Introduction to S Corporations & LLC's - Part 1

[Music] welcome to instruction to s corporations and LLC's part 1 this is a two-part class we really do intend that the class be taken in its entirety part 1 followed by part 2 there's nothing to prevent a person from doing only one or the other but today's class is laying the foundation for the class that you will hold on Thursday which is part two my name is a pocket Harris I am your instructor for today's class and pretty much all the classes here at Pacific Northwest tech school I wrote this course out of necessity S corporations are a fairly common small business entity type and we do lots of them in our own practice and I was getting a lot of requests from students for more classes that would cover as corporations and so I created this course and over the years it's really rounded out to the point where it is that now there's been very few updates to the class this year because not much has changed from last year but this of course I've been teaching it for over a decade and just refining it as I go each year and we're going to really in today's class start at the very very very beginning we're assuming that you have some understanding of tax law in other words you understand what it is to have a profit and loss for a business the types of income and types of expense items that are common to businesses so we're assuming you have that kind of a background but beyond that we're assuming you know very little about preparation of form 1065 or form 1120s or if you know somewhat about it but you're not real clear on it we're basically going to be taking you from the very beginning today so we're gonna start with a description of the various entity types and if you flip in the manual to page 4 you'll be where I'm at now and business entity types are important because depending on the type of entity you are that's really gonna dictate how the IRS taxes you so we're going to talk about the different entity types how they're formed how they're changed how they end and then we'll move on to a discussion of how each of these entity types is taxed then we're going to move on to a closer in-depth look at the preparation of form 1065 and the reason we're going to be looking at 1065 is that most limited liability companies are going to default to form 1065 unless action is taken to become an S corporation or make that F corporation taxation election so we're gonna look first at the default form of how a limited liability company is taxed and then we're gonna go to the next level in part two of this course where we look at how F corporations are taxed and how to prepare form 1120s so beginning up at the top of page page four with business entity types there are a number of different organizational structures that are available to business owners and each type of business structure has its advantages and disadvantages one of the key things that I say to my clients is there's no one best entity type it really depends on your business and your ability to manage your business size of your business who else you're working with that's going to determine what is the best entity type for you and it could be easy to just make this general blanket statement OS corporations are the best everyone should be enough corporation but that would not be true everyone shouldn't see an S corporation and is it really necessary to form an LLC does everyone have to have an LLC because they're in business some of these are getting into legal questions that are best left in the hands of attorneys but when it comes to the actual preparation of a tax return I find things are a little bit clearer what decisions should you make for taxes can be clearer than what decision should you make for liability protection say but let's look first at the different types of entity types that are out there we have the sole proprietor which is typically a business that is owned by one person there's also a general partnership that is owned by two or more entities it could be persons or entities other than persons or a separate legal entity that operates as a corporation a limited liability company a limited liability partnership or a limited partnership the sole proprietorship is the simplest form of business and if you're working as a tax preparer and you've had no education and S corporations up until now odds are that you you're experienced with the preparation of business returns is going to be limited to Schedule C with the Schedule C you have an individual person who conducts business and his or her name or under an assumed business name and unless the business owner files Articles of Incorporation with the Secretary of State's office and his or her state his or her business is gonna be automatically classified as a sole proprietorship a very active operating a for-profit business turns you into sole proprietorship unless you're a partnership right so you don't have to do anything others and just decide to engage in an activity with a profit motive the sole proprietorship is a simple and informal structure that is inexpensive to form in fact it's so inexpensive to form you can have one when you don't even know it it is usually owned by a single person or a marital community and the sole proprietor business owner is personally liable for the obligations of the business except in certain situations where he or she has filed or articles of organization with the Secretary of State's office to form a limited liability company a sole proprietor can freely transfer all or part of the business and reports business profit or loss on a personal income tax return by filing Schedule C or F F would of course be if there are farmers let's talk now about an assumed business name because generally as sole proprietor does not have to be registered with his or her State's business registry unless he or she is using an assumed business name if the name of the business does not include the full legal name of the business owner the business name must generally be registered as an assumed business name with the business registry of the state in which that proprietor is operating his or her business the registration allows the public to identify who is transacting business under that business name so let's just suppose we've got a pocket ears I'm an enrolled agent if I decide to do business as April gutierrez enrolled agent there's nothing i need to do to register that business name i.e a is merely my title and a pocket teres is my name so i'm really good to go but if i want to run a business that's called april 15th tax service day and there was attack sirs here in portland called April 15th tax service for a while many years ago they're gone out of it April 15 tax service that might be cute name it might be relevant to my name but it obviously isn't my name and there's no way for people to really Coral April 15 tack service with charities and so as such I would need to register that business name with the state am I allowed to do so well that would depend on whether anyone else has already registered that name and where they've registered that name if it's established that that business name is available then I can register it the importance of registering that name is that if someone wants to know who's doing business is April 15 check service they're gonna be able to go to the business registry for the state and establish who that business owner is so anonymity I guess you could say is what is being avoided with this registration of business names the government doesn't want people to be able to just operate businesses anonymously they want to be able to hold people accountable so how do you go about registering a business name well to check a name for availability prior to submitting an application which is a good idea you may check the website of the appropriate secretary of state office for the state in which you want to register your business the specifics of business name registration are going to vary by state and a name availability check does not guarantee that the name will still be available when that state's business registry receives the application now things have gotten a lot simpler I've been around long enough and I remember when there was no internet and that if he wanted to register a business name the starting point was to call up the secretaries feed on the phone up that office speak to someone over the phone you know offer up some proposed names and they would let you know if that name had was available and then you could fill out a manual form submit a fee and register your business with the internet things are much easier I mean you really can these days go onto the internet do a search for business name see if anything pops up see if anything is similar or different enough and then fill out an online application pretty much on the spot and get your business registered so it's much much easier these days to do that now how do you do it in your state well you're gonna scratch figure that out here in Oregon we have a website called filing in Oregon comm and it makes it super simple to determine if a business name is available you can also use it to search who owns business names who's the registered agent of a business name the type of business that has been registered under your name is it a is it a corporate is that a limited liability company is it a DBA all of those things can be determined very readily in in just a couple of minutes over the Internet so I'm sure that your state has something similar to filing in Oregon comm and it wouldn't hurt to just on your own time go and explore that and figure out how it all works the next pattern we're going to talk about is the general partnership partnerships are a little bit like sole proprietorships and that they automatically happen even though the business owners may not intentionally have been creating them because a partnership is automatically formed when two or more persons or business entities agree to jointly own and operate a business profit loss and managerial duties are shared among the partners and each partner is personally liable for the partnership debts partnerships are an inexpensive to form and a formal organizational agreement is not required it's simply enough to shake hands let's go do this together let's buy this car and fix it up together and sell it that would be a you know it could be it could be deemed to be a hobby but if the object of purchasing that car fixing up and selling it was to make a profit then you'd probably just treated the partnership and maybe it wasn't quite intentional now partnerships do not pay income taxes directly however an informational return form 1065 must be filed to report business income and expenses of the partnership and individual partners report their share of profits and losses on their personal return a joint undertaking nearly though to share expenses is not a partnership miracle ownership the property that is maintained and leased or rented is not a partnership however if the co-owners provide services to the tenants a partnership exists so what this is saying is that if you and another person agree to purchase a vacant lot together for investment purposes that is not creating a partnership just the mere co-ownership of it it even goes to one step further and say if you and another individual decide to purchase the rental property in each of you on 5050 and it's done as a passive activity odds are you don't have a partnership there either you can just each report your individual share of income expenses but there are certain actions that can occur that would turn what would otherwise not be a partnership into a part we're going to now look at what makes the partnership work who comprises the partnership and a first item we're gonna look at is a general partner a general partner is a partner who is personally liable for the partnership depth a general partnership is composed only of general partners a limited partner is a partner in a partnership undeformed under state limited partnership laws whose personal liability for partnership debts is limited to the amount of money or other property that the partner is required to contribute to the partnership and a limited partnership is formed under state limited partnership laws and is composed of at least one general partner and one or more limited partners we then have a limited liability partnership and a limited liability partnership or LLP is formed under state limited liability partnership laws and generally a partner in an LLP is not personally liable for the debts of the LLP or any other partner nor is a partner liable for the acts or emissions of any other partner solely by reason of being a partner now one of the things to be aware of with these LLP s is that the shape and nature of an LLP is really gonna vary by state I can't give you a blanket terminology of all the rules that apply to an LLP because those are really set at the state level at which that LLP is formed and they do vary by stage non-recourse lows are those liabilities of a partnership for which no partner bears economic risk of loss let's talk now about a qualified joint venture or qjd under the default rules a business that is owned by two or more individuals is automatically classified as a partnership and this is true even if the owners of the partnership are spouses who file a joint return since 2007 the IRS rules have permitted a married couple to elect to file as a qualified joint venture rather than as a partnership a qjd is a joint venture that conducts a trader business where the only members of that joint venture are a married couple who file a joint return both spouses materially participate paid in the trader business and both spouses elect not to be treated as a partnership a qjv includes only businesses that are owned and operated by the spouses as co-owners and not in the name of a state law entity including a limited partnership or an LLC but there is an exception to this rule if the spouses reside in a community property stage and I just wanted to point out here there's a little asterisk up here and it says note that the instructions for form 1065 have replaced the phrase husband and wife with either a married couple or spouses and you should refer to the following URL for more information on that you can also learn more about qualified joint ventures by visiting this URL where the IRS talks more about qualified joint ventures so let's continue on though with a little bit more on qualified joint ventures they're a rather interesting concept because remember when two individuals agreed to go into a profit-making venture together a business venture together they automatically form a partnership and Ira says it doesn't matter if they're married or even filing a joint return the partnership really is a default mechanism you've got two individuals have gone into business together but there is a relatively new rule that the IRS says even though we consider you to be a partnership we're going to allow you to avoid filing form 1065 so long as you are married and filing a joint return and instead of filing form 1065 you can file to schedule fees with your individual return so what would be the motive for avoiding the 1065 and filing to schedule seeds instead and the answer is just because then you don't have to do a 1065 you could say that there's more complexity to the 1065 it's a more difficult tax return to complete it might be that a husband and wife who are in business together might be able to repair their own schedule sees that going over the 1065 is more complex so that would be I my guests for the motives that iris has and allowing a qualified joint venture so how do you go about making this qualified joint venture the spouse is electing qjv status are treated as sole proprietors for federal tax purposes the spouses must share the business's items of income gain lost deduction and credit and under these reporting procedures must take into account the items in accordance with each spouse's interest in the business as follows each spouse must file a separate Schedule C or schedule F to report profits and losses and if otherwise required a separate schedule SC to report self-employment tax for each spouse spouses with a rental real estate business can now be reported on Schedule E by checking the cute jay-z box on line 2 and you should refer to the Schedule E instructions for pages a 1 and E 2 on that particular topic if the election is made for a farm rental business that is not included in self-employment you would file 2 forms 4835 instead of a Schedule F and here is an illustration of how a qjv would report income and expenses on a tax return Lucy and Ricky are a married couple Lucy and Ricky own and operate a business called Lucy's boutique in 2010 they made an election to file as a qualified joint venture as a qualified joint venture they report the income and expenses of Lucy's boutique on their jointly filed Form 1040 return by dividing income and expenses between the two schedules fees Lucy reports her share of income and expenses on her Schedule C and Ricky reports his share of income and expenses on his Schedule C limited liability company is the next item we're gonna be looking at so we studied the concept of a Phillip Ryder a partnership a qualified joint venture now we're moving on to something else against a limited liability company a limited liability company is an entity or association that is formed under state law by filing articles of organization as an LLC unlike a partnership none of the members of the LLC are personally liable for its death I was a little bit interested in an LLC the LLC and where they came from I've been doing taxes since the early 1990s and I can remember in those early years people were coming in and saying they'd formed LLC's and I would go to quick finder and open it up and quick finder would say ok I'll see you I'll a partnership return and I go hot dog and prepare a partnership return but it wasn't always possible to file a partnership return because in order to have a partnership you have to have two or more members and and so this was a topic of discussion and I look back on it and how silly and ignorant I was back then but the reality is most people were trying to figure out LLC's at that time so actually this morning as I was preparing for a class okay well I keep reading these things that say that the limited liability company is a relatively new business structure and I certainly know back in the mid nineties it seemed really new and the reason for that is that according to Wikipedia the very earliest limited liability company was formed back in 1977 and it was in one state only and then subsequent to that another state came up with it and sometime around the early 90s there seemed to be a uniformity where most states were now allowing limited liability companies and there was confusion and then sometime in the mid 90s when the IRS really started to create regulations to help guide the principles behind LLC's so when we talk about an LLC being a new type of business structure it really is new only in the last 20 years or so and we compare that to corporations now one of the corporations I remember very vividly he cooked out in terms of age is the Hudson's Bay Company and it's because I'm Canadian Hudson's Bay Company owns the bay and the bay is everywhere in Canada he's a shopping there's always going to be bay department store somewhere like Macy's here we have the bay in Canada but the bay is really old the Hudson's Bay Company was formed back in 1670 so it's a it's over 300 years old and I can remember my father worked for the bay when I was a little girl and he came home with some balloons because they were celebrating their 300th birthday so we compared the concept of the corporation which is centuries old with these new limited liability rules that's why people are still figuring LLC's out there just isn't the case history or the case history that we have is much much more recent so back to the top here limited liability company in order to be an LLC you have to obviously make a decision to be an LLC and then you file articles of organization to form that LLC and you file those articles with the state that you're doing business center that you want to do business then typically but you don't have to you can actually fire our articles of the organization with any state and do business in another state that is possible and it is done but typically when I see LLC's form they want to do business in their home state that's where they form them now unlike a partnership none of the members of an LLC are personally liable for its deaths so what does that sentence me well when you form a partnership this is a pretty interesting concept and I can't remember in the very basic basic classes that are taking in college like 30 years ago there was this concept that if we were told that if you form a partnership with someone handshake partnership to do business together and one partner goes off and makes a deal with a vendor you're automatically liable for that so that's a pretty risky thing to just form a general partnership like that you can be held liable for all of the partnerships of debt even if you didn't agree to be a part of that debt you're automatically going to be liable for it so that is a key reason why an LLP is going to be an attractive entity type for people who want to go into business together because it's going to help protect them from personal liability for the business's debt the LC can be operated by managers or members and managers can be but are not required to be members it must be stated in the articles of organization if the LLC is to be managed by a manager the LLC is a relatively new business structure as I have been explaining and it is allowed by state statute LLC's are popular because they offer a sort of hybrid business type which combines certain features of both corporations and partnerships and now LLC may be classified for federal income tax purposes as a partnership a corporation or this is a confusing one for a lot of people an entity disregarded as an entity separate from its owner by applying rules in the regulations section 3 0 1 . 