Sale of Business Property

Form 4797 is used to report the sale of business property and other depreciable and amortizable property. On part I are reported losses on property held for more than one year, which recieve ordinary loss treatment. On part II are reported sales for property held for one year or less and on Part III property sold held for more than one year for which depreciation is a taxable component. Part IV included recapture of depreciation and amortization under Section 179 and Section 280F when business use declines below 50%.

IRC Section 1231 provides the best of both worlds on the sale of business assets and residential property. If cumulative Section 1231 losses have exceeded Section 1231 gains from the prior 5 years then the difference is treated as ordinary income.

Taxation for Investor and Traders

For tax purposes the tax treatment for a trader in securities or commodities depends on their tax classification.

A trader is engaged in the business of buying and selling securities for one's own account. To be classified as a trader the trader must seek to profit from daily market fluctuations in the prices of securities or commodities and not from dividends, interest or capital appreciation. Factors that are considered for this include the typical holding periods for securities bought and sold, the frequency and dollar amount of trades during the year, the extent to which a taxpayer pursues the trading activity to produce income from a livelihood, and the amount of time devoted to the activity. A trader who chooses to elect mark to market accounting methods reports both gain and losses as ordinary income instead of capital gain and losses on form 4797.

An investor typically seeks to profit from investment earnings and capital appreciation.

A dealer in securities in the business of resale to customers and typically profit from the business transaction and not from appreciation in the security.

Dealers report transaction on a Schedule C, Investors report transaction on Schedule D, and Traders on schedule D, unless they market to market which they then report on Part II form 4797.

Personal Service Corporations

Personal Service Corporations exist where corporations are formed for professional services such as accounting, actuarial science, architecture, consulting, engineering, health, law and the performing arts.

A qualified personal service corporation is taxed at a flat rate of 35% of taxable income. A corporation is a PSC if it meets both of following tests

1. Substantially all the corporation's activities involve the performance of personal services
2. At least 95% of the corporations stock by value is owned by a. employees performing personal services b. retired employees who were involved with the corporation c. an estate of an employee or retiree d. any person who acquired the stock of the corporation as a result of the death of an employee or retiree.

A PSC has a safe harbor of $150,000 for accumulated earnings. IRC 535.

C Corporation Rental Agreements

The IRS may challenge the following rental situations between shareholders and a corporation:

1. If the rent has the character of a distribution of profits from the corporation (i.e. variable rate rent that minimized the profitability of the corporation)
2. If the rent is paid to an employee, IRS may attempt to recharacterize the payments as wages
3. A self rental rule blocks taxpayers from offsetting passive losses with income from rental property
4. Payments made to employees for equipment that is required as a condition of employment are taxable wages, unless the amount is paid under an accountable plan
5. Rental of personal property must be clearly segregated from employment activities

While rents can be used by taxpayers to gain income from property rented to a wholly owned C corporation, the IRS is cautious to minimize the advantage of self interests in rental agreements.

Meal and Travel Expenses

Most usually, meal expenses are limited to 50% of the expense. When providing meals and entertainment to clients the following rules apply.

1. entertaining clients must be directly related to or associated with the active conduct of business such as discussing deals before, during or after the meals
2. the taxpayer or employee must present when the meal or entertainment occur
3. if a group or business acquaintances take turns picking up the tab whether business activity occurs or not, the expense cannot be deductible
4. lavish or extravagant meals and entertainment are not deductible
5. only the cost of face value of a ticket is deductible

Travel primarily for business outside the United States is prorated on the expense for personal and business. If all travel is for business then the entire expense is deductible, however, if some is for personal purposes, then that % is a nondeductible expense. For instance, if a taxpayer travels outside the US for 30 days and 15 days are for business purposes, then 50% of the trip cost is deductible.

Nontaxable Transfers - IRC Section 351

In a Section 351 transfer no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation, and immediately after the exchange such person or persons are in control - as defined in Section 368(c) - of the corporation.

Control of the corporation is defined as ownership of 80% of more of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation. IRC 368(C).

One or more persons may include individuals, trusts, estates, partnerships, associations or corporations. Money is treated as property for purposes of Section 351. Services do not qualify as property for purposes of Section 351.

Transfers in bankruptcy do not qualify for the Section 351 treatment.

