Tax Education Center 2021-2022 PDF

TAX EDUCATION CENTER TESTING SEASON 2021-2022 NEW TAX LAW TOPICS: PART TWO INSTRUCTOR: STANDLEY TILERIN, EA Unit: 1 Business Entities and Requirements SOLE  A sole proprietorship is not a separate legal entity. It is an unin...

TAX EDUCATION CENTER TESTING SEASON 2021-2022 NEW TAX LAW TOPICS: PART TWO INSTRUCTOR: STANDLEY TILERIN, EA Unit: 1 Business Entities and Requirements SOLE  A sole proprietorship is not a separate legal entity. It is an unincorporated business that is owned and PROPRIETORSHIPS controlled by one person. A sole proprietorship may be a single-person business, or it may have several employees, but there is only one owner who accepts all the risk and liability of the business. It is the simplest business type and also the easiest to start. An estimated 70% of businesses in the United States are sole proprietorships.  If a business operated as a sole proprietorship is sold, it must be operated by the new owner as either a different sole proprietorship or as a different type of business entity through a sale of assets of the business.   An unincorporated organization with two or more owners is generally classified as a partnership for federal tax purposes if its members carry on a business and divide its profits. It can be anything from a small business run by a married couple to a complex business organization PARTNERSHIPS with thousands of general partners and limited partners.  A partnership must file an annual information return to report the income, deductions, gains, and losses from its operations, but the partnership itself does not pay income tax. Instead, any profits or losses “pass through” to its partners, who are then responsible for reporting their respective shares of the partnership’s income or loss on their individual returns.  A partnership can have an unlimited number of partners, and can have partners that are foreign or domestic.  A partnership must always have at least one general partner whose actions legally bind the business and who is legally responsible for a partnership’s debts and liabilities. A partnership’s annual tax return is filed on Form 1065, U.S. Return of Partnership Income.  Partners are not employees of the business, and they should not be issued a Form W-2. Instead, the partnership must furnish a copy of Schedule K-1 to each of its partners, showing the income and losses allocated to him. A partnership return must show the name and address of each partner and the partner’s share of taxable income. The return must be signed by a general partner  However, a “joint undertaking” merely to share JOINT  expenses is not automatically a partnership. For example, co-ownership of rental property is usually not UNDERTAKING considered a formal partnership unless the co-owners provide substantial services to the tenants.  The IRS defines “substantial services” as services that are primarily for the tenant’s convenience, such as regular cleaning, changing linen, or maid service. This would be something like a hotel or bed-and- breakfast. In that case, the rental activity could not be classified as a joint undertaking, because it would not be reported on Schedule E as a passive rental. Instead, it would be reported on Schedule C, or, if the rental was owned and operated by more than one person, it would be classified as a partnership.  Example: Russel and Ethan are cousins who own a residential EXAMPLE  rental property together. Each owns a 50% interest in the rental. Russek takes care of any repairs, and Ethan collects and divides the rent. They do not have any other business with each other. The co-ownership of the rental property is not considered a partnership for tax purposes. Instead, they would divide the income and expenses based on their ownership percentages, and each would report his respective share on Schedule E on his individual return.  Example: David and Jackie are siblings. In 2020, they purchase a Victorian home in downtown New Orleans. They spend a substantial sum to divide the home into four separate units, which they then advertise as a bed-and- breakfast. They offer maid service and daily breakfast to all their guests. The IRS would classify their business as a hotel, rather than a passive rental activity. Therefore, David and Jackie would be required to file a partnership return in order to report their earnings and profits.  A limited partnership (LP) is a partnership that has at least one LIMITED  limited partner in addition to its general partner(s). A limited partnership allows an investor (the limited partner) to own an PARTNERSHIP interest in a business without assuming personal liability or risk beyond the amount of his investment in the partnership.  Note: A Limited Partnership (LP) is a state-level entity. Unlike a general partnership (GP), which can be formed merely with a handshake between two persons, in many states, in order to form an LP, a Certificate of Limited Partnership or Certificate of Formation must generally be filed with the Secretary of State in which the partnership chooses to do business. For example, in order to form an LP in California, a Certificate of Limited Partnership (Form LP–1) must be filed with the California Secretary of State, and the applicable filing fees must be paid.  