7 7 0 1-3 so what that is saying the sentences you've formed an entity but we're working a pretended entity doesn't exist in other words we're not going to recognize the entity as being separate from you all we do is see you so IRS says that an LLC when it is formed is either going to be formed as a partnership or it Krispies taxed as a corporation or it's neither of those things because it's a disregarded entity and and in the case of a disregarded entity iris doesn't even recognize that any entity was formed it's just gonna look strictly at the owner you should note that atomistic LLC with at least two members that does not file form 8832 is classified as a partnership for federal income tax purposes so let's look at how the LLC has similarities to a corporation and also to a partnership so corporate similarity first and LLC is similar to a corporation in that the owners have limited personal liability for the debts and actions of the LLC partnerships similarity operationally LLC's are more like a partnership because they allow management flexibility and the benefit of passed through taxation owners of an LLC are called members as a member your liability for LLC death is limited by state law however you may be held personally liable in situations involving unpaid employee with holdings if you are found to be the person who was responsible for making the payments in other words iris says whoever is is the person or persons in a business charged with making sure that payroll withholdings actually make it to the treasury you're not going to use the LLC to escape that obligation so if you've been paying employees you've been withholding taxes from their pay you've been supposedly filing the 941 reports as you were required to do so and then you don't send that money on to the Treasury as you were supposed to don't expect the LLC to protect you because it won't so who can own an LLC most states do not restrict LLC ownership therefore members may include individuals corporations other limited liability companies and foreign entities also there is no maximum number of members most states also permit single member LLC's which have only one owner a few types of businesses generally cannot be LLC's though and these include banks insurance companies and nonprofit organizations so what are the advantages of an LLC well they all LC is generally considered to be advantageous for small businesses because it combines the limited personal liability benefit of corporation with the tax advantages of a partnership and sole proprietorship profits and losses can be through to the company are passed through the company to its members or the LLC can elect to be taxed to the corporation LLC's do not have stock and are not required to observe corporate formalities the owners are called members in the LLC is managed by these members or by appointed managers so are there disadvantages to LLC's well yeah there are some disadvantages well LLC's continue to be a popular business model and they are often preferred by attorneys who recommend them to individuals who are starting up new businesses there are certain disadvantages to be aware of including LLC managers must pay taxes on their distributive share of the profits of the company even if they've not received a distribution of those profits by comparison the owners of the C corporation do not pay taxes on profits unless they are distributed usually in the form of dividends so let's just think about this a minute you are an owner of stock in a C corporation I'm just gonna pick a company out there I went to Disneyland recently so let's make it Disney you want Disney stock and the Disney stock over time goes up in value it also in a good year so hopefully most 50 years or good years it's going to be issuing dividends to the shareholders but the dividends that are issued to the shareholders are the only form of income that that schorl holder ever needs to recognize Disney itself could be highly profitable file a corporate tax return pay taxes on its corporate profits and not distribute any of those profits to its shareholders in theory there's going to be rules that prescribe when and how much they do need to distribute but let's just suppose Disney filed a return and decided not to do any corporate distributions that year the shareholders would not be on the hook for reporting any kind of income from Disney stock because they didn't receive any distributions but with an LLC things are very different if we take a business entity and say instead of being a corporation now you're now I'll see that LLC can turn a profit and the LLC if it is not made a corporate election is going to be taxed typically as a partnership and if that LLC makes a decision not to distribute any income to its member those members are going to have to pay tax on money they have not received so that can be a distinct disadvantage and I have a client mm-hmm this wasn't happening with an LLC was actually happening with or not with a partnership it was happening with an S corporation and they're very similar where every year he was getting this phantom income off of the entity he's getting a k1 every year showing his distributive share of income from the business but he wasn't ever actually being given an e that income and so every year he was having to report and pay tax on money he didn't receive so LLC owners must pay taxes on their distributive share of the profit of the company even if they have not received a distribution of those profits and this contrasts with the corporation where with a C corporation you pay tax only if you actually receive a dividend LLC owners who perform services for the LLC must pay self-employment taxes including Social Security and Medicare tax on all income and profits unless the LLC elects to be taxed as a corporation and for a single-member LLC the formation of an LLC may impose certain filing requirements at the state level minimum registration fees and/or taxes can be imposed on the LLC that would not be imposed on a sole proprietorship and here's an example of what I mean I can't really say that this is in every state I just know that this is a thing that is very specific to California the state of California imposes a mandatory filing requirement of all LLC's registered or conducting business within the state of California the minimum annual filing fee of $800 must be paid whether or not the business had California income for the year the sole proprietorship operating in California may benefit by not forming an LLC because the non LLC sole proprietorship is not subject to that minimum $800 tax so if you've got a client in California who's operating their own little business and it's not much of a business forming an LLC might be very very expensive decision not only are they gonna have to file the articles of organization and renew those each year with California be paying those minimum fees every year but on top of that they're gonna have to file an LLC return California doesn't accept a Schedule C from a single-member LLC is a specific LLC return be filed and then it wants that minimum $800 fee every year so that would be another disadvantages another disadvantage LLC organizational structure and now LC operates in a manner similar to a corporation however the controlling parties have different titles as follows LLC managers can be compared to the board of directors of a corporation and LLC members can be compared to the shareholders of the corporation in order to be a member of an LLC a contribution such as cash property or services rendered must be made next up we have the operating agreement and the internal affairs of the LLC are governed by operating agreements which may be oral or written these operating agreements are comparable to the bylaws of a corporation and the internal affairs are managed by the members unless the articles of organization specifically state that they shall be managed by one or more managers now it isn't necessary for every LLC to have an operating agreement and many don'ts in Oregon for example you go to filing in Oregon comm and you file articles of organization with the Secretary of State here in Oregon and you're done you're now LC there's no requirement that you actually go and form an operating agreement but an operating agreement is a pretty good idea especially if you've got more than one owner in that business because that is really the agreement between the owners on how they're going to run that business and any type of decision made by two or more people on how to run a business should really be in writing and the operating agreement is typically where an attorney is going to come in to play a good attorney is going to sit down with thee they propose partners in a limited liability company or even in a general partnership and work out hash out the details of how they wish to run that business together who's going to do what what the responsibilities are going to be how profits are going to be distributed what kind of tax election if any is going to be made that is what the purpose of the operating agreement is registered agent and they all LC must generally have a registered agent in the state where the registered office is located as well as in other states where the LLC conducts business when an LLC is food the legal papers are served on that registered agent it is required that the registered office is a street address a registered agent can be an individual or a legal entity so the bottom line is when you do business in any state people who do business with you need to be able to identify who you are and how to get hold of you physically in person and if you are it for example are running your business from your home and you do not want people to be able to come to your home cause you want to have a sense of privacy there you could employ a registered agent and use the services of that registered agent and so if someone decides that they want to sue your business or serve papers on your business they can instead give those to the registered agent and you will have been considered served if your registered agent receives that paperwork and then obviously the registration needs to know how to get hold of you domestic versus foreign LLC LLC is organized under a particular state statute are referred to in that state as domestic limited liability companies when operating in states other than those in which they were formed LLC's are referred to as foreign limited liability companies so let's just suppose you decide to form an LLC in the state of Washington you form your LLC in Washington and as far as Washington is concerned you are a domestic LLC but if you cross over and decide to do business in Idaho or Montana both those states would consider your LLC to be foreign because your LLC was not formed in those states now to form a domestic LLC the usual procedure is to file articles of organization and pay a non-refundable processing fee to the business registry of the state in which the LLC is being formed before filing articles of organization the desired name should be checked for availability the name must be distinguishable from other active names on the business registry records and in addition the name of the LLC must contain the word limited liability company or the abbreviation LLC with little decimal points or LLC without them in other words if you're registering your business as an LLC it needs to be a parent and obvious to anyone who does business with the LLP that you are an LLC if the business name is distinguishable and the articles conform to state statutes the business registry of the applicable state will process the document in return and acknowledgement to the filer let's compare that with a for now I'll see excuse me and now LC formed in a state other than that in which it is operating is a foreign ll see if the LLC wants to conduct business in a state others that suspend the state in which it was formed it may be required to obtain permission from the other state or states in which it wishes to conduct business most states require that the LLC submit an application of authority which includes the name and the address of the local registered agent as well as a processing fee which must be submitted to the state business registry a certificate of existence or a similar document from the jurisdiction where the LLC was organized must be submitted with the application form before an application of authority is filed the name should be checked for availability and although the register although registered in another state the name must again be distinguishable from other active names in the new state's business registry records so for example let's just suppose you've been running your business in the state that you're in under a particular assumes business name and now you decide you want to expand and add an office in another state well you're gonna need to check with that state's business registry to see if the name you've been using is even available because it could be that another business there is already using that name and if another business is already using that name and you're probably going to need to come up with a new name for your business in that state so your business might have one name in one state and another name in another state and there really wouldn't be much that you could do about that in that situation the other part that goes on is that you are typically gonna have to prove that your business exists or that your entity exists to this new state so if you cross from Washington in to say opening of another location in Montana you're gonna need to show the Montana Secretary of State office that your LLC actually does exist in Washington State so that would require submitting a form to Washington to state to ask them to show that you really do exist and this is through something called a certificate of existence you ask your home state for the certificate of existence then you send that certificate of existence to the new state that you want to do business in and pay all their fees and you're up and running so let's now look at a corporation a corporation is a legal entity created under state statute by submitting Articles of Incorporation with the state business registry a corporation is owned by its shareholders and the names and number of shares issued to each shareholder are registered in the records of the corporation the Articles of Incorporation must state how many shares the corporation has the authority to issue and there are three main types of corporations including business corporations nonprofit corporations and professional corporations businesses and professional corporations are for-profit corporations and a nonprofit corporation is formed for any lawful purpose other than financial profit a professional corporation is a for-profit corporation formed for the purpose of providing one or more specific types of professional service many states require that all shareholders of the professional corporation must be licensed to render the professional services offered through the corporation and I'll give you an example with what is meant by this I had a client one year who who came to me and he wanted to form an S corporation for his chiropractic business oddly enough he was an attorney seems to me that as an attorney he could have done that on his own but apparently he wasn't that kind of attorney he was an attorney he wanted to be a chiropractor and he was hiring me to help him form an S corporation and I said he was talking about professional corporation he was talking about making an S election he was talking about who could be owners and I said well there's nothing at the IRS level that would preclude your non chiropractic spouse your wife from being an owner in the corporation but I would check with the state of Oregon because there could be something at the state level so off he went he came back and he said yeah I checked and there was nothing to preclude it so he we firm to the corporation made his wife as a 50% shareholder got all the letterhead printed he got signage made and then lo and behold he learned that the board of chiropractic medicine here in Oregon did not allow that so it had nothing to do at all with the Secretary of State Office or Oregon Department of Revenue it came right down to the board level about whether or not a corporation in this state that is a professional corporation for a chiropractic business could have owners that are not chiropractors and so the caution is that when you're dealing with people who are professionals including CPAs or attorneys or chiropractors or veterinarians most of those fields of occupation have state boards that govern their conduct and you should be examining what those board requirements are at the time a corporation is being formed now a corporation is a separate entity from its owners a corporation acts as a single entity it exists separately from its owners and continues to exist even though the shareholders may change as the separate entity a corporation must file federal and most often state income tax returns it may own property it can sue and it can be sued let's talk now about the ownership and management structure of a corporation a corporation is owned by its shareholders and managed by the board of directors the shareholders appoint the members to the board of directors and except for the initial board the shareholders generally select the directors the number of directors is determined by the Articles of Incorporation or by the bylaws of the corporation election and appointment of officers every corporation must have a president and a secretary and some states require that corporations also have a treasurer the authority and responsibilities of each officer is described in the corporate bylaws and may be further defined by an employment contract or a job description some states allow a single person to hold all three titles within a corporation the president the first and we think of as the head of the company has the overall executive responsibility for the management of the corporation and is directly responsible for carrying out the orders of the board of directors he or she is usually elected by the board of directors the secretary is typically responsible for maintaining the corporate records and the treasurer is the chief financial officer of the corporation and is responsible for controlling the and recording its finances including maintaining corporate bank accounts fiscal policy of the corporation may rest with the Board of Directors and be largely controlled by the president on a day to day basis though the Board of Directors elects the president and the secretary and adopts bylaws of the corporation the board may elect or appoint other offices or the bylaws may prescribe how these officers are selected the same person can hold two or more offices so it's possible of what the small corporation this is very often the case that a single person is going to be the president the secretary and if necessary the treasurer all at one time and they're also