If a transferor receives boot in the exchange, the gain is realized to the extent of the money or property received (boot).

Group control in a Section 351 exchange must include substantial contributions by shareholders. For instance two shareholders cannot contribute to meet the 80% control test if the contribution by either shareholder is less than 10% of fair market value of stock and securities already owned by the person.

Liabilities contributed in a Section 351 exchange reduce the basis of the shareholders stock. If the liability contributed exceeds the basis, the excess is treated as gain.

Controlled Groups

In order to minimize an owner or groups of owners from dividing one corporation in multiple corporations for the sole purpose of lowering tax liabilities, IRC Section 1561 limits the benefits to equalize as if multiple corporations under that same ownership were one corporations.

The types of controlled groups are:

1. Parent - subsidiary group: one or more chains or corporations connected through stock ownership with a common parent

2. Brother -sister group: two or more corporations owned by the same five or fewer shareholders

3. Combined group: three or more corporations, each of which is a member of a parent-subsidiary or brother - sister group and one of which is a common parent and also included in a brother - sister group.

4. Consolidated group: members of a parent subsidiary group that file a consolidated tax return.

C Corporations which are part of a controlled group, must file a Schedule O Form 1120 under regulation Section 1.561-1T(a).

Guaranteed Payments

Guaranteed Payments are payments made from a partnership to a partner regardless of the partnerships profitability. Guaranteed payments are deducted from partnership income in determining the distributive share of partnership gain or loss for the year. Guaranteed payments are a partnerships form of payments to partnership, similar to wages in an corporation. For instance, if a partnership earns $800,000 for the year, with two partners, and each partner receives guaranteed payments of $150,000, the distributive share of partnership profits would be $500,000 ( $800,000 profit - $150,000 to each partner). The partners would receive $400,000 each, $150,000 in guaranteed payments subject to SE tax, and $250,000 of distributive profit, subject to SE tax if both partners are general partners.

Single Member LLC to Multiple Member LLC

A single-owner LLC is a "disregarded entity" assuming it has not made the election to be taxed as a corporation. If the single-owner LLC brings on a new member, the entity ceases to be a disregarded entity and a partnership is created for federal tax purposes. If the new owner pays the old owner for an interest then a deemed sale of assets occurs and the old owner recognizes gain or loss. If the new owners contributes money, then the adjusted basis changes for the old owner to reflect the new percentages of ownership.

S Corporation Conversion to LLC

An S-Corporation convert to an LLC - that elects to be taxed as a corporation - with a tax free reorganization. With IRC Section 368(a)(1)(F) a reorganization can take place if the basis and holding periods of the assets in the new LLC were the same as in the S-Corporation before the reorganization takes place.

LLC Member and Limited Partners

Limited partners in a partnership, have their liability classified to included the amount of their investment. A general partner in a partnership on the other hand, hold unlimited liability to the debts and obligations of the partnership. General partners pay SE tax on their distributive share of income from the partnership, while limited partners do not.

The IRS regulations currently facilitate that logically, an LLC member who is personally involved with an LLC, likely should be subject the SE tax. The best way to handle this, is with guaranteed payments from the LLC to the members - subject the SE tax, with the distributive share not subject to the SE tax. This is similar to an S-Corporation, where reasonable wages are paid, and the distributive share is non-taxable.

Domestic Production Activities Deduction

For businesses that manufacture or produce new assets, the IRS permits a Section 199 deduction on a form 8903, also known as the Domestic Production Activities Deduction. The deduction percentage equals the lesser of qualified production activities income (DPAI) multipled by 9% for 2010 or 50% of W-2 wage expenses. Individuals deduct DPAD on line 35 of the 1040 to arrive at AGI, while corporations deduct it on line 25 of the 1120, and 1065 and 1120S filers pass the deduction through to shareholders on the K-1.

QPAI is defined as domestic production gross receipts minus other direct costs allocable to such gross receipts. Sales tax is not included as a gross revenue.

W-2 wages are those wages paid to employees relating to domestic production gross receipts (DPGR). For instance lets take an example where an construction company has DPAI of $10,000,000, COGS of $5,000,000 and 75% of gross receipts are DGPR, with W-2 income relating to DPGR of $2,000,000. The DPAD deduction would be the lesser of $10m - $5m = $5m * .75 = 3.75m * 9% = $337,500 or $1,000,000 (50% of W-2 Wages). So if the entity was a C-Corporation they would deduct $337,500 on line 25 of Form 1120 as an expense.