A limited partner generally has no obligation to contribute additional capital to the partnership and, therefore, does not have an economic risk of loss for partnership liabilities. A limited partner may not sign the partnership return or represent the business before the IRS in their capacity as a limited partner. In most states, a limited partner is restricted regarding how active they can be in the management of the partnership.  Example: Tyler wants to open a dance club. He EXAMPLE  approaches his aunt, Cindy, for the funds. Cindy agrees to invest in her nephew’s business, but she does not want to be involved in the day-to-day running of the club. After consulting with a legal advisor, Tyler and his aunt form a limited partnership (LP). Per their partnership agreement, Cindy is a limited partner. She is an investor in the club and contributes $250,000 to establish the club. Tyler is an experienced restaurateur and nightlife expert, so he runs the club. Tyler is the general partner.  A Limited Liability Partnership (LLP) is an entity that is formed LLP  under state law and is generally used for specific professional services, such as those offered by a law firm or CPA firm. Some professionals form an LLP because the option of an LLC is prohibited in their state for their particular business type.  For example, in California and New York, LLCs cannot provide certain professional services. Doctors, CPAs, attorneys, veterinarians, and other similar, licensed professionals cannot form an LLC for those particular business activities, but they are allowed to form an LLP and offer these professional services.  Typically, an LLP allows each partner to actively participate in management affairs but still provides limited liability protection to each partner. A partner in an LLP generally would not be personally liable for the partnership debts or the malpractice of other partners (or the employees under the management of other partners) and would only be at risk for his own malpractice and his interest in the partnership’s assets  Example: Jeff and Andrew are licensed attorneys EXAMPLE  in California who decide to go into business with each other. They form an LLP by registering their business with California’s Secretary of State. Once they complete their registration, they open an office and begin accepting new clients. For tax purposes, their business will be taxed as a partnership, and they will be required to file a Form 1065 every year. In a limited liability partnership, the partners enjoy some protection against personal legal liability  Often, a small business is operated by spouses without QUALIFIED  incorporating or creating a formal partnership agreement. The business is usually considered a partnership, whether or not there is JOINT a formal partnership agreement. VENTURES  However, if both spouses materially participate as the only members of a jointly owned and operated business, the business may be treated as a qualified joint venture, or QJV. The spouses then file separate Schedules C and separate Schedules SE. This option is available only to married couples who file joint tax returns.  A partnership would be required to file a partnership tax return (Form 1065) if the entity is a state-level entity (such as an MMLLC) In general, spouses cannot file as a Qualified Joint Venture.  There is a narrow exception in the law for married couples who live in a community property state. Married couples who co-own and operate an MMLLC in a community property state may still file as a QJV. (See Rev. Proc. 2002-69, 2002-2). Community property states as of 2020 include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin  Example: Sheldon and Trinna live in Hawaii, where EXAMPLE  they operate a small business together as husband and wife. They qualify for and treat their business as a qualified joint venture and file on two Schedule Cs. Later in the year, they decide to form an LLC. They must file a partnership return (Form 1065) for their business, starting with the date of formation of the LLC. They can no longer treat their business activity as a qualified joint venture.  Example: Brian and Kelly are married and file jointly. They live in Texas and run a small grocery store together as a qualified joint venture. During the year, they form an LLC for liability protection. Since Texas is a community property state, they are allowed to continue treating their business as a qualified joint venture and report their income and loss on two Schedule Cs.   A corporation is considered an entity separate from its shareholders and must elect a board of directors who are responsible for oversight of the company. A corporation C conducts business, realizes net income or loss, and distributes profits to shareholders. CORPORATIONS  Most major companies are organized as C corporations. A C corporation may have an unlimited number of shareholders and may be either foreign or domestic. A C corporation must file annual income tax returns on Form 1120, U.S. Corporation Income Tax Return, to report its net income and losses, and pay tax on its income. Its after-tax profits may also be taxable income to its shareholders when distributed as dividends, resulting in double taxation.  The corporation does not receive a tax deduction when it distributes dividends to shareholders, and shareholders cannot deduct any losses of the corporation.  A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income, but it is also allowed certain special deductions. C corporations are now taxed at a flat rate.  