going to be the board of directors so a single person can be all of those things obviously in big corporations things are very different that you're going to have a dedicated board the board is going to be formally deciding key strategies for the corporation and then getting the president and other key vice president type personnel to follow through with their vision for small business I'm just gonna run my own business do my own thing make my day-to-day decisions and I'm everything all at one time registered agent a corporation must have a registered agent with the street address being the registered office when a corporation is sued the legal papers are served on that registered agent this is why there has to be a street address a registered agent can be an individual or a legal entity so foreign or domestic under state law well similar to the LLC a corporation formed on the laws of any state is a domestic corporation in the state of incorporation and a foreign corporation in all other states in which it conducts business whether a foreign corporation must register to do business in any state and maintain a registered agent within any state is determined by the laws of each individual state as a general rule a corporation will be required to register in a state if it maintains an office in the state has employees working in the stage or performs services in the state to determine if a corporation is required to register and/or maintain a registered agent within a particular state and to determine the filing requirements for that state you should contact the secretary of state office for that particular state so one of the things I commonly see many small business owners have a difficult time grasping and a lot of tax professionals too is that you've formed your business you've been doing your business in your home state for a period of time and now you decide to cross state line to conduct business and in another state now if you're just crossing the state line to sell your product and then you return to your state and carry on the other business activities and the only reason you passed into a particular state was to sell your product you're probably not gonna have to worry about registering in that state but if you hire someone to perform services for you in another state odds are you are going to have to take some action or if you yourself perform services in another state so let's just suppose try to think of a good example you are a software engineer you've been working from your home office in your home state let's make that home state I don't know Colorado so you're a software engineer you've been working from your home office in Colorado and all of a sudden you come up with this a great opportunity to go work in Alabama for six months on a big project and you go well that's an offer I can't refuse and so you move temporarily to Alabama to do your work there well you're not giving up your home in Colorado when you're doing it your intention is to return to Colorado and you maintain your home in Colorado so as far as Colorado is concerned you're still going to be a resident of Colorado your business is still going to need to report income and expenses for Colorado you're still have to file all of your Colorado returns so what about Alabama well Alabama it's going to depend on what kind of business you are if you're nothing more than a sole proprietor you probably just gonna need to file an Alabama return and report whatever income Alabama wants but if you are actually a corporation or a limited liability company and you then do business in Alabama and I know nothing about Alabama it could be that there's all kinds of special rules I should know that I don't but you would need as a preparer to look up those rules for Alabama does Alabama tax corporations does Alabama tax small businesses what are the filing requirements Alabama these are all questions that need to be answered does the business need to register to even run in Alabama and if so how is that done so these are sensible questions that every preparer needs to be asking and every small business owner needs to be asking but frequently they are not asked and it's basically blinkers on and pretend it never has and to go back to Colorado refil return and hope no no no one notices one of the other things to be concerned about is that certain types of business activities performed in a state can be subjected to things other than income tax for example Washington State has no income tax but it does have a business occupation tax so if you go into Washington State to perform services odds are you need to be filing a piano returned and paying a gross receipts tax to Washington State so these types of things are often neglected simply because people don't understand that they exist or how to go about figuring it so foreign or domestic preparation under federal law though we talked about a foreign corporation under state law but what does it mean at the federal level well the IRS considers a corporation formed outside of the United States to be a foreign corporation and all corporations formed within the United States are domestic corporations as far as the IRS is concerned so what are the organizational procedures for forming a corporation well once the existence of a corporation is established an organizational meeting of the Board of Directors is generally held to adopt bylaws and to elect the officers in forming a domestic corporation articles of or incorporation and a non-refundable processing fee must generally be submitted to the business registrar of the state in which the corporation is formed before articles of corporation are filed the name should be checked for availability and just as with LLC's and DBAs the name must be distinguishable from the other active names in that state's business registry records if the name is distinguishable and the articles conform to that state's statutes the business registry will process the document and return an acknowledgement to the filer bylaws the bylaws of the corporation must contain provisions to regulate and manage the affairs of the corporation that are consistent with the statutes of the Articles of Incorporation so there what are the advantages of a corporation why would someone decide to form a corporation versus an LLC are the reasons for doing so well a corporation is a legal entity that is separate from its owners who own shares of stock in the company so the shareholders are not personally liable for corporate obligations unless corporate formalities have not been observed and one of the things that happens when a corporation is sued especially a closely held corporation as there can be an effort made to do what is called pierce the corporate veil piercing the corporate veil means basically showing that the corporation was a sham that these four corporate formalities were not followed therefore really there was no corporation and it was just the individuals operating in their own name it is important that if you formed a corporation specifically for limited liability protection for the owners that the corporate formalities are properly observed now if you have got a corporation where the property formalities are properly observed one of the benefits of that will be limited liability one of the key reasons to form a corporation is the limited liability protection provided to its owners because the corporation is considered a separate legal entity the shareholders have limited liability for the corporations debts and the personal assets of the shareholders are not at risk to satisfy debts or liabilities of the corporation corporate tax treatment since the corporation is a separate legal entity it pays taxes separate and apart from its owners the owners of a corporation only pay taxes on corporate profits that are paid to them in the form of wages salaries bonuses and dividends the corporation pays taxes at the corporate rate on any of its profits attractive investment the built in structure of a corporation makes it attractive to investors capital incentive the stock structure also allows the corporation to attract key and talented employees by offering them an ownership interest in the form of stock options or stock owner employee a business owner who works for his or her own business may become an employee and thus be eligible for reimbursement or deduction of many types of expenses including health and life insurance another benefit for an owner employee of a corporation is that if the corporation folds they can go and apply for unemployment insurance which is something the sole proprietor is not able to do operational structure corporations have a set management structure the owners of a corporation are shareholders who elect a board of directors the board of directors have then elects the officers other than the election of directors shareholders do not participate in the operations of the corporation and then finally perpetual existence a corporation continues to exist until the show holders decide to dissolve or merge it with another business and during today's class I'm going to give you a series of three passwords but I'm not going to give you one on this first break so do stay tuned for throughout today's class for more for passwords but right now I'm not going to give you passwords so we're just going to resume class at the top of the hour all right everyone welcome to back to class the camera should be unfrozen for you and you should have had a chance to get yourself awake okay walking around for 10 minutes this part of the class is difficult to be exciting when you're talking about terminology but I feel the terminology is apartment so we're going to continue on we started the break after we finished talking about some of the benefits of corporations and now I'm going to talk about some of the disadvantages of corporations the legal rules and laws that affect corporations can mean that they are not the best entity choice for many small business owners disadvantages of the corporate entity status can include complexity a corporation is a complex business structure that can be costly to start-up and to maintain fees are assessed for various government filings including annual report feeds that are payable to the secretary of state minimum filing aspies are assessed by state governments on corporate tax returns for example Massachusetts minimum filing fee is 456 dollars California has a minimum filing fee of $800 even Oregon has a minimum filing fee of 150 dollars many other states also impose minimum filing fees and it should be noted that many states also impose similar filing fees though on LLC's and partnerships double taxation of profits profits are taxed at both the corporate level and again when they are distributed to shareholders so when a corporation files a tax return it files form 1120 it figures its income it figures is expenses that come to a bottom-line profit and pays tax on that profit to the IRS if it then distributes any of those profits to shareholders in the form of dividends the shareholders now have to report and pay tax on the dividends that they've received as well and that creates the double taxation corporate roma formalities must be filed to provide evidence that the corporation is a separate legal entity from its shareholders and failure to do so may open the shareholders to liabilities for the corporation's debts corporate formalities include issuing stock certificates holding annual meetings recording the minutes of the meetings and electing directors or ratifying the status of existing directors so all of that takes time if you're a small business you know with two or three employees do you really need to be going through all of those corporate formalities every year do you even stop what you're doing to think about the corporate formalities probably not and so the day comes where legally you need to prove that you are a corporation that has perfected these corporate formalities and you cannot do so maybe you didn't even know how to paperwork paperwork is a huge component of the corporate formalities that have to be followed reports and tax returns must be compiled and filed in a timely manner business bank accounts and records must be maintained and kept separate from personal accounts in assets records must be kept of corporate actions including meetings of shareholders and board of directors and licenses must be maintained so that's the C corporation now let's talk about the F corporation and an S corporation is an interesting animal it is everything and nothing at the same time it's really interesting where we've gotten with those corporations over the last 20 years when I got into this business of taxes back in the early 90s the the steps to becoming a S corporation where you a became a corporation and then B you made the subchapter F election and over the years it's become quite apparent that you don't have to do those two things that you can become an S corporation without ever having formed a corporation so an S corporation is a very interesting animal or entity type as we're about to see the S corporation structure is identical to a C corporation structure in many ways that offers the avoidance of double taxation profits and losses of an S corporation flow through to shareholders to report profit and loss sharing items on their individual returns an S corporation is initially formed in the same a c-corporation which had just described you form the c-corporation then he make an S election by filing incorporation documents with the state of incorporation but once the business has incorporated the owners may decide to elect S corporation status the election must generally be made within the first 75 days of the year for which the S election is to become effective so what are advantages of the S corporation S corporations are a popular choice for many small businesses S corporations provide the following legal and tax advantages for owners corporate losses can be passed through to the shareholders who may be able to use the losses to offset their income or their income on their personal return limited liability for texture holders from personal liability for corporation debts without requiring a CS corporation to pay corporate taxes it is possible to minimize self-employment tax and FICA taxes because the shareholder profits are not generally subjected to these taxes so this is a difference from the partnership with a partnership return the partnership reports income and expenses on 1065 it flows through the profits to the partners and the profs and the partners if they are active participants in that partnership are typically going to be subjected to income tax as well as self-employment tax but at the F corporation level no self-employment tax is assessed on those corporate distributions so are there disadvantages to S corporations well yes there are of course although S corporations provide an attractive business model there are certain disadvantages which should be considered including regulations and requirements imposed on C corporations must be held up by an S corporation there is a limit on the number of shareholders like a C corporation it can be costly to set up and follow the corporate formalities in fact if you are a C corporation who has made an S election all of the corporate formalities remain unchanged and so an S corporation is merely a tax election it is not a change in the type of entity that you are so if you formed the corporation you have to abide by all of the rules that are imposed on corporations and the only difference between a regular corporation and an S corporation is how they're taxed all of the other rules that are imposed on are basically going to be the same the IRS closely scrutinizes payments of an S corporation or by an S corporation to a shareholder employee who must receive reasonable compensation that is subject to employment taxes before any non wage distributions can be made to that shareholder employee all shareholders in addition must be US citizens or residents of the United States all shareholders must be must vote in favor of F corporation status before the election can become effective and benefits such as health or accident insurance for employees shareholders with at least a 2 percent shareholder holder ownership must be treated as wages paid to the shareholder before they can be deducted by the corporation so that concludes the the overall look at the different types of business entities and now we're going to look at how they get taxed businesses are generally taxed under default rules applied by the IRS and state governments however it is possible for business to elect other tax treatments as allowed by federal and state laws for the sole proprietorship that entity files a form 1040 is your an individual he file a 1040 intuit you attach either Schedule C or C ez unless you're a farmer in which case you'll attach Schedule F and you do so to meet your federal income tax obligations net profits from a sole proprietorship business generally make the proprietor liable for self-employment as Social Security and Medicare taxes Schedule SV must be filed with the 1040 return to calculate and report to these taxes with respect to the sole proprietor business the filing deadline for Schedule C or Schedule F is going to be the same as the filing deadline for the individual return and for most the filing deadline is the 15th day of the fourth month following the end of the tax year and if you are an individual filer we're on a calendar year that means your filing deadline will be April 15th but if that April 15 deadline falls on a weekend or national holiday then the filing deadline will move to the next business days an individual can file for an extension of time to file by submitting form 4868 to the IRS and it has to be done of course by the original D Day the return and once that return and that form is filed the filer has an additional six months to file typically taking them to October what are the fight late filing penalties if you fail to file on time as a sole proprietor well failure to file and late filing penalties are assessed based upon rules that apply to individuals so there's no special tax or late filing penalty imposed on the Schedule C rather it's imposed on the individual filer that attaches the Schedule C to their return and so if you're trying to figure out what the late filing penalty is for a business owner who filed Schedule C it's going to be all the rules that apply to individuals but let's compare those rules to the partnership the partnership is the relationship between two or more persons or entities who join to carry on a trade or business with each person or entity contributing money property or labor or skill and each expecting to share in the profits and losses of the business whether or not a formal partnership agreement is made at the simplest level a partnership occurs when two or more individuals agree to work together in the active conduct of a trade or business individual partners are personally liable for the debts and other obligations of the partnership and partnerships generally file IRS form 1065 net profits of the business are generally not taxed at the partnership level but instead flow through to individual partners who must include their respective profit share an income reported on their individual 1040 return and conversely if the partnership runs a loss the partnership will flow that loss 3 to the partners who will claim if they are eligible to claim that loss against other income on the return generally partners who are active participants in their partnerships must pay self-employment tax on their share of partnership earnings and many cities require that businesses apply for it and maintain a current business license and partners must comply with other state and local laws as well for domestic partnerships except as provided below every domestic partnership must file form 1065 unless it neither received income nor encourage any expenditures treated as deductions or credits for federal income tax purposes entities formed as LLC that are classified as partnerships for federal income tax purposes also must file form 1065 for foreign partnerships generally a foreign partnership that has growth income effectively connected with the conduct of a trade or business within the United States or has gross income derived from sources in the United States must file form 1065 even if its principal place of business is outside of the United States or all of its members are foreign persons a foreign partnership required to file a return generally must report all of