Corporations and Compensation

Although management in an S-Corporation and a C-Corporation may be very similar, wages may differ due to tax treatment of the entities. In an S-Corporation, shareholders are inclined to pay themselves a lower salary and take a larger distribution - taxed at ordinary rates on the flow through to the individual 1040. However, in a C-Corporation, income is taxed first at the entity level, and then again as a dividend. But C-Corporations have one major advantage over an S-Corporation, and that is the deduction of fringe benefits. A C-Corporation can deduct health insurance, and other fringe benefits paid to shareholders directly from income. In an S-Corporation, health insurance is added to the W-2 and taxed at the individual level. So in an S-Corporation reasonable compensation is essential as a lower wage may result in dividends being reclassified as wages. In a C-Corporation, high wages may be considered to be too substantial and reclassified as dividends, if wage and bonuses are to high. Therefore, before deciding on salary levels, it is best to check what is an equitable wage according to the IRS, and pay the dividend tax in C-Corporations.

Partnership Basis

A partners basis in a partnership upon creation is the combination of cash, property and services contributed. A partners basis increases with cash contributions or increases in liabilities assumed by the partnership, and the distributive share of income. Basis decreases occur when money is paid to partners, liabilities decrease or distributive losses are incurred. Basis is also decreased with non-deductible expenses and section 179 expenses that are disallowed on the personal return.

A partners capital is usually tracked on the K-1 on a tax basis, unless the partnership has a GAAP balance sheet which is required when a M-3 is used.

S Corporation Requirements

For a corporate shareholder in a C corporation, there are tax advantages to electing S-status. The main advantages is being taxed only once on the corporations net income, and with adequate basis, deducting losses on there 1040. However, not all C-Corporations can elect S-status with the filing of the 2553.

To elect to be taxed as an S-Corp, the following requirements are necessary:
1. All shareholders must consent to the S Corporation status, and sign the 2553
2. There can be no more than 100 shareholders
3. There can be only one class of stock (voting and non-voting stock is permitted)
4. The corporation must be a domestic corporation and shareholders must be U.S. citizens or residents
5. Only individuals, estates, and certain trusts and charties can be shareholders. Corporations, partnerships, LLC's, LLP's, IRA's are ineligible shareholders.

If S status is elected, the shareholder receives flow-through income from the corporation on a K-1 which is reported on the shareholders 1040. This avoids the taxation at the Corporate level, and then as a distribution at the individual level, thus avoiding double taxation.

S-Corporations vs. LLC's

S-corporations and multi-member LLC's are taxed both as flow through entities. As flow through entities, in essence, the taxable income is passed from entity to the individual shareholders 1040 via a K-1.

However, there are differences between LLC's and S-Corporations. While both provide limited liability to the owners, LLC's permit losses in excess of basis, while S-corporations losses if in excess of basis are not deductible. While S-corp's are exempt from local tax, LLC gains are not.

With a tax on Medicare of 1.45% for both the employee and employer for example is another difference. For a highly profitable S-corporation, if a salary is paid of $106,800, which is the SE limit, and income in excess of this is paid to the shareholders in the form of a distribution, the gain is non-taxable for Medicare purposes.

Partnership Capital Accounts and 754 Basis Changes

Partners in a partnership, have a capital account that track's the cumulative earnings or losses of the partnership interest. On the date the partnership beings, the book value should reflect the FMV of the partnership. One unique feature of partnerships is the fact that special allocations can be made for partnership income/loss. This however, usually increases audit risk of the partnership.

Capital accounts differ from basis. Capital accounts are calculated with the FMV contributions, plus percentage of earnings, minus distributions, minus losses. Basis changes as depreciation of partnership assets occur. A 754 step-up can occur when a partner sells his partnership interest, which is a transaction that increases inside basis in the partnership. This step-up in is depreciated on the partnerships books. A 754 election is made by attaching a written statement to the 1065 filed by the due date. The statement must include information on the partnership. Once the election is made, it cannot be revoked without IRS consent.