The Tax Cuts and Jobs Act permanently eliminated the graduated rates for C Corporations. All C corporations are now taxed at a flat rate of 21%. S  An S corporation is a distinct form of entity organized as a corporation for legal purposes, CORPORATIONS but elected with the IRS for tax purposes. For federal income tax purposes, an S corporation is generally not subject to tax; instead, its income, losses, deductions, and credits are passed through directly to its shareholders in a manner similar to a partnership. However, while not common, the S corporation itself may be responsible for income tax on certain built-in gains and passive investment income.  We will cover these special rules that apply to S corporations in a later unit.   A limited liability company (LLC) is another type of business entity that may be formed under state law. Depending upon whether it has a single owner or multiple owners, an LLC will LLCS be treated for federal tax purposes either as:  A “disregarded entity,”  A corporation; if the entity elects to be treated as a corporation, or  As a partnership (if more than one owner).  Most LLCs in the United States are taxed as partnerships. If a multi-member limited liability company (MMLLC) is treated as a partnership for tax purposes, it must file Form 1065 annually, and one of its owners/members must sign the return.  A Professional Service Limited Liability Company, or PLLC is a type of limited liability company that is owned and operated by licensed professionals, such as doctors, lawyers, engineers, and CPAs. PLLCs are not available in every state, and have ownership restrictions and can generally only offer services related to its profession. FARMERS  Farming businesses are primarily engaged in crop production, animal production, or forestry AND and logging. They may include stock, dairy, poultry, fish, fruit, and tree farms, as well as FISHERMEN plantations, ranches, timber farms, and orchards. It is the nature of the activity, and not the entity type that determines whether a business qualifies as a farming business.  Congress has enacted many tax laws specific to farming, which we will cover in detail in a later unit. TAX EXEMPT  Tax-Exempt Organizations (Nonprofit Entities) ORGANIZATIONS  The Internal Revenue Code (IRC Section 501(c)) outlines the requirements for tax-exempt organizations. These organizations must have a “tax-exempt” purpose, and none of their earnings may be used to benefit any private shareholder or individual.  Nonprofit organizations may be created as corporations, trusts, or unincorporated associations, but never as partnerships or sole proprietorships.   An employer identification number is used for reporting purposes. Unlike Social Security numbers that are assigned to individuals, EINs are assigned to business entities. EIN  If a sole proprietor has no employees, the business owner is normally not required to obtain an EIN. However, an EIN can be requested by a sole proprietor who simply wishes to protect his Social Security number for privacy reasons. This way, a sole proprietor can provide his EIN rather than his SSN to companies that need to issue him a Form 1099-NEC for independent contractor payments. If a sole proprietor decides to form a business entity such as a partnership or corporation, he will be required to request an EIN for each separate entity. A business must apply for an EIN if any of the following apply:  The business pays employees,  The business operates as a corporation, exempt organization, trust, estate, or partnership for tax purposes,  The business files any of these tax returns:  Employment taxes (payroll taxes)  Excise tax  Alcohol, Tobacco, and Firearms  The business withholds taxes paid to a nonresident alien  The business establishes a pension, profit-sharing, or retirement plan  Businesses are subject to a number of reporting REPORTING  requirements, including the following: REQUIREMENTS  Form W-2: A business must complete and file with the Social Security Administration Forms W-2, Wage, and Tax Statement, showing the wages paid and taxes withheld for the year for each employee no later than January 31 of the following year.  Form W-9: A taxpayer uses this form to provide his correct taxpayer identification number (TIN) to any individual or entity who is required to file an information return with the IRS.  Form 1099-NEC: A business must report nonemployee compensation paid during the year to certain independent contractors that provided services by providing a Form 1099-NEC by January 31 of the following year.  Form 1099-MISC: This form was redesigned for 2020 to remove the REPORTING  box for nonemployee compensation. Amounts that are reported on the 1099-MISC include: REQUIREMENTS  Payments of $600 or more for rents, prizes and awards, crop insurance proceeds, and certain medical and health care payments,  Royalties over $10,  Gross proceeds paid to an attorney’s office, when the total amount is $600 or more.  Except for incorporated attorneys, payments to corporations are generally exempt from Form 1099 reporting requirements. Forms 1099 should only be used for payments that are made in the course of a trade or business. Personal payments are not reportable.  A business should only include payments made by cash, check, ACH transfer or other direct means on Form 1099-MISC or 1099NEC. Credit card payments, including third party network transactions, must be reported on Form 1099-K by the payment settlement entity and are not subject to reporting on Form 1099MISC or 1099-NEC.  