its foreign as well as its us source income partnership filing deadlines and penalties these are quite a bit different than we see for the sole proprietor every partnership engaged in a trade or a business must file a return the filing deadline extension and penalty rules for partnerships are described next first we have the form 1065 filing deadline for form 1065 your filing deadline is the 15th day of the fourth month which is actually the same as for individuals so for partnerships that are calendar year partnerships the filing deadline is going to be April 15th but again accept falls on a weekend or national holiday then it's going to move to the next business day now if the partnership is unable to file a timely return it can request an extension by filing form 7 zero zero for applications for automatic extension of time to file certain business income tax information and other returns to extend the filing deadline by five months for calendar year partnerships a timely filed form seven zero zero four will extend the filing deadline to September 15 so for individuals a six month extension takes you to October 15th but for partnerships it's a five month extension that will take you until September 15th which is a full month earlier there are penalties for failure to file a return and there are a hundred and ninety five dollars per month per partner for each month where part of a month up to a maximum of 12 months well that can get pretty spendy the penalties assessed against the partnership and an additional hundred dollar penalty may be imposed with respect to each schedule k-1 that the partnership fails to provide to each partner on time so now you're up to two hundred ninety five dollars per month per partner $100 penalty also applies as failed to correctly include all required information on each partners k1 now there are some rules that will waive the penalty for small partnerships the penalty will be abated if the partnership can show reasonable cause for its late filing domestic partnerships with 10 or fewer partners will generally qualify for the reasonable cause exception if all partners have fully reported their shares of income deductions and credits on their own time we filed returns and each partner is an individual a/c corporation or an estate of a deceased taxpayer or deceased partner to request a waiver of penalty for late follow at filing you should follow revenue procedure 84 - 3 5 as it was amended in 1997 for corporations a domestic US corporation is formed when Articles of Incorporation are filed with the secretary of state office of any state unless exempt under Section 5 0 1 all domestic corporations including corporations in bankruptcy must file an income tax return whether or not they have taxable income domestic corporations must file form 1120 unless they are required to file a special return you should see special returns for certain organizations which are shown in this chart below and unless the corporation elects to be taxed as an S corporation by timely filing form 2553 most US corporations are going to be filing form 1120 now there are some special returns for certain types of organizations and instead of filing 1120 those organizations will file a different alternative type of form that you see here for example if you are an exempt organization with unrelated trade or business or income in other words you're a nonprofit organization you would file Form 990 you can see here that obviously if you're now LC then you would typically be filing form 1065 your subchapter t Cooperative Association including a farmers co-op then you would file 1120 C if you are a condominium management or residential real estate management or timeshare Association you typically file form 1120 H and they are also political organizations that would file 1120 pol and so forth let's talk now about the taxation of the limited liability company the formation of a corporation under the laws of any state is the formation of a corporate entity under the rules of the Internal Revenue Code in other words the IRS recognizes the formation of a corporation as the formation of a specific entity type that it will tax in a very specific way all corporations are required to file form 1120 no similar guidance however applies to limited liability companies because the formation of an LLC does not create a single kind of taxable entity instead the makeup of the ownership of an LLC will determine what kind of tax return that LLC needs to file depending on the number of members now LLC has the IRS will automatically classify the LLC is either a sole proprietorship or a partnership if the only member of an LLC is a single individual the LLC is treated as a disregarded entity for tax purposes income and expenses are going to be reported on Form 1040 Schedule C E or F so here's one of the real common things I guess actually one of the most common reasons we will be contacted by a prospective new client and sometimes even by existing clients is they've decided to go into business or maybe they were already in business this is another one I have a client who's already in business I've been preparing their tax returns for years by Elango proprietor business income and expenses on Schedule C the big day has come and they formed an LLC and they're the only member of the LLC and so they call me they're all excited because everything has probably changed now that they're now LC and the answer is nothing changed as far as the IRS is concerned for tax purposes now if they have employees and they're filing payroll reports there are some changes we need to be concerned with there but if it's just you know an independent contractor that was doing business as a handyman for the last ten years and now he's decided to form an LLC and it's still his handyman business and nothing else has changed then as far as IRS is concerned that new entity that formation of the LLC they couldn't care less about it the entity is disregarded a disregarded entity is an eligible entity that is treated as not being separate from its single owner its separate existence is ignored for federal tax purposes unless it elects corporate tax treatment if the LLC has only one owner it will automatically be considered to be a sole proprietorship for income tax purposes a sole proprietorship is referred to as an entity to be disregarded as separate from its owner unless an election is made to be treated as a corporation if you prefer to be treated as a corporation instead of as a disregarded entity form 8832 must be submitted to make that entity classification election single member LLC's may not file a partnership return so what if the single member of the LLC is a corporation because that could happen you could have a corporation that decides to form an LLC and the corporation is the sole owner of that LLC a liar says if the only member of the LLC is a corporation then the LLC income and expenses are reported on the corporations tax return which is usually form 1120 or it could be 11 20s if the single-member LLC is owned by a corporation or a partnership the LLC should be reflected on its owners federal tax return as a division of the corporation or partnership multi-member LLC most LLC's with more than one member are going to file form 1065 partnership return but if you would rather file as a corporation form 8832 must be submitted you don't need to file form 8832 if you want to be filing as a partnership and now I'll see with two or more members files the same tax forms as a partnership self-employment taxes for members of LLC's filing form 1065 generally a partnership LLC is taxed in the same manner as an ordinary partnership however there is a difference in the treatment regarding self-employment tax in bet active members pay self-employment tax on their share of the LLC partnership earnings but inactive members who are the equivalent of limited partners do not pay self-employment tax on their earnings unless the LLC pays them for services joint ownership of LLC by spouse in a community property state in revenue procedure 2002 - 69 and there's a link here that you can click on if you want to read more address the issue of classification for an entity that is solely owned by a husband and wife as community property under the laws of a state a foreign country or a possession of the United States now most states in the United States are not community property States I happen to sit in Oregon we are a non community property state and so these rules would not apply to businesses or individuals residing in the state of Oregon but we're surrounded by community property states that is organisms we've got Washington to the North Idaho to the East California to the south there's a number of other community property states as well as when you go into the southern United States I don't have them all on my head but there's a roughly around ten community property States which is a significant number but even more significant is the fact that most states are not community property States so if you're in a community property state it would behoove you to be familiar with the rules that affect individuals in community property States and these rules apply only to individuals through our residents of community property States if there is a qualified entity owned by a husband and wife as community property owners and they treat that entity as a disregarded entity for federal tax purposes the Internal Revenue Service will accept the position that the entity is a disregarded entity for federal tax purposes and if they decide to treat that entity as a partnership for federal tax purposes and the IRS will accept the position that the entity is a partnership for federal tax purposes a change in the reporting position will be treated for federal purposes as a conversion of the entity a business entity is a qualified entity if the business entity is wholly owned by a husband and wife and this actually would be OSes as community property under the laws of a state a foreign country or a possession of the United States no person other than one or both spouses would be considered an owner for federal tax purposes and the business entity is not treated as a corporation under IRC section code 310 - 7 7 0 1 - 2 now joint ownership of an LLC by a spouse in a non community property state if an LLC is owned by a married couple in a non community property state which is most of the country the owl the LLC should file as a partnership LLC is owned by a married couple are not eligible to be qualified joint ventures which can elect not to be treated as partnerships because these are state law entities so this is one of the interesting things we say that IRS says well the formation of an LLC is really not necessarily going to be recognized by us or by the IRS but in fact they there is something very significant going on here and I had to deal with this a few years ago had a client husband and wife they are graphic designers I've been doing their tax returns for years to schedule see see how he was actually she was a graphic designer and he was a writer so they complemented each other but they each had their own clients and sometimes they work together but often they didn't and one day they contacted me very excited to let me know that they'd formed an LLC and the sad part about that was that they were pretty nickel-and-dime very very careful with their money and the formation of the LLC meant that I had to prepare a partnership return for them the Schedule C days were over and they were pretty unhappy with that position that all of a sudden their tax preparation feed balloons because they had decided to form this LLC and I really highly questioned whether or not L C was even necessary in fact what they could have done is each of them could have formed two separate Ella he's each in their own name a continued filing Schedule C as they always have done but instead they formed one LLC with both of them as members of the LLC because Oregon is a non community property state it automatically forced them into filing a partnership return taxation elections so we've been talking about how the various entity types are taxed and now I'm going to tell you that they don't have to be taxed that way that they can actually choose to be taxed in a way other than what we would call the default way the Internal Revenue Code provides automatic tax classification to businesses and under the default rules businesses will automatically be required to file as follows they'll file the Schedule C or F if they are a sole proprietor or a single-member LLC they'll file form 1065 if they are a partnership or multi-member LLC they'll file form 1120 if they are a C corporation and they'll file form 1120s if they are an S corporation well that all seems perfectly except now we're gonna muddy the water certain types of business entities can change their classification for tax purposes by filing form 8832 entity classification election with the IRS so what is this entity classification what's essentially saying even though I am this I'm gonna pretend I'm that and the IRS is going to allow that if you go through the procedures an entity may be recognized under the federal or state laws as an individual a partnership or a corporation and an entity designated as a corporation under state law must file a corporate tax return using either form 1120 or 1120 F as applicable but a domestic entity that is not a corporation is going to automatically be classified as either a sole proprietorship if they are owned by a single individual or as a partnership if the business has two or more owners and the table that I'm going to show you on the next page provides a useful reference for determining the default tax treatments that is given to sole proprietorships partnerships LLC's and corporations an entity is automatically taxed under the default rules by the IRS unless it decides to be taxed in a way other than the default rules and it does this through entity classification election and the filing of form 8832 so let's take a look at this chart I'm going to zoom in on it a little make it a little bit bigger and we can see that we have the domestic entity type and then how it is automatically going to be taxed under the default rules by the IRS but a choice can be made to be taxed in another way by file a form 8832 or form 2553 or combination of the two and in the final column we can see the choice that would never be available to that particular entity type so firstly let's look at the sole proprietor who is an individual owner the default treatment by the IRS is to file Schedule C or F as a sole proprietor but that full proprietor can actually make a corporate election to be taxed either as a C corporation or as an S corporation but the sole proprietor would never be taxed as a partnership under the partnership entity type we have to have at least two or more owners and when there are two or more owners in a partnership the default classification is a partnership in that partnership files form 1065 but a partnership can make an election to be taxed as a corporation it can also make an election if it qualifies to be taxed as an S corporation but a partnership would never file Schedule C to be taxed as a sole proprietor now C corporation is pretty straightforward if C corporation is automatically a corporation that files form 1120 and if it files 25:53 and is comprised of the proper makeup and is awarded the S corporation status it can choose to file as an S corporation but a C corporation would never have the option available to it of filing as a partnership or as a sole proprietorship for the S corporation an S corporation is obviously recognized by the IRS as an S corporation when the formalities are completed and an arrest corporation is always going to file as an S corporation on form 1120s unless it decides to revoke that s election status and revert to a C corporation but an S corporation would never file as a sole proprietorship or as a partnership for the LLC we have to look at who makes it LLC up so C LLC have one owner or more than one owner it has one owner it is automatically classified as a sole proprietor in a file Schedule C or F but an LLC member can also like the sole proprietor make an election to be taxed as a corporation and even as an F corporation but a single-member LLC would never get taxed as a partnership and with a multi-member LLC the classification is automatically partnerships but again that multi-member LLC could choose through election to be taxed as if it was the corporation or it could elect to be taxed as an S corporation but it would never be taxed as a sole proprietor so what we're seeing is that out of all of these different entity types the S corporation and the C corporation are the ones that really remain constant there are always corporations and I that you're making a tax election to be taxed as an S corporation or you're not it's gonna be pretty simple you're filing 1120 or 1120 F but when we're dealing with these in jewelle business owners partnerships and limited liability companies we can see that things are a little more malleable that we can make some decisions about how we want to file so in effect a single-member LLC or a sole proprietor without actually ever forming a corporation could decide that it wants to pay taxes as if it was a corporation why would they want to do that well actually there can be some reasons to do that I kind of like the idea that you may not have to go through all of those corporate formalities to prove that your corporation and still be able to file the tax return and take some of the tax advantages that are available to corporations it's a rather interesting concept so if you want to make that election to be taxed as a corporation you do so by filing form 8832 and that's what we're going to talk about now generally an eligible entity that does not file form 8832 is going to be classified under the default rules that we just covered up here unless an election is made by filing form 8832 a domestic eligible entity is a partnership if it has two or more members or is disregarded as an entity separate from its owner if it has only one owner eligible entities including fil proprietorships partnerships and most limited liability companies can elect to change their classification to be taxed under a different entity status to make an election to be taxed under another eligible status an eligible entity must generally file form 8832 to elect that different classification the IRS uses information provided on form 8832 to establish the entity's filing and reporting requirements for federal tax purposes so here is form 8832 we're going to take a look at it now and I've essentially highlighted the key areas of the form that I think are relevant I filed this form a number of times over the years and kind of plunk it on the desk in front of you and start trying to figure it out so I'm gonna help you along a little bit with that if it's new to you on the name of the eligible entity making the election you should enter the name of the eligible entity that is electing to be classified so if it was an LLC you'd put the LLC name here if it's a sole proprietor you'd put the sole proprietor name here and then you enter the identification number in the area this box fits a little bit bluish in color for the employer identification number you should show the ein of the eligible entity that is electing to be classified do not put applied for on this line an entity that has an e ein will retain that E is even if it's federal tax classification changes so if you are an LLC and you applied for an EIN for that LLC and now you are making an election for that LLC to be taxed as a corporation you're not going to apply for a new employer identification number because the entity itself is still the same it's still an LLC what's the only thing that's changing is how that LLC is going to be taxed by the IRS and Sedaris wants continuity wants that LLC to retain its existing employer ID number now if a disregarded entity x' classification changes so that becomes recognized as a partnership or association for federal tax purposes and that entity had an EIN then the entity must continue to use that ein if the entity did not already own an EIN then the entity must apply for an EIN and may not use the identifying number of the single owner for example Jenny's Cafe LLC is a single member LLC owned by Jenny Smith which is a disregarded entity for tax purposes Jenny's Cafe is making an election to be taxable as a corporation if Jenny's cafe has received a federal ein it should enter that e.i an on the form 8832 