Question

Tax implications of business entities: corporations, S corporations,partnership, and LLCs.

List and explain the pros and cons, from a taxation sense, of operating each type of business.

Explain the importance of the passive activity loss rules. Why do you think these rules were put into law?

Answer 1

Solution

    S corporations are a special type of corporation that is created by filing an election with the IRS. An S corporation is a corporation that elects to pass on its corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. The shareholders of the S corporation report the flow-through income and losses from the business on their personal tax returns. The flow-through income and losses are then assessed tax at the shareholders’ individual income tax rates.

LLC stands for Limited Liability Corporation. An LLC is a hybrid type of entity that combines the limited liability of a corporation and the tax efficiencies and operational flexibility of a partnership. The owners of an LLC are called members. The members can consist of a single owner, two or more owners, corporations, or other LLCs. LLCs are not taxed as a separate entity.

A partnership is a single business where two or more people share ownership. In the partnership, each partner contributes to all of the aspects of the business. This includes money, property, labor, or skill. Each partner will then share all of the profits and losses of the business. A partnership should start with a legal partnership agreement to discuss issues of the partnership.

Starting a new business is an exciting prospect, and there are several types of business entities to choose from. A business entity is a separate and distinct legal organization created to conduct business and establish legal relationships. There are many important considerations as to the type of business entity that will best suit the business you wish to conduct. Depending upon the type of business entity, creating a business entity can provide personal protection to the business owner, dictate the amount and types of taxes paid, and control how the business operates and functions internally. The following represents a summary of the types of business entities available as well as some of the pros and cons of each.

There are two rules that limit the amount of a business loss you may deduct from your other sources of income in any given tax year:

1. Passive Activity Rules
2. At-Risk Rules

Passive Activity Rules

The passive activity rules (Section 469, Passive Activity Losses and Credits Limited) were enacted into law with the passage of the Tax Reform Act of 1986

Passive activity rules deal with participation in a business. Passive activity rules target investors who do not materially participate in the businesses they invest in. Such investors simply expect a return on their investment.

It's easy to know whether you have income or loss from real estate rentals. But the concept of "material participation" is more complicated. You materially participate in a business only if you are involved with its day-to-day operations on a regular, continuous, and substantial basis. (I.R.C. Section 469(h).) The IRS has created several tests to determine material participation, based on the amount of time you spend working at it.