Forms of Business and Tax Laws
Taxable Year and Taxation of the Owner
Under the provisions of the general rules that govern tax years, partnerships use the calendar year. At the same time, the IRS can allow partnerships to use the requested year if they can provide an evidence of business purpose for the fiscal year. When they use a fiscal year, partners may be allowed to defer from paying taxes for the income earned during the end of the fiscal year until the close of the calendar year. It is recommendable that partners should apply the gross receipt test from the IRS as outlined in the Revenue Procedure 2006-2046 to check whether they are eligible for the fiscal year.
The owner’s basis in a partnership refers to amount of money plus the adjusted basis of all the property that the partner contributed to the business. If the partner gains from his/her contribution, the gain is attached to his/her basis interest. Similarly, any increase in his/her individual liabilities due to an assumption of the business liabilities is also considered a money contribution to the partnership CITATION IRS16 \l 1033 (IRS, 2016). Since partnerships create unlimited liability to the owner (partner), one of the significances of the basis amount is that it can be used to cover the losses incurred by the businessCITATION Cornd \l 1033 (Cornell Law School, n.d.).
Since partnerships are “pass-through” entities, they are not subject to federal income tax. Instead, its owners’ share of profit is taxed. The taxable income of a partnership is taxed using three documents Schedule K, Schedule K-1, and Form 1065. The latter is used to calculate the profits and losses of the partnership while Schedule K is designed for breaking down the incomes and deductions of the business by category. Lastly, Schedule K-1 is used to show the allocated share of the deductions and income for each partner. Deductions and income from a partnership keep their standard classification when they pass through to the partners. For example, the maximum tax rate for capital gains from long-term business operations is 23.8%, and the ordinary income for the business is taxed in line with the rates of self-employment tax. As of 2018, the IRS allowed partners to claim deductions equal to 20% of their share in the profits of the partnership, subject to limitations. In most cases, partners are taxed as per their allocated portion of the business’s profits, regardless of the actual profits that the business pay to them CITATION Mik18 \l 1033 (Piper, 2018). For example, a partnership of three owners makes a profit of $90,000 in the first year, each of them will be taxed on $30,000 of the income (1/3 of the $90,000), even if they use all or part of the profits to upgrade their business.
Deductibility of Losses
The IRS requires those who run partnerships to abide by the laws that govern their ability to deduct losses. It requires that all partners who are allocated a distributive portion of loss have to satisfy three limitations of a loss before it is used. The limitations, in their order of application, include: the basis limitation of Section 704(d); the at-risk limitation covered by Section 465; and the passive loss limitation covered by Section 469. In most cases, the partners who satisfy the first two sets of limitations readily meet the requirements for the third one, so they are readily considered eligible for loss deductions.
The Basis Limitation of Section 704(d)
According to the provisions of Section 704(d), distributive share of a partner’s loss is only allowable to the extent of the adjusted tax basis in his/her interests in the business at the close of the year in which the losses are incurred. The pro rata, as covered by the Regulations of Section 1.704-1(d), disallows all the losses in the excess of the tax basis of a partner, and carried forward indefinitely as long as the partner operates as part of the business.
The at-risk rules limit loss deductibility, and not the deductibility of any expenses associated with a particular activity. They define a “loss” as the excess of all allowable deductions that can be allocated to an activity against the earnings received during the tax year (Section 465[d]). For that reason, the taxpayers in a partnership are still eligible for expense deductions up to the earnings from a particular activity even in the year when the at-risk amount of the partners is negative or zero.
Taxability of Distributions
In partnerships, distributions are not taken into consideration when determining the distributive share of the partner from the losses or earnings of the business. If a partner recognizes any loss or gain, then it must indicated in his/her returns for the tax year during which the distributions are received. In addition to that, property or money withdrawn by a partner if he/she anticipates the earnings of the current year, are also considered distributions received at the end of the tax year.
Tax Treatment to the Business and the Owner
In partnerships, each partner is required to report a share of his/her annual earnings from their personal returns. For that reason, a partnership’s tax effects associated with liquidating distributions only target those who receive them. However, a partner is only taxed as a distribution of liquidation if he/she terminates his/her interest in the partnership. Only partners who get money as a liquidating distribution may have immediate taxable losses or gains to report.
Marketable securities like the stock investments traded on the public stock exchange, as well as a decrease in the partners’ share in the business’s debts are classified as cash distributions. When the amount of money distributed exceeds the basis of a partner’s interest in the partnership, the difference in the two values falls under gains. Losses are recorded when the distribution of liquidation is less than the basis of a partner in the business. However, a partner can only take losses on his/her returns if they solely emanate from a liquidating distribution of money, outstanding partnership inventory items or receivables.
If the business distributes property (that is, property treated as money and anything other than money) during its liquidation, it will not have any immediate tax effect. Instead, losses or gains are delayed until the partners sell the property. Provided the liquidation of the partnership terminates a partner’s entire interest in the business, his/her tax basis in all the distributed property equals the share of his/her adjusted basis interest in the partnership minus the money distributed to him/her. Regardless of the sum of money a partner receives, his/her basis in the company’s distributed property cannot be zero.
Taxable Year and Taxation of the Owner
Just like partnerships, the provisions of the general rules that govern tax years require S corporations to use the calendar year in most cases. However, the IRS can allow S corporation shareholders to use the requested year if the entity can provide a business purpose for a particular fiscal year. The advantage of using a fiscal year for the shareholders is that the IRS can allow them to defer from taxation of the income earned during the period starting from the end of the fiscal year to the close of the calendar year. For that reason, the tax advisers for S corporations should apply the IRS’s test for gross receipts in line with the provisions of Revenue Procedure 2006-2046 to check whether the IRS can grant the fiscal year.
A detailed overview of the computations associated with determining the tax basis of a shareholder for tax basis is included in the Form 1120S and Schedule K-1 information. In computing the stock basis in an S corporation, shareholders are require to use either first capital contribution to the business or the first value of the stock purchased at the start of the corporation. The next step involves increasing or decreasing the amount in line with the pass-through amounts distributed by the S corporation. A distribution, loss, or deduction decreases the stock basis, while an item of income increases it.
Just like partnerships, S corporations are pass-through business for the tax purposes, so there are no federal income taxes charged at the corporate level. For that reason, the profits of an S corporation are allocated to the shareholders, meaning that the business owners are taxed, instead. The taxation of S corporations is conducted using Form 1120S, which is designed to file the annual tax returns. One of the positives of S-corporation taxation is that the shareholders are exempted from paying self-employment taxes on their share of the profits from the business. However, all shareholders who are also employees of the corporation are paid “reasonable” salary, which is subject to both Medicare and Social Security taxes half of which are covered by the employee while the corporation clears the rest. For that reason, the savings made from not paying self-employment tax are only made when the S corporation makes enough to have profits to pay out even after paying the “reasonable” salary CITATION Mik18 \l 1033 (Piper, 2018).
Deductibility of Losses
Since an S Corporation is a “pass-through” tax entity, income, credits, deductions, and other activities are allocated (passed) to its shareholders to be tied to their tax returns. Shareholders can also use losses to offset income from sources outside the business when the S corporation allocates the losses to them. Primarily, losses are used to offset incomes if they pass three tests, the first pair of which, the rules of “at-risk” limitation and “stock basis,” are widely used. Both of them are used in line with how the losses were funded.