but do not enter the social security number of the single owner that is Jenny Smith next we go on to line one where we make a check box here for the type of election is this an initial classification by a newly formed entity or is this a change in the current classification of an existing entity if the entity is choosing a classification for the first time that is the entity does not want to be classified under the applicable default classification do not file this form if the entity wants to be classified under the default rules so let's just suppose you are forming a new LLC as a single member LLC and from the get out you know you want to be taxed as a corporation and not as a sole proprietor so from the very first onset of forming your LLC you file this form you would check box 1a to say that this is an initial classification on the other hand if you don't want to be taxed as a corporation and you would rather be taxed as a sole proprietor you don't file the form at all and for box B you would check this box if the entity is changing its current classification so let's just suppose you've been operating as a single-member LLC filing Schedule C for a number of years and you've decided that without forming a corporation you would like to be taxed as if you were a corporation and so you're going to change your entity classification from sole proprietor to corporation by checking box 1b now moving onto lines 2a has the eligible entity previously filed an entity election that had an effective date within the last 16 months that is five years once an eligible entity makes an election to change its classification the entity generally cannot change its classification by election again during the 60 months after the effective date of the election however the IRS may buy a private letter ruling permit the entity to change its classification by election inside of that 60 month period if more than 50% of the ownership interest in the entity as of the effective date of the election are owned by persons that did not own any interest in the entity on the effective date of the entity's prior election so what this is saying is once you have made an election for your entity to change its tax classification Barriss does not want you to make another change in under five years I want you to wait five years before you change your mind again however if one of the reasons that you're making a change in that entity classification is that more than 50% of the ownership has changed since that initial election then the IRS could consider allowing you to change inside of that 60 month window but it needs to be done through a private letter ruling you should note that the 60 month limitation though does not apply if the previous election was made by a newly eligible entity and was effective from the date of formation so let's just suppose you've got a newly formed LLC with two members and they agree at the time that they form the LLC that they don't want to be taxed as a partnership they want to be taxed as a corporation so that partnership or that newly formed LLC would file form 8832 in checkbox 1a for initial classification an IRS is saying that because from the very onset you've been taxed as a corporation that that 60 month rule would not apply to you and you could subsequent to that decide to revert and go to a partnership and then on line five if the eligible entity is owned by one or more affiliated corporations that file a consolidated return provide the employer identification number of the parent corporation and on line four if the eligible entity has only one owner provide the following information about that single owner who is the one person and who what is the identifying number of that one person so that is page 1a form 8832 let's move on now to page 2 and on page 2 we're going to select the type of entity that is making the election you can see that we have a domestic eligible entity electing to be classified as an association that is taxable as a corporation so if you're a sole proprietor or a single-member LLC then you would check box 6a but if you are already an LLC that's previously been taxed as a corporation and you wish to revert to being taxed as a partnership then you would check box 6b if you are a domestic eligible entity with a single owner electing to be disregarded as a separate entity then you would check this box and so on you check the appropriate box if you were changing your current classification no matter how you achieved it or you are electing out of a default classification do not file form 8832 if your default classification is the actual classification that you want to use for example jacob's Tree Service LLC is a newly formed multi-member LLC and it is a default rule Jacob's Tree Service is automatically classified as a partnership Jacobs tree service would only file form 8832 is it as electing to be taxed as a corporation in which checks that in which case it would check box a if Jacob Street service wishes to be taxed as a partnership then form 8832 should not be filed at all moving on to line 8 election is to be effective beginning the date and months the iris actually wants to know what date you want this election to take effect if you leave the box of blank or the line blank they're going to make the election effective the date they received the forum but typically you're going to think this through and make a decision about what date you want this entity classification election to take effect an end to an election specifying an entity's classification for federal tax purposes though can not be more than 75 days prior to the date the election is filed or later than twelve months after the date on which the election is filed so if I file this form today and I want it to take effect for January 1 of 2015 I'm going to have a problem because that is more than 75 days prior to the date that the form is being filed also if I want this entity classification to take effect as of the first day of 2017 I have a problem because that is more than 12 months in the future so the IRS wants to see a date entered on here that is not more than 75 days earlier than today's date and not more than 12 months after today's date and then in this section right here that you see in yellow this is the consent statement and signature section form 8832 must be signed by each member of the electing entity who is an owner at the time the election is filed or any officer manager or member of the electing entity that is authorized under local law or the organizational documents to make the election and the elector does need to represent that they have the authorization under penalties of perjury if an election is to be effective for any period of time prior to the time it is filed then each person who was an owner between the date of the election and the date that it becomes effective must also find if you need a continuation sheet or a separate statement attach that to form 8832 and the separate consent statement must contain all of the same information that's contained on the form do not find the copy that it is attached to your tax return then we move on to page 3 of the document and on page 3 that part 2 where you can make late election relief so this is rather interesting because up here it says do not enter a date earlier than 75 days prior to today's date are not more than 12 months after today's date but then down here we say oh maybe you can because there are some late election procedures so if you're going to use a late election election procedure you need to explain the reason for the failure to timely file your entity election classification and then finally in the signature section of part 2 this must be signed by an authorized representative of the eligible entity and also by each effective person the individual or individuals who signed the declaration must have personal knowledge of the facts and circumstances related to the election so let's talk a little bit about these elections and what they mean next an LLC with a single member is classified as a disregarded entity taxable as a sole proprietorship unless it decides to file form 8832 and a multi-member LLC will automatically be classified as a partnership unless it elects to file form 8832 the following rules apply to limited liability companies where there is a change in the number of members a change in the number of members in an LLC does not effect the entity's classification as long as there are two or more members and now I'll see that it's classified and taxed as a partnership so will become a disregarded entity taxable on form 1040 scheduled see if the entity's membership is reduced to only one member and an LLC that is treated as a disregarded entity taxable on Form 1040 Schedule C will be classified and taxed as a partnership if the entity grows to more than one member but a change in the number of members in an LLC that is filed form 8832 to elect to be taxed either as a C corporation or perhaps later on as an S corporation will have no effect on the elected corporation classification so now I'll see that as elected corporate classification will continue to be taxed as a corporation by the IRS regardless of the number of members that it has and here are some examples of what I mean in this first example we have a single-member LLC that adds a member Jenny is the single owner of the LLC Jenny's cafe and for the past three years Jenny has reported income and expenses of the LLC on Schedule C with her form 1040 return on July 1 of 2014 Jenny decided to bring in a partner Jeff into her business Jeff contributed capital of twenty thousand dollars to the business in exchange for his 20% share of ownership then on seven one of fourteen Jenny's cafe became a partnership because it now has two or more members Jenny's cafe will need to file two short year returns and for the period of January 1 through June 30th Jenny's cafe will report income and expenses on Jenny's personal return with a Schedule C attached and for the period of July 1 through December 31 and for any future years Jenny's cafe will file a partnership return on form 1065 let's look at the next example where we have a single member LLC filing as an S corporation and it adds the member we have seen the same taxes as the example we just described except that Jenny's cafe made an election to tax as an S corporation in an earlier year and is reporting income and expenses on form 1120s the addition of Jeff as an additional member has no effect on the tax status of Jenny's cafes of the LLC we'll continue to file form 1120s in example number 3 we have a multi-member LLC that adds a member assume the same facts is an example one except that Jenny's cafe was originally formed by Jenni and Jeff three years ago and on July 1st of 2014 they decide to bring in a third member Jessica because Jenny's cafe had two or more members in the earlier years it has been required to file form 1065 and the addition of Jessica as a third member does not change the entity status as such it will continue to file form 1065 until the number of partners reduces down to one or it makes an S election or C corporation elections so let's now look at the definition of Association for purposes of form 8832 an association is an eligible entity that is taxable as a corporation by election the federal tax treatment of elective changes in classification as described in regulations is some as follows if an eligible entity classified as a partnership elects to be classified as an association it is deemed that the partnership contributes all of its assets and liabilities to the Association in exchange for stock in the Association and immediately thereafter the partnership will liquidate by distributing the stock of the Association to its partners if an eligible entity that is disregarded as an entity separate from its owner elects to be classified as an association then the owner of the eligible entity is deemed to have contributed all of the assets and liabilities of the entities to the Association in exchange for stock in the Association so what the iris is simply saying is that even though you're not a corporation you're going to be deemed to be treated as a corporation you're going to be deemed to have stock in the corporation and so all of the normal treatment that would be awarded in a situation for a stock owner is going to apply employer ID numbers with respect to employer identification numbers there is a difference in this disregarded entity treatment disregarded entities that is a single member LLC's are not disregarded for pre-employment tax and excise tax purposes beginning in 2008 disregarded entities including single-member limited liability companies that are disregarded as separate from their owner as well as qualified subchapter S subsidiaries are required to file excise returns using the disregarded entity's name and ein rather than its owner's name Andy I M so what does the thing is if you are an individual that formed an LLC the LLC is not recognized for tax purposes unless you file form 8832 and so you would file typically Schedule C but if you hire employees for your business the employment situation is going to be treated as a separate entity and so for employment purposes the LLC does need to apply for an EIN and you should use the ein of the LLC for filing payroll reports but the ein of the LLC is not entered anywhere on the personal return it is only entered on the payroll reports now this filing requirement for disregarded entity is also applies to employment tax returns effective for we just paid on or after January 1 2009 disregarded entities not previously needing an EIN may now need to apply for an EIN for the payment and reporting of these taxes so where do you file form 8832 well it depends on where in the country or in the world you are if you are in any of the states listed in this top box then you file form 8832 with the Cincinnati office of the IRS if you are living in any of the states shown here then you would file in Ogden Utah and if you are in a foreign country or a US possession you also file with Ogden Utah but you have that little suffix on the end you should also attach a copy of form 8832 to the entity's federal income tax or information return for the tax year of the election if the entity is not required to file a return for that year a copy of its form 8832 must be attached to the federal income tax or information return for all direct or indirect owners of the entity for the tax year that includes the date on which that election took effect although failure to attach a copy of form 8832 will not invalidate an otherwise valid election each member of the entity is required to file returns that are consistent with the entity's election penalties may be assessed against persons who are required to but do not attach form 8832 to their return and other penalties may apply for filing federal income tax or information returns that are inconsistent with the entity's election for more information on how to make an entity classification you can of course refer to the form 8832 instructions and now we're going to talk about the due date for filing form 8832 and also what to do if you find out that the window of time for filing the form has passed what do you do can you file late and it's so how do you go about doing that well form 8832 can generally be filed at any time the iris will begin recognizing the selected entity classification as follows generally the election will take effect on the date that is entered on line 8 of form 8832 or on the date form 8832 is filed if no date is entered on line 8 however IRS recognition of the classification can begin no later than 75 days prior to the date the election is file or 12 months after the date on which the election is filed now if line 8 of form 8832 shows a date that is more than 17 I have five days prior to the date on which the election is filed then the election will take effect 75 days before the date it is filed so let's just suppose you're filing the the form on August 1st 2015 and you want it to take effect January 1st 2015 the IRS is automatically going to process that and apply it 75 days earlier it's not gonna give you that January 1 date we've just talked about the filing deadlines for form 8832 and what we'll do is we'll take another break rest your mind and I'll get the camera unlocked for you but after the break we're going to come back and talk about late election relief and what you do if you want to make an entity classification that is outside that window of time password number one is Scotia SC ot I a Scotia all right everyone welcome back from break hopefully you've got your computers are able to see and you're able to see your manual we're going to be getting into form 1065 during this next segment as well and so if you've not already printed out a copy of form 1065 you probably should it's just going to make it easier for you to follow along with me because I'll be talking about a particular line of the form and it's nice if you have that line of the form right in front of you at the time so we were talking about how an entity can decide to be taxed in a way other than its default status and that that is typically done by filing form 8832 and that there are time frames by which 8832 must be filed the IRS also have procedures in place though for late election called a late election relief and an eligible entity may be eligible for late election relief under Internal Revenue Code procedure 2009 - for one as well as 2009 - 3 9 if each of the following requirements is met number one the entity's failed to obtain its requested classification as of the date of its formation or upon the entity's classification becoming relevant or failed to obtain its requested change in classification solely because the form was not filed on time and either the entity has not filed a federal return or the for the first year for which the election was intended because the due date for that year has not yet passed or the entity has timely filed all of the required federal tax returns and information returns or if not timely filed at least within six months after the due date excluding extensions consistent with its requested classification for all of the years that the entity intended the requested election to be effective and no inconsistent tax or information returns have been filed by or with respect to the entity during any of those years now if the eligible entity is not required to file a federal return or information return then each affected person who is required to file a federal tax return or information return must have finally filed all such returns consistent with the entities requested flat classification for all of the years that the entity intended the requested election to be effective and no inconsistent tax or information returns have been filed during any of the years so essentially what this is saying is you are supposed to have this return this form 8832 filed within 75 days prior to the date you want it to take effect but if you file it late you can still be treated as have being given an earlier classification date if the filing deadline for the return to which it applies has not yet passed or even if that deadline has passed you actually filed a form that is consistent with the entity classification you're selecting so let's just suppose you are an LLC that decided that you wanted to be taxed as a corporation and so you filed form 1120 as a corporation you send it off and the IRS sent it back thing but you're not a corporation well you could at that point say oh well we thought we were a corporation we're going to attach this ad 832 to make sure that election is accepted and because you file to the corporation even though you weren't and now you're submitting this ad 832 and resubmitting it again that would be a situation where the IRS is going to accept it even though it's late now the entity must have reasonable cause for failure to timely make the entity classification and also there is a limit on how far late election can be granted and that is three years and seventy-five days from the requested effective date of the eligible entities classification election has not passed an effective person referred to in the requirement to be our 2a above includes any direct or indirect owner of the element electing entity that would have been required to attach a copy of the form 8832 to their federal income tax return for the year so how do you obtain relief well form 8832 contains a checkbox and a description area that I showed you earlier for making the election you need to file form 8832 with the applicable IRS office