Example: Kelly hires a painter to paint the EXAMPLE  exterior of her home. The job costs $3,500. Stephanie is not required to report the payment to the painter because it is for her personal residence. Since it was a personal payment, she cannot deduct the cost on her income tax return. However, the painter is still required to report the income on his income tax return. The following year, Kelly calls the same painter to paint the interior of her business office, which she owns. The painting job costs $2,000. Since the cost is a business expense, Kelly is required to issue a Form 1099-NEC to the contractor.  Form 1099-K: The Form 1099-K, Payment Card and 1099-K  Third Party Network Transactions, is an IRS information return used by payment settlement entities (like Paypal and Stripe) to report online payment transactions.  Note: Rideshare drivers, like those that work for Uber and Lyft, generally receive a Form 1099-K for their driving services, since the payments made to them are processed by a thirdparty network. The 1099-K includes a breakdown of the driver’s annual gross earnings. Not every driver receives a 1099-K. The current 1099-K reporting threshold is either (1) $20,000 in gross earnings and (2) 200 transactions. A driver would typically receive a 1099-K if they earned more than $20,000 in fees and provided more than 200 rides to passengers.  Form 8300, Report of Cash Transactions over $10,000: CASH  When a business receives a cash payment of more than TRANSACTIONS $10,000 from one transaction (or two or more related transactions), it must file Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business within 15 days after they receive the cash. This type of transaction is also called a “designated reporting transaction.”  A business must also provide a written statement to each person or customer named on any Form 8300 that is filed. The statement must be provided to the customer no later than January 31 of the following year.  For the purposes of this rule, “cash” includes the coins and currency of the United States, cashier’s checks, bank drafts, traveler’s checks, as well as cash in a foreign currency. “Cash” does not include bank wire transfers, credit card transactions, ACH transactions, or amounts paid with personal checks.  Example: Johns’s Used Autos, LLC is a small, family- CASH  owned car dealership. On January 6, 2020, Jenny Adams TRANSACTIONS buys a used car from John’s Used Autos and pays $17,000 in cash. The dealership asks Jenny for her driver’s license and verifies her identification, in order to get the necessary information to complete Form 8300. John’s Used Autos must file the Form 8300 no later than January 21, 2020 (15 days later). The dealership must also send a statement to Jenny by January 31, 2021 (the following year).  Example: Maria is an elementary school teacher. She decides to sell her personal vehicle. She places an ad in her local newspaper listing her car for $12,500. She finds a buyer for the car, who pays her $12,500 in cash a week later. Sheena does not have to report the sale on Form 8300 because she is not a professional car dealer, and the transaction was not a business transaction.  Because businesses are responsible for withholding and WORKER  paying income, employment, and FUTA taxes, as well as CLASSIFICATION reporting payments to independent contractors, they must accurately determine whether a person they pay is an independent contractor or an employee.  A business is generally not required to withhold or pay taxes in connection with payments to independent contractors. However, it must understand the relationship that exists with each person it pays to perform services. A person performing services for a business may be:  An independent contractor  An employee  A statutory employee  A statutory nonemployee  Some workers are classified as statutory employees. Statutory employees STATUTORY  are unique, because they are issued Forms W-2 by their employers, but report their wages, income, and allowable expenses on Schedule C, just like self-employed taxpayers. EMPLOYEES  Statutory employees are usually salespeople or other employees who work on commission. The difference is that statutory employees are not required to pay self-employment tax, because their employers must treat them as employees for Social Security tax purposes. Examples of statutory employees include: Full-time life insurance salespeople, Traveling salespeople, Certain commissioned truck drivers, Directors (board members) of corporations and officers of nonprofit organizations, Certain home workers who perform work on materials or goods furnished by the employer.  If a person is a statutory employee, the “statutory employee” in box 13 of Form W-2 should be checked. SAMPLE W-2  There are two main categories of statutory nonemployees: direct sellers and STATUTORY  licensed real estate agents. They are treated as self-employed for federal tax purposes. NONEMPLOYEES  In 2020, compensation for a statutory nonemployee is reported on Form 1099- NEC. The taxpayer then reports the income on Schedule C.  