the Secretary of State if

they will be operating under any name other than the legal names of the

partners, as well as file a fictitious name statement in the county where

they will be operating.

In California there are three types of partnerships:

General

Limited

Limited Liability Partnerships.

GENERAL PARTNERSHIPS

General partnerships are a legal entity separate from the partners.

The partners owe certain fiduciary duties to the partnership and to each

other. If a partner violates their fiduciary duty, the other partner(s) may

sue for breach of those duties.

General partners have individual liability for all the partnership’s debt and other obligations.


Together with the liability risk, each partner is able to contract in the name of the partnership.

Each partner will have an account for their share of the profit, losses and liabilities.

Each partner will be able to increase their basis not only by

contributing to the partnership and loaning money directly, but also but by

borrowing for the benefit of the partnership or co-signing or guaranteeing loans of the partnership.

A distinct tax advantage for General Partnerships is that there is no

$800 minimum Franchise tax in CA and no need to register with the Secretary of State.

A non-tax advantage of General Partnership is the ability to raise

funds over a period of time before switching to a different type of entity without much government intervention.

The net profits, losses will flow through to the partners according to

the percentage of ownership. Expenses born by the individual partner and

not reimbursed by the partnership may be included on the reporting of the partnership income(loss) on Schedule E.

The ability to deduct losses will be limited by the partner’s basis,

but will be suspended for succeeding years. So again, tracking basis is

important for each partner – and is not the responsibility of the partnership.

LIMITED PARTNERSHIPS

As the name implies, there is some liability protection for the limited

partners. However, there must be at least one general partner to protect

the people that the partnership is doing business with. The name of the

partnership is required to include “Limited Partnership” or “LP” to inform

vendors and lenders that the majority of the partners have this limited financial liability.

A limited partnership must have a written agreement.

The limited partner’s liability is limited to the amount that the partner has invested in the partnership.

In California, limited partnerships are required to register with the

SOS. There needs to be a Limited Partnership Agreement and a listing of

each general partner’s name and address. Limited partnership must also


do a fictitious name filing if it will be using a DBA for carrying out its business.

Again, the partner’s share of profits, loss and other information will

be reported to them on a K-1 and flow through from the partnership to

their tax return. A limited partner’s losses will be limited by their basis, by

the amount at which they are at risk, and by their percentage of ownership

per the partnership agreement. Therefore again it is important for the partner to track their basis.

Partners who work in the partnership business do not receive W-2s but instead receive guaranteed payments.

GUARANTEED PAYMENTS

If a partner wants to be assured of receiving a specific amount of

return on his investment, or payment for time worked for the partnership, the partnership agreement must provide for a Guaranteed Payment.

This amount will be subject to SE tax for individual taxpayers and is

an expense of the partnership because it must be paid even if it creates a loss for the partnership.

LIMITED LIABILITY PARTNERSHIPS

California limits Limited Liability Partnerships (LLPs) to licensed

professional such as attorneys, accountants, architects. There are LLPs

formed by people licensed to provide professional services in other state

or LLPs that are “related” to other LLPs that practice public accounting or law. We are going to cover the first type of LLP.

Like a limited partnership, the LLP’s name must include either

“Limited Liability Partnership” or “LLP” in its name. The LLP must register with the SOS.

Unlike a limited partnership, in an LLP, all of the partners are

limited partners. This means that they receive limited liability in case of

lawsuits against another member of the firm – but not because of any action of their own or of the firm’s decision.

California law requires LLPs to have security for claims against it. This equates generally to:


• Legal service firms with 5 or fewer partners - $1

million

• Legal service firms with more than 5 an additional

coverage of $100,000 up to a maximum of $7.5

million

• Public accounting firms with 5 or fewer licensed

partners - $1 million

• Public accounting firms with more than 5 licensed

partners an additional $100,000 for each additional

partner up to a maximum of $5 million

• Architectural firms have the same requirements as

accounting firms.

LLPs are subject to the $800 minimum franchise tax. In some

states LLPs must file an annual report and or renew their registration each year.

LIMITED LIABILITY COMPANIES (LLCs)

LLCs are generally thought to have the most advantages over sole

proprietorships and partnerships. However, not all businesses are at a stage when an LLC makes good business sense.

LLCs offer limited liability protection to its owners, have fewer

corporate formalities than corporations, and greater tax flexibility than the other entities.

Unlike limited partnerships, LLCs offer limited liability protection to

all members – not just the general partners. This means that if the LLC gets sued, the only the LLC’s assets can be used to satisfy the debt

However, LLCs must register with the Secretary of State and pay

the minimum franchise tax of $800 to the FTB. It must have articles of organization and an operating agreement.

In addition, in California, if an LLC’s gross receipts are more than

$250,000, the LLC must pay a Gross Receipts Tax, which increases as the LLC’s income increases.

The flexibility of the LLC allows its members to choose how to be

taxed: as a partnership or as a corporation – even as an s-corporation.

Even if the LLC chooses to be taxed as a corporation, the requirements

for minutes, etc are not present If the LLC is a single member LLC, it can

choose to be a “disregarded entity” – which means that the income and

expenses will be reported on the appropriate schedule on the member’s

BUSINESS BOOTCAMP 16 CHAPTER 2: FUNDAMENTALS OF BUSINESS RETURNS

tax return. A husband and wife can choose to be single member in a community property state.

The company also needs to decide if it’s going to be “member-

managed” or manager-managed”. In a “member-managed” LLC, all of the

members participate in the decision making. In a “manager-managed”

LLC selected members or an outside company will make the decisions.

An attachment to the Articles of Organization detailing limited liability

protection, indemnification of the managers and officer of the LLC, and

notice to 3rd parties as to which members or managers can bind the

company is good business practice.

Even though the LLC elects its tax status, that election is only for the tax status. For everything else it is just an LLC.

The IRS doesn’t recognize LLCs – they are a state legal entity – so

the LLC files either on a Form 1065 or a Form 1120 or a Form 1120S if not a disregarded entity.

Like the partnership and S-corporation, the income, losses, etc.

flow through to the member’s tax return with the same character as in the LLC.

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