within three years and seventy-five days from the date the requested effective date of the entity's classification election and then on page one of the form put a check in the box late classification relief sought under Internal Revenue procedure 2009 - for one you then complete part two a form 88 - which is page three and on line eleven you explained the reason for the failure to timely file an entity classification election parts you must be signed by an authorized representative of the eligible entity as well as each affected person the individual or individuals who signed the Act declaration must have personal knowledge of the facts and circumstances that are relating to the election and an additional copy form 8832 must be attached to either the eligible entities or the affected persons return if revenue procedure 2009 - for one does not apply an entity may seek relief for a late election by requesting a private letter ruling and paying a user fee so let's talk about the effective entity classification and F election on the tax year now formation of a new partnership or multi-member LLC or a corporation can occur on the first day of the year more often however a partnership or corporation will be formed at another time during the year similarly the dissolution of a partnership LLC or corporation can occur on a day other than the last day of the year and when that happens a short year return is often filed by partnerships and corporations on the first and last year of business in addition to the formation or dissolution of a partnership multi-member LLC or corporation either of the following events can trigger a short year firstly form 8832 entity classification election is filed by an entity electing to begin or end corporate tax treatment if the election occurs on a date other than January 1 there will generally need to be two short year returns filed or form 2553 election by a small corporation is filed or revoked in the year corporation begins or ends its s election status that the corporation may need to file a short year 1120 and an 1120 F tax return and here is an example where an entity change has created two short year returns on August 1 2014 tribbles LLC a multi-member LLC filed IRS form 2553 to elect S corporation status tribbles LLC is a calendar year filer for tax year 2014 tribbles LLC will while two short year returns as follows form 1065 with the short tax year of January 1 through July 31 and form 1120s with a short tax year of August 1 through December 31 tribbles LLC members will then receive to schedule k1 for tax year 2014 and 1 k1 will report income from the 1065 election north from the 1065 filing and the second k1 will report income from the 1120s filing thereby reflecting income earned by tribbles LLC under each of its entity statuses you should note that the due date for partnership returns is the 15th day of the fourth month following the end of the partnerships year and for partnerships that are filing calendar year returns and that filing deadline would be April 15th but for triples LLC with that short year return that means that the partnerships final 1065 has a year end of July 31 and that means that it's a 15th day of the fourth month would put you on November 15th of the same year the same calendar year that is or if an extension is filed it would give another 5 months to timely file that return so that's one of the other things to be making note of if you have a client make an entity classification choice you should be really aware of what time in the year you've done that if it's made an entity classification choice it takes part place midway through a year you have to be aware of we now have a short year and what the filing deadline is for that short year not kind of just forget about it until they come in at filing time because by then it could be too late in other words a late filing that could be objected to some penalties so this is the point where we are getting on with looking at the 1065 form now there are a lot of similarities and a number of differences between form 1065 and form 1120s if you're trying to file like a 2015 tax return and the 2015 forms aren't out yet the iris actually that's what you have up here you see at the top of the form I'll just do a minute so you can see it oops she's far as zoom I'm just seeing a chat in the chat box so the question is what if the forms aren't available to file and you're partway through the year that's why you see for calendar year test 2014 or tax year beginning or ending in 2014 and ending on a different date and I've also seen people actually draw a line through 2014 and handwrite 2015 on there those are the methods that I've seen done to deal with that alright so here we are now on form 1065 and we're gonna spend a good part of the day looking at 1065 when we come back to class for a part 2 of this course we're going to begin that class by comparing 1065 to 1120 F and then we're gonna really get into depth into 1120s but today because we're talking about I'll seas and because the default classification of a multi-member LLC is a partnership I felt that we should start with the partnership return and then in our next class we'll look at what happens if an LLC makes an S corporation election or whether you have a corporation that makes an S corporation election how is that handled in terms of how do we prepare that F that S corporation return so to start with I'm a very form based person I like IRS form to be forums help clarify the tax law if I don't understand a form and how to fill it out it's probably because I don't understand the tax law surrounding it the form is being used to apply the tax law so when I'm studying a form and trying to understand it what I'm really trying to do is understand the law that applies to the forum and why are they filling the form out in the way that they are why is this piece of information requested on the forum there's a rhyme and a reason behind all of it IRS employees people who sit in rooms for weeks and months at a time designing and redesigning these forums as they're trying to apply certain aspects of tax law and so I figure I'm gonna take all of that effort they put and take that to my advantage a by understanding the forum and B by reading the instructions that help me interpret the form and then if the instructions aren't enough then I may go farther into it and start reading code god forbid reading code is very boring but sometimes necessary and then of course the iris publications can be a little bit more entertaining and finally if I'm still not understanding something I can just do general internet searches and end up on websites of law firms and so forth reading opinions that they have but I always prefer to start with the form itself and work outwards from there so when we're looking at the 1065 the first thing to be aware of is that it is a five-page form and I'm showing you page one and further than breaking the 1065 into five pages I'm going to take each page you divided into its component parts and I'll Co those component parts sections now these sections are not described in the IRS instructions these are my instructions essentially I look at the form and I can see these sections and and that's how we're going to take it and the first section you can see is the identification information in this top section in yellow you're going to provide the IRS with information that identifies your partnership and the type of Elections and so forth that might apply to that partnership there's some specific information that we're lifting up here and I'm going to get into that in a minute we then move on down the form to the business income section and I'm calling a business income although it says income we have to be very specific that it R if it references business income IRS hasn't said business income here but that's what it means and I'll show you why and then we see business deductions and it doesn't say business deductions but again only business deductions are allowed here other deductions are not allowed here and are entered in other parts of the form and then in the final section we have signatures this is where the tax return gets the signs so let's take a look first at page 1 and we're going to begin with that first top section which is where we enter identification information the top section of page 1 is used to provide information about the business that is filing the tax return and care should be taken to properly provide all of the information that is requested in this section now one of the things our firm does and every firm really should have procedures in place to do this and that is review tax returns whoever did that a tax return someone else needs to be reviewing that tax return and whoever is reviewing that tax return should be looking for the types of things that are easy to miss it can be all-encompassing or the focus of preparing a tax return is I got all the numbers right am i balancing to the profit in law have I put income and expenses on the correct lines am i doing all of those things correctly and the focus is all on that and there's like a brow weight when I'm all done oh I got it at balances yeehaw I'm done when in fact there's a lot of work that still needs to be done and it's easy to miss and that's why I have another person review the work can be found official firstly they can make sure that you are in fact balancing as you think you are but secondly to just look for all of those mundane little boxes and information fields that need to be filled in that quite frankly often just don't get filled in embarrassingly so and what happens is when the client picks up this tax return that they just paid you a bunch of money to prepare and they sit down and look at it and you haven't entered any information that is requested in these boxes up here it just makes you look really bad so we're gonna talk about the identification information section and I just don't want you to discount it or there should always be a priority that you can get this part right and again you should have some kind of a double-check procedure in place to catch errors specifically omissions where these fields are just entirely left blank and it is possible when these fields are left blank to still electronically submit a return they're not necessarily going to cause the return to reject but they certainly are errors and when they're not filled in so we're gonna take a look firstly up at the top here zoom in again and you can see that on 1065 the first box is box a and it asks for the principal business activity of the business and the principal product or service and the iris wants you to enter a description for each of these we then go on to business code number and the appropriate activity code for a principal type of business of an S corporation or partnership can be obtained from the instructions for those forms and so you just simply go under the instructions for either form 1065 or form 1120s and look up the code that is appropriate for the type of business that you are operating and then enter that code in here whether you're an S corporation or a partnership the code is identical then we move on to a box d employer identification number you should enter the ein of the partnership in this space and if the partnership does not have an EIN then it must be applied for online box he you enter the day that the business started and then on box F you enter total assets and then it has note there to see the instructions well the reason it's so see instructions is you may or may not have to enter a number there partnerships who answer yes to question six on form 1065 Section B our Schedule B do not need to complete box F a partnership must answer no however to question six and then would be required to make an entry in box F if any of the following is true one the gross receipts of the business are equal to or greater than 250,000 or the total assets of the partnership are equal to or greater than a million or schedule k-1 was not timely provided to all partners by the due date of the return including extension in other words this is a late return or the partnership is required to complete schedule m3 item number G check applicable boxes so let's go up and take a look at these applicable boxes we've got check applicable boxes initial return final return name change address change amended return technical termination but if this is a technical termination also check either box one for an initial return or technical termination plus box to you for a final return so let's talk a little bit about that you check the applicable box as appropriate for the form 1065 that is being filed you should check the technical termination box if there has been a technical termination of the partnership a technical termination occurs if any one of the following is true all operations are discontinued and no part of any business financial or operation or ventures is continued by any of its partners in a partnership or at least 50% of the total interest in partnership capital and profits is sold or exchanged within a 12-month period including a sale or exchange to another partner the partnership year ends on the date of termination and in the case of one above the date of termination is the date that all operations cease and the business winds up its affairs or in the case of two above the date of transfer of 50% or more interest in the partnership capital and profit with respect to attack of technical termination section 7:08 b provides the determination occurs where within a 12-month period there is a sale or exchange of fifty percent or more of the total interest in the partnership capital and profits this is known as a type b termination or technical termination if a technical termination has occurred you will need to prepare two returns for the year of termination on the final return of the old partnership you will check out the g2 final return as well as vox g6 technical termination and then on the initial return of the new partnership you will check Vox g1 initial return and box g6 technical termination a new ein is not needed in a technical termination the new partnership will continue to use the ein of the terminated partnership you should prepare your returns for the appropriate tax period reflected in the respective partnership interests during that time and for more information you should see item G on the front page of form 1065 and the instruction accounting method is an Xbox box H every taxpayer whether an individual or a business entity must figure taxable income on an annual accounting period that is called a tax year the calendar year is the most common tax years that other tax years are a fiscal year or a short tax year and each taxpayer must also use a consistent accounting method an accounting method is a set of rules for determining when to report income and expenses the most commonly used accounting methods are the cash method and the accrual method under the cash method you generally report income in the tax year in which you receive it and you deduct expenses in the tax year in which you pay them under the accrual method you generally report income in the tax year in which you earn it regardless of when payment is received and you deduct expenses in the tax year you incur them regardless of when payment is made there's also something called a combination or a hybrid method and generally and except as otherwise required you can use any combination of cash accrual and special methods of accounting if the combination clearly reflects your income and you use it consistently however there are the following restrictions that apply firstly if an inventory is necessary to account for your income you must use an accrual method for purchases and sales generally you can use the cash method for all other items of income and expense but if you use one method for reporting your income you must use the same method for reporting your expenses and any combination that includes the cash method is treated as a cash method for purposes of section 448 next up we have box I enter the number of Schedule K ones that are attached the partnership must issue a schedule k-1 to each partner who had an ownership interest in the partnership during the year so it's possible at the beginning and ending number of partners in a partnership is going to be smaller than the number of partners who owned interest in the partnership for the year and there needs to be a k1 for every person or entity that had an interest in that partnership during the year and the iris wants to know how many K ones are supposed to be attached to the return item number J check if schedules C and m3 are attached a partnership must complete schedule m3 net income loss reconciliation instead of schedule m1 if any of the following applies the amount of total assets at the end of the year is 10 million dollars or more the amount of adjusted total assets for the tax year is 10 million dollars or more the amount of total receipts for the tax year is 35 million dollars or more or an entity that is a reportable entity partner owned or is deemed to own directly or indirectly 50% or more of the partnerships capital profit or loss on any day during the year a partnership not required to file Schedule m3 can voluntarily choose to file Schedule m3 instead of Schedule m1 and a partnership that files Schedule m3 must also file form 1065 Schedule C additional information for Schedule and three filers so that's the tub that's the end of what we're going to talk about with the information section of the 1065 and now we're going to move on to that second piece of the form where we hat reports income and remember earlier I said you report business income in section and here it says caution only trade or business income and expenses are entered on lines 1a through 22 below see the instructions for more information you should report only gross income from the business activity minus cost of goods sold in this section if cost of goods sold is shown online to complete form 1125 a four form 1065 do not include portfolio income or income from rental property in this income section portfolio income includes interest dividend and capital gain income that is earned from bank account holdings and stock holdings that are owned by the partnership on line 1a you will enter the gross receipts or sales gross receipts or sales come from trades or business activities of the partnership on line 1b you will enter cash and credit refunds the partnership made to customers or returned merchandise as well as rebates and other allowances that are made on gross receipts or sales then on line 2 you enter cost of goods sold and if you are entering an expense for cost of goods sold you need to complete in a chat form 88 35 a and once you've completed that form you will then carry the total from that form over to line 2 of 10 55 on line 4 you will enter the ordinary income or loss from other partnerships estates and trusts if the partnership owns an interest in another partnership or Trust and received a k1 enter the amount of ordinary income or loss from that other partnership or trust on line 4 you should attach a statement to the tax return that shows the name address and employer identification number of the partnership or trust that issued that k1 but do not include the following kinds of income from that partnership or trust on this line portfolio income rental income or lost or publicly traded partnership income if you're reporting income from a publicly traded partnership also called a PPP you include that income on schedule K line 11 and on schedule k-1 in box 11 using a code F and if the amount included on line 4 is a loss from another partnership the amount of the loss that can be claimed may be subject to at risk and basis limitations as is appropriate moving on to line five this is where net profit or loss from farming is entered you would enter the partnerships net profit or loss from farming and if you are reporting farming income and expenses you attach a Schedule F and it's the same Schedule F that you would use and attach to form 1040 if you were filing for a sole proprietor do not include though on this line any farm profit or loss from other partnerships and also do not include any section 179 deduction on this line line six net gain or loss from form forty seven ninety seven you report on this line the gain are lost from the sale exchange or involuntary conversion of assets used by the partnership in a trade or business activity do not include on this line the sale of assets that are used in a rental activity of the partnership also do not use this line