Example: Wonda works as a full-time real estate agent for Trusty Realty Services. She visits the realty office at least once a day to check her mail and her messages. She manages dozens of listings and splits her real estate commissions with Trusty Realty. She does not work for any other real estate company. Wonda is classified as a statutory nonemployee. Trusty Realty issues Wonda a Form 1099-NEC for commissions, and she files Schedule C to report her income and expenses from her realty business.  Example: Betty sells cosmetics, perfumes and personal products as an independent sales representative of Kary Mare. Betty’s customers pick products directly out of catalogs. Betty then orders the products and delivers them to her customers personally. Sometimes she will host Kary Mare parties at her home, where customers can socialize and try different products. Betty earns a 40% commission on her product sales. She is not an employee of Kary Mare. She will file a Schedule C to report her income and expenses.  FICA AND SE TAX  Employers must report federal income taxes withheld and employment taxes on Form 941, Employer’s Quarterly Federal Tax Return, or Form 944, Employer’s Annual Federal Tax Return. Businesses must also make federal tax deposits using the Electronic Federal Tax Payment System (EFTPS).  In 2020, only the first $137,700 of an individual’s employee compensation and/or net earnings from self-employment is subject to the Social Security tax. The maximum amount of Social Security tax is $8,537.40 in 2020 for employees and $17,074.80 for self employed individuals. There is no cap on the Medicare tax.  For tax year 2020, the CARES Act provides a CARES ACT  temporary payroll tax deferral. This applies to DEFERRAL wages paid between March 27, 2020, and December 31, 2020. This is only a deferral, not forgiveness of the tax owed. All employers (including self-employed taxpayers) may defer the deposit and payment of the employer's share of Social Security tax.  If elected, this means the business could defer the 6.2% “employer portion” of the Social Security tax. Self-employed individuals may also choose to defer the employer portion of their self-employment taxes and defer payments that would otherwise be required to be made for the period beginning on March 27, 2020, and ending December 31, 2020 FUTA TAX  The Federal Unemployment Tax Act (FUTA), provides for payments of unemployment compensation to workers who have lost their jobs. A business reports and pays FUTA tax separately from federal income tax, and Social Security and Medicare taxes. FUTA tax is paid only by the employer, never by the employee. The current FUTA tax rate is 6% on the first $7,000 of each employee’s wages. Most employers receive a maximum credit of up to 5.4% against this FUTA tax for any unemployment tax paid to the state. The tax is reported on Form 940, Employer's Annual Federal Unemployment (FUTA) Tax Return.  Once an employee earns $7,000 in gross wages for the year, that is the maximum amount of wages that are subject to FUTA. Which means that the business no longer has to pay FUTA for that particular employee. However, if an employee quits, and a new employee is hired, then the FUTA tax must be collected on the new employee’s wages, as well, up to the $7,000 limit.  Example: Brokers, Inc. hires a new receptionist on January 10. The receptionist only works a month before quitting. She had earned $2,300 in wages in January before she quit. Pathway Brokers must pay $138 in FUTA tax on her wages ($2,300 x 6% = $138). If the company hires another employee to replace her, it will be required to pay FUTA tax on the new employee’s wages as well, up to the $7,000 threshold.  This penalty is also called the “100% penalty.” If a business does TRUST FUND  not deposit its trust fund taxes in a timely manner, the IRS may assess a trust fund recovery penalty (TFRP). The amount of the RECOVERY penalty is equal to the unpaid balance of the trust fund taxes. This penalty is also called the “100% penalty.” If a business does PENALTY  not deposit its trust fund taxes in a timely manner, the IRS may assess a trust fund recovery penalty (TFRP). The amount of the (TFRP) penalty is equal to the unpaid balance of the trust fund taxes.  The TFRP may be assessed against any person who: Is responsible for collecting or paying withheld income and employment taxes, or for paying collected excise taxes, and Willfully fails to collect or pay them.  Once the IRS asserts the penalty, it can take collection action against the personal assets of anyone who is deemed a “responsible person.” It is not only the executives of businesses or the top finance and accounting personnel who may be held responsible for the TFRP. A responsible person may also include a person who signs checks for the company or who otherwise has the authority to spend business funds, such as a bookkeeper.  Example: Anna ran her own tax preparation TFRP:  business and also processed the payroll for her EXAMPLE local church. The church had four employees. Anna prepared and signed the payroll tax returns and all the checks and then gave them to the pastor to mail. The pastor did not mail the payroll tax reports or remit the payments to the IRS. Instead, he used the money to purchase a new piano for the church. Anna knew the pastor was misusing the funds but did not report the information to authorities. The IRS assessed the TFRP against the pastor, the church, and Anna. Even though Anna was just the bookkeeper, she knew that the pastor was improperly handling the payroll tax funds, and she did nothing about it, so the IRS can assess 100% of the penalty against Anna.