to report a recapture of the section 179 expensing that was previously passed through to partners instead report any recapture on schedule k-1 box twenty with a code l line seven other income or loss enter any other trade or business income not included on lines one A through six examples of other incomes reported on this line include interest income charged on receivable balances recoveries of bad debts deducted in prior years taxable income from insurance proceeds the recapture amount under Section two eight zero F if the business use of listed property drops to 50 percent or less if this happens you complete and attach from forty seven ninety seven part four to show how that recapture amount is figured and finally five income adjustments resulting from a change in accounting method all right so that's the income section what you would report there now let's look at deduction and you're going to use the deductions section to report operational expenses of the business activity allowable expenses of the business activities should be entered on lines nine through twenty one according to the categories that are provided for on these lines and then all other deductible expenses of the partnerships business activity not including rental real estate expenses reportable on eighty eight twenty five and other rental expenses reported on Schedule K line three which we're going to discuss a little bit later in today's class these are together as a total amount on line 20 and the statement should be attached to the return describing each expense category and the amount that is included on line 20 so the deductions are then entered on line 21 and a net ordinary business income or loss is shown on line 22 the amount from line 22 will then carry over to line 1 of Schedule K which is located on page 4 of form 1065 now let's talk about the types of deductions that you would not enter on line 9 at 3:20 you do not report it's the following expenses anywhere on page 1 of form 1065 rental activities expenses rental activity expenses are reported on Form 88 25 or on line 3b of Schedule K or deductions that are allocable to portfolio income you report these deductions on line 13 D of Schedule K and in box 13 of schedule k-1 using codes I K or L do not enter non deductible expenses for example expenses connected with the production of tax exempt income or the non-deductible part of the meal or entertainment expenses report non deductible expenses on line 18 C of Schedule K and in box 18 of schedule k-1 using a code c qualified expenditures to which an election under section 59 a may apply including circulation expenses research and experimental expenditures intangible drilling and development costs or mining exploration and development costs and finally do not enter as an expense on page 1 of 10 65 items that the partnership must state separately that require separate computations by the partners examples of these types of separately stated items include expenses incurred for the production of income instead of in a trade or business charitable contributions foreign taxes paid or accrued intangible drilling and development costs soil and water conservation expenditures an amortizable basis of reforestation expenditures and exploration expenditures the distributive shares of these expenses are reported separately to each partner on schedule k-1 also there are some limitations deductions rebate leading to cogs do not include as expenses on lines 9 through 21 any cost of goods sold expenses that have already been included on Form 1125 a that seems self-evident if the partnership is an eligible small business it may be able to claim certain cost of goods sold expenses as the cost of supplies or materials and I'm going to talk about that a little bit more later in today's class when we get to page 64 of the manual reporting trade or business activity deductions you report only trade or business activity deductions on lines 9 through 20 as described next on line 9 you will enter salaries and wages deduct only salaries and wages paid to employees of the partnership do not include any payments that are made made to independent contractors or partners of the partnership on this line and this seems like a pretty mundane line but it's actually the point where I'm gonna stop and divert your attention for a little bit because what happens with small business owners who form LLC's or just decide to form a partnership together they don't know any better they think that they formed a business and they're paying all their employees and they need to pay themselves too and they'll go off and hire ATP or paychecks or some other payroll company a salesperson will come down ask them scripts to fill out w-4 is for all of the employees have them fill out some forms and they'll do all of that and then they'll start submitting their payroll each a week or every two weeks to the payroll service that they're using and the payroll reports get filed and at the end of the year they get these W shoes and as far as these small business owners are concerned they've done everything correctly they think that they followed through with all of their legal obligations and they've done things right until they come in to get their taxes done now when they come in and get their taxes done they may or may not find out that they've made a mistake that would depend on the competence of the tax professional that they're working with but if the tax professional understands the rules relating to partnerships then the tax professional is going to say wait stop because if you did payroll on your spouse as an owner of your partnership or as a member of your LLC you cannot be yourself on a w-2 the line instructions are very specific doctor only salaries and wages paid from of the partnership and do not include payments made to partners of the partnership on this line in effect a partner in a partnership is never an employee of the partnership and this is where clients of mine more often than I would like to see happen this happens that they've engaged in all of these procedures to do payroll on themselves and now I get to tell them but wait you shouldn't have done that you're kind of in a pickle math line 10 is actually where compensation to partners is entered as an expense and this is the guaranteed payment line the partnership may claim a deduction for payments made to a partner in exchange for services provided to the partnership medical insurance premiums paid on behalf of partners partners spouses or partners dependents are also included on this line so let's just go back up and take a look at this 1065 lines 9 and 10 again if the partnership has employees then it needs to pay those employees on a w-2 and the amount of wage paid to those employees is entered as an expense on the line 9 if the partnership made payments to any of the partners for services those partners rendered to the partnership then those would be entered on line 10 now it's possible for partners in a partnership not to receive guaranteed payments and not to have received payroll it's possible that they've taken profit shares from the partnership just throughout the year when money seemed available but there was no you know direct allocation that this profit share is awarded to you based on services provided it's just we've gotten to the midpoint of the year we have this much money we're gonna give you this amount instead of partnership are the partners take their distributive share of the partnership income at that point in a year it could be as if that is considered to be a guaranteed payment if it was a payment for services but it doesn't necessarily need to be a guaranteed payment but if it was payroll that went to the partner then we're gonna get you into a little bit later what needs to be done when payroll was paid when it shouldn't have been but this is the line line 10 where payments to partners are entered and it should not have been through payroll okay so passing on the guaranteed payments were now onto line 11 repairs maintenance include on this line the cost of repairs and maintenance that are incidental to the cost of owning property used for income production and do not add to its value or prolong its useful life on line 12 you enter bad debts if the partnership has included in income and amount which is fully or partially uncollectible include an expense for the amount of bad debt that was previously included in income on this line so a cash basis partnership will never have a bad debt bad debts are only going to apply when you have an accrual filing partnership that's using the accrual method of accounting and then in line 13 rents include on this line the amount the partnership paid in rents for the year do not include any rent paid by the partnership for a dwelling unit that is occupied by a partner in the partnership if the partnership leaves the vehicle an inclusion amount may need to be included on this line and you can refer to IRS Publication 463 for information on how to figure the inclusion amount also complete form 4562 part 5 to report business use of vehicle information we actually briefly talk about inclusion amounts and of course I teach called depreciation made easy that's the one place I can tell you to go that IRS Publication 463 also provides information on inclusions line 14 taxes and license to enter the amount paid for taxes and licenses in the trade or business that have not been detected elsewhere on this line examples of taxes and licenses would be payroll taxes but do not include payroll taxes that were withheld from employee pay for example if you're paying an employee a gross wage for the month of $1,000 but their net check is only $800 because you withheld payroll taxes from their pay you would enter $1,000 as wage income on the wage line you would not enter any of the amount withheld from that employees pay as a tax if that tax is not your tax but if you make a matching tax which most employers are required to do you're required to make a matching tax payment on your employees wage then the employer match amount is an amount that you would enter on line 14 as well as any other license amounts or taxes that you paid line 15 interest include interest incurred in the trade or business activities of the partnership that has not claimed elsewhere on the return but do not include the following interest expense amounts on this line debt used to purchase rental property this type of interest expense is claimed on Form 88 25 debt used to buy investment property debt required to be allocated to the production of property this kind of debt must generally be allocated to the cost of producing the property under cost of goods sold prepaid interest which can generally only be deducted over the life of the loans interest paid to a partner in the partnership for the use of capital this type of interest payment should be treated as a guaranteed payment to the partner line 16 depreciation do not include on line 16 any section 179 expense if you're filing a sole proprietor return with a Schedule C you use form 4562 to figure and claim the section 179 deduction in that seventh of section 179 deduction flows through to the Schedule C and is entered on the depreciation line of the Schedule C but partnerships are not allowed to claim a section 179 deduction the section 179 deduction is going to flow through to the individual partners and they will claim that deduction on their own individual returns line 17 depletion if the partnership is claiming a deduction for timber depletion you would complete form P for timber and then enter as a deduction here do not include a deduction for depletion on oil and gas properties on this line deductions for oil and gas properties are separately reported on Schedule K 1 line 18 retirement plans enter amounts contributed by the partnership to the retirement plans of common law employees of the partnership employers who maintain a pension profit sharing or other federal funded deferred compensation plan other than a step or simple ira must generally file one of the following forms form 5500 annual return or report of employee benefit plan or form 550 SF which is the short form or form 5500 easy annual return of a one participant plan do not include however on this line amounts that the partnership contributed to the retirement plans of partners these amounts are reported on Schedule k1 in box 13 using code R and are deducted by the partners on their individual return payments made to retire accounts on behalf of employees under a salary reduction plan instead the partners should claim a deduction for salaries or wages paid to the employees on form 1065 line 9 so again this is similar to payroll tax if you have a monthly wage that you're paying to employee of a thousand dollars and that employee decides to divert a hundred dollars to their 401k plan that's their money it's not a deduction you claim you claim the thousand dollars you paid them as a wage and it doesn't matter whether the wage you paid was divided between taxes take-home and contributions to their 401k plan you're going to claim that flat gross wage as your expense I'm the only time you would claim a deduction for contributions made to an employee retirement plan is if you are making a matching contribution out of your business pocket to that employees account and it's not a reduction to their wage line 19 employee benefit programs enter the partnerships contributions to the employee benefit program not claimed elsewhere on the return an example of an expense to include on this line is employee health insurance do not include though health insurance payments for any partner or for us both or a dependents of any partner health insurance expenses of partners are reported on line 10 as a guaranteed payment and finally line 20 other deductions you enter a total of all other allowable trade or business expenses of the partnership on this line then attach a statement to the return that describes the type and amount of each expense and examples of expenses that can be included on this line our amortization allow the deductions for business startup and organizational cost reduction for certain energy efficient commercial building property gifts insurance premiums legal and professional fees meals and entertainment expenses membership dues supplies used and consumed in the business travel and utilities so we're not going to spend a lot of time talking about these but I will talk about a couple of items one of these is the business and startup organizational cost because it typically will cost some money to form your partnership generally a partnership can elect to deduct up to five thousand dollars of business startup and organizational cost paid or incurred after October 22 2004 and these are separate amounts up to $5,000 a startup up to $5,000 of organizational any remaining costs are capitalized and then amortized over a 15-year period the $5,000 deduction is reduced but not below zero by the amount of total costs that exceed $50,000 if the Pella costs are fifty five thousand dollars or more than the deduction is reduced to zero and anything the costs not deduct must be amortized the partnership generally elected a tech startup costs by claiming the deduction on its return filed by the due date including extensions for the year in which the active trade or our business begins under gifts the deduction for gift expenses is generally limited to $25 per person per year and for purposes of the gift rule a family member of a person is considered to be the person so you can't get around the gift rule by giving a business client a $25 gift and then giving their spouse another $25 gift that would be deemed to be a $50 gift amounts treated as compensation generally the partnership may be able to deduct otherwise non-deductible entertainment amusement or recreational expenses if the amounts are treated as compensation to the recipient and reported on Form w2 for an employee or on form 1099 miscellaneous for an independent contractor so the outright deduction for a gift is limited to $25 a year but let's just suppose that really the gift is a form of compensation you would then deduct that gift not as a gift expense but as the actual expense that it is deemed to be so for example if you give an employee a five thousand dollar reward for years of service then that five thousand dollar reward would actually need to be gross stuff and claims as a payroll expense Neal and entertainment expenses generally the partnership can deduct only 50% of the amount otherwise allowable for meals and entertainment expenses paid or incurred in its trade or business in addition subject to exceptions under Section 274 the meals must not be lavish or extravagant and a bona fide business discussion must occur during immediately before or immediately after the meal and a partner or employee of the partnership must be present at the meal 80% of meal expenses allocable to travel away from home may be deducted if the meals are consumed by individual subject to the hours of service limits of the Department of Transportation membership dues the partnership may deduct amounts paid or incurred for membership dues in the following kinds of organizations civic or public service organizations professional organizations such as bar and medical associations business leagues trade associations chambers of commerce boards of trade and real estate boards however no deduction is allowed if the principal purpose of the organization is to entertain or provide entertainment facilities for members or their deaths so we could say say a golf club membership or a health club membership or the dues are for membership in any club organized for business pleasure recreation or other social purpose this includes country clubs golf and athletic clubs airline and hotel clubs and clubs operated to provide meals under conditions favorable to a business discussion travel the partnership cannot deduct travel expenses of any individual accompanying a partner or partnership employee including a spouse or a dependent of the partner or employee unless that individual is an employee of the partnership and his or her travel is for a bona fide business purpose and would otherwise be deductible by that individual expenses not reported on line 20 do not include the following types of expenses on line 20 you can see that there's a limited number of lines we just go back up here there's really not a lot of lines here for entering deductions salaries guaranteed payments repairs bad debts rent taxes licenses interest appreciate depreciation depletion retirement plans to ploy benefit programs and then everything else there's not a lot of description left there so it stands to reason that there's a lot of things that you would automatically think are going to go on the other deduction line and so it's important to pay attention to what you do not enter on that other deduction line do not enter as an expense on line 20 items that must be separately stated on schedules K&K one real estate expenses fines or penalties to a government for violating any law for example parking tickets expenses allocable to tax exempt income report these expenses on Schedule K line 18 see net operating losses only individuals and corporations can claim in NOL amount paid to political candidates parties or campaigns to influence the public regarding legislative matters elections or referendum report these amounts on Schedule K line 18 C amount paid or incurred to influence federal or state legislation or to influence actions or positions of certain federal executive branch officials however certain in-house lobbying expenditures that do not exceed $2,000 may be deductible also do not enter charitable contributions anywhere as an expense or the cost of entertainment facilities regarding entertainment facilities the partnership cannot deduct an expense paid or incurred for facilities such as a yachting or hunting lodge used for an activity usually considered to be entertainment amusement or recreation and finally section 4 where we enter signatures form 1065 must be signed by a General Partner or LLC member to be valid in certain situations where a return is filed for a partnership by a receiver or trustee the fiduciary must sign the return also a paid tax return preparer other than employee of the partnership is required to sign the return all right so we are at the top of the hour due for a final break of the day I'm going to give you a password again and when we come back from that break the course is actually going to move much more quickly and in the final hour of the course we're going to be continuing with the discussion of the 1065 return but we're also going to be looking at how to complete each section of the form so we've just finished talking about page one of the form and when we come back from our break we're going to take a look at how to take a sample illustration and take numbers from that illustration and put them on the form so I'm going to give you your second password of the day password number two is computer C o MP u ter computer okay everyone welcome back to class we're going to now take a look at an illustration where we're going to use this illustration to complete form 1065 and the characters in this story are Kira and Jadzia who are 50/50 partners in Dax LLC Dax LLC is a consulting business in which Kira and as Jadzia participated equally their P&L is shown below and Dax LLC will claim a section 179 deduction for assets that were purchased during the year what we'd like to do now is prepare page 1a form 1065 for decks LLC and we're going to do it as shown next so here we've got the P&L for Dax LLC and we've kept it pretty simple and it basically highlighted in various colors the things that should leap out you at you as being relevant firstly we can see that total income for the year is one hundred and ten thousand and fifty dollars but of that one hundred and ten thousand and fifty $50 is checking account interest and we've already learned in the class that you don't enter portfolio income as income on the front page of the tax return and so that means that on the align one of the tax return we're going to enter one hundred and ten thousand instead of one hundred and ten thousand and fifty dollars now we know under expenses that charitable donations are not deductible to the partnership and are not included on page one so even though we've listed an expense here of five hundred dollars for charity we know we need to leave that off of page one all of the computer and office equipment purchases since I've told you in the wording of the problem that Dax LLC is going to be claiming as section 179 deduction for these expenses we know that we're not going to enter a depreciation deduction on the front page of 1040 or not on the front page 140 but on the front page of 1065 for the computer equipment so that's another ten thousand dollar difference between the profit and loss and the return and then finally meals and entertainment 50% of meals and entertainment expense is not deductible for tax purposes and so although the P&L shows that meal expenses were a thousand dollars we know that five hundred dollars is going to be the amount of the deduction that can be claimed so form 1065 provides dedicated lines for only of the few of the expenses shown here including repairs in the amount of $300 rent in the amount of $5,000 and interest in the amount of $100 so these expenses do you have dedicated lines on form 1065 but all of the other expenses shown here that are included on page 1 of 1065 these are going to have to be included on a separate statement finally the net profit Pradaxa LLC ebooks as you can see right here is seventy nine thousand and fifty dollars however fifty dollars of interest income is not reportable on page one a form 1065 also the following expenses are not deductible on page one the charity the section 179 deduction and fifty percent of meals so the total amount of non deductible expenses is eleven thousand and the total amount of non includable income is fifty dollars therefore the net ordinary business of DAX LLC that is going to be entered on line 22 1065 is ninety thousand dollars rather than the seventy nine thousand and fifty that we see on the P&L so moving over to the 1065 we begin by entering one hundred and ten thousand on the line one a remembering to leave the fifty dollars out we even enter the repair rent and interest expenses from the P&L and then we move on to line twenty and on line twenty we're going to prepare a statement on on this statement we list all of the other allowable expenses including meals and entertainment after subjecting that expense to the fifty percent limit we total those expenses up and we get fourteen thousand six hundred dollars and entered that on line 20 we then add up the total the deductions and they come to twenty thousand dollars for the year we subtract 20 from 110 and we get ninety thousand dollars so let's now move on to page two Schedule B on page two you can see right here called Schedule B this schedule is used to report information that must be disclosed to the IRS about the partnership and you use Schedule B to report the method of accounting the business activities description and other questions relating to the partnership Schedule B was result revised for tax years after 2007 to provide space to enter information identifying ownership relationships between the partnership and other entities then in 2009 it was revised again to add line three in 3d and if the yes box is checked on these lines then scheduled b1 also needs to be filled out I'm not going to read through all of the lines here but if we go up to line one it says what type of entity is filing this at return this is the point where you actually tell the IRS whether this is a general partnership a domestic limited liability company a foreign partnership etc and then over here you can see line three at the end of the year did any foreign or domestic corporation partnership trust or tax-exempt organization or any foreign government own directly or indirectly an interest of 50% or more in the profit loss or capital of the partnership and then on line 3b it says did any individual or state directly or indirectly own an interest of 50% or more if you answer yes to either of these questions then you have to complete the additional Schedule B one then down at the bottom it says does the partnership satisfy all of the following conditions this is literally the place where we keep referring did the partnership answer yes or no to question six this is question six I'll just zoom in a little so you can see it does the partnership satisfy all four of the following conditions a the partnership total receipts for the year were less than 250 the partnerships total assets for the year were less than a million Schedule K ones were filed with the partnership return and furnished to all partners honor before the due date of the return and is the partnership is not filing and is not required to file Schedule m3 if you're able to answer yes then this is deemed to be a more simple return and you don't have to complete schedule L m1 or m2 or answer item F on page one of the form we'll see that I'm going to prepare those schedules for Dax LLC anyway I prefer to do those schedules because I find that they help improve the accuracy of the tax return and help me determine whether my client is missing money which any IRS auditor that's going to be the first thing they zero in on is where has the money gone is all of the money being accounted for and those schedules really help you to balance the return to the income and expense activity of the bank account the business now on line one you should indicate the type of entities that is filing the return and if this is a general partnership checkbox a and if it's an LLC checkbox C binds to two for answer all questions yes or no and if you answer yes to question 3a or three be attached Schedule B and this is it right here if you are dealing with a partnership that is owned only by individuals or estates you would typically move down to part two and you would list the name social security number country of citizenship and the percentage that partner owned in the partnership if they owned 50% or more of the partnership then we move on to page three page three is a continuation of Schedule B you answer yes or no to each question listed beginning in tax your 2008 Schedule B was expanded to include questions relating to cancelled debt prior year distributions and contributions to other entities of properties that are received in like 10 exchanges then for 2011 and later years new questions 18 a and B were added that require the partnership to disclose whether or not it made payments that are required to be reported on form 1099 and if so required did the partnership actually issue those forms spaces then provided at the bottom of page 3 to enter information identifying the designated tax matters partner a tax matters partner should be indicated if the partnership is subjected to rules for consolidated audit of proceeding and then form 1065 page for Schedule K so page 1 of the 1065 is where we enter the business income and expenses of the business activity of the partnership but there are other types of income and expenses that are not entered on page 1 what do you do with those will they get entered here on Schedule K Schedule K is used to report certain net income and deduction items as they must be allocated to the partners Schedule K reports the combined total of each reportable item that will flow through to all the partners the sum of the combined amounts for each line number on all partners schedule k-1 should match the corresponding line amounts that are shown on Schedule K and Schedule K can be divided into the seven sections that you see here in section one we are and income and loss amounts in section two were entering deduction amounts in section three were entering information relating to self-employment line our section four is for credits section five is for foreign transactions section six is for alternative minimum tax items and section seven is for other information so we're gonna take each of these sections in turn beginning with section one on income or loss on line one you will enter net income from the partnerships business activity after you finish completing page one you will have a number on line 22 of page one whatever that number is you're going to carry it over and entered on line one of schedule K you then move on to line two and this is the line used to report income from rental real estate activities if the partnership engaged in a rental real estate activity it's going to attach form eighty-eight 2588 twenty five is very similar to Schedule E in its function and purpose Schedule E that is attached to the individual returns is used to report income and expenses from rental properties and so if the partnership owns rental properties it's going to prepare the equivalent form eighty eight twenty five whatever amount of net income or loss that is figured on eighty eight twenty five you're going to enter that on line two of the schedule k then on line three you are entering other gross rental income enter gross income from rental activities other than real estate activities that are reported on Form eighty eight twenty five you should also attach a statement to describe the expenses that are reported on line three B Line for guaranteed payments report guaranteed payments remade made to the partners or LLC members here so on 1065 on line 22 you figure a net income or a loss amount that carries to line one and on line ten of the page one of the ten sixty five that's where you list guaranteed payments whatever amount you've listed on page one line ten as a guaranteed payment you're gonna carry and enter that again on line four actually there is a an adjustment to that line then on line five you're gonna enter interest income that comes from portfolio income you would not enter interest that as received and accounts receivable but if you have bank account Holdings you know money in the bank and it earned interest that is where you enter that interest income and on line ten then you're going to enter the net section 12:31 gain or loss report gains or losses from the sale disposition or involuntary conversion of section 12:30 at that are held for income production on this line we're not going to get into completion of form forty seven ninety seven in this course at all I have another course that we discussed that it's called sale of business assets where we look in-depth at form forty seven ninety seven but not more than that today and then online eleven other income or loss is not reported on lines one through ten those are entered here next we're going to look at section two of Schedule K which is the partners distributive share of deductions certain expenses such as the section 179 deduction investment interest expense and charitable deductions or contributions are not deductible directly by the partnership and are not reflected in the net income that is shown on line 22 of form 1065 instead these deductions flow through to the tax returns of the individual partners or members you claim each deduction on a pro-rata basis for charitable contributions cash contributions of any amount must be supported by a date a dated bank record or receipt enter charitable contributions made during the tax year on line 13 a then attach a statement to form 1065 that separately identifies the partnerships contribution for each of the following categories the following codes should be used to report charitable contributions that are entered on schedule k-1 you need to identify the contribution as a cash contribution or a non-cash contribution and then is the cash contribution a fifty percent limit organization or was it made to a thirty percent limit organization that will dictate how much deduction the individual partner is allowed to claim on their individual schedule a so this is information that the partner uses in preparation of their personal return then we move on to section 3 which is the partners distributive share of self-employment earnings generally the profits from the business activity of the partnership that are reported on line 22 of form 1065 are subject to self-employment tax when they are passed through to the general partners or active LLC members so on line 14 a of Schedule K you're going to enter the net earnings or lost from self-employment but this is also going to include any guaranteed payments made to the partners preparers should make note of the following income items or of how the following income items are treated for self-employment tax purposes though a limited partner share of income is not self-employment income unless it is considered to be a guaranteed payment for services rendered to the partnership portfolio income and rental real estate income are generally not subject to self-employment tax unless obtained in the ordinary course of a business activity guaranteed payments that are shown on form 1065 line 10 and on Schedule K line for are subject to efi tax the portion of income reported on line 22 of form 1065 that is due to ordinary gain from form 47 97 is reported on line 6 the form 1065 and is not subject to SE tax and the instructions for form 1065 provide the following worksheet which can be used to determine the amount to enter on line 14 a i've slapped it in here for you but let's see how we would fill that form out for Dax LLC we're gonna figure the amount of stuff employment income that was earned by the active partners in Dax LLC is shown below and remember when we prepared page 1 of the 1065 for Dax LLC we arrived at a net profit of $90,000 and that is the amount that is going to be carried here ordinary business income are lost from Schedule K line 1 there are actually no other addition amounts on here we didn't have any guaranteed payments made to the partners it's possible we could have and if we had had a guaranteed payment we would enter that amount on line for a but there were no guaranteed payments so it's 90 thousand all the way down and that 90 thousand then we'll carry down to line 14 a of the schedule K and then you can see it says not growth non-farm income this is the gross receipts of Dax LLC prior to any expenses being claimed that's the equivalent of what we entered on line one of the 1065 in this case 110 thousand next step is the section for the partner's distributive share of credits net income of the partnership from line 22 of form 1065 does not reflect adjustments for tax credits if the business activity and expenses of the partnership our LLC are eligible for any tax credits these credits are reported on line 15 a through 15 F of the schedule K so let's just look at an example of a credit if you have a restaurant activity where the servers are received the tip income of the server's there is a credit that an employer can claim for the employers share a pack speed on reported tips of an employee and that credit is not claimable by the partnership the partnership would actually have to reduce its expense deductions for payroll by any amount of credit claims but the credit claimed does not benefit the partnership because it can't claim a credit it isn't taxed so that credit is going to be put in the credit section of the schedule K and it will carry to the K one of the partners and the partners will individually claim any benefit from that credit on lines 15 H or 15 D enter credits relating to rental real estate activities online 15 e enter credits related to rental activities other than rental real estate activities and use line 15 asked to report all other credits that are not include Alliance 15 a through E identify the type of credit in the space provided if there is more than one type of credit or if there are any credits that are subject to recapture attach a statement to form 1065 that separately identifies each type and amount of credit and the credit recapture information for each category you can see the instructions for form 1065 for a description of the available credits and their codes and the net affection then is foreign transactions the partners distributive share of foreign transactions you're going to use line 16 a through n if the partnership has foreign income deductions or losses or has paid or accrued foreign taxes then in Section 6 this section has to do with alternative minimum tax again a partnership doesn't pay a tax or alternative minimum tax but it could be that certain income or expense items may have impact on calculations of alternative minimum tax at the partner level and sense net income of the 1065 may come from sources that have an impact under alternative minimum tax this is the section of the forum where you identify those items and then these items are reflected on the individuals return and then the individual is going to make adjustments typically on Form 6251 for alternative minimum tax computations in section 7 this is the partners distributive share of other information this section of the schedule K is used to report tax-exempt interest income non deductible expenses distributions investment income and expenses and dividend distributions of the partnership next page we're actually going to take the information for Dax LLC and prepare schedule case for Dax LLC we're continuing with the same information that we provided on the earlier pages but in addition to that earlier information I'm going to tell you that Dax LLC made a profit shared distribution to its partners in the amount of $80,000 the partnership distribution went out equally with $40,000 each so let's take a look at how this information is going to get reflected on Schedule K we begin on line 1 by entering $90,000 this was the net ordinary business income from line 22 of the form 1065 remember that line 22 does not account for the $50 of interest the $500 of meal and entertainment expense $500 of charity or that $10,000 section 179 deduction then on line 5 12 and 13 we entered the separately stated income and deduction items including $50 of interest and $10,000 of section 179 deduction and $500 of charitable contribution then on line 14 a $90,000 is entered as the net amount of income subject to self-employment tax and line 14 B is where we enter the gross non-farm income of Docs LLC we then scoot all the way down to the bottom of the form and in the other information section we're going to enter $500 of non deductible expense that's the 50% of the non-deductible meal and entertainment expense on line 19 we're going to enter that $80,000 of distribution that went out to the partners and then on line 20 we're going to enter investment income of $50 investment income of $50 is relevant to the partner on the partners return they're going to report that as a form of investment income and ultimately can affect how much they are allowed to deduct on Schedule A as an investment by completing form 49 52 alright then we move on to form 1065 page 5 page 5 is probably the page that intimidates people the most it's the most confusing part and for that reason small partnerships are actually not required to fill this form out the whole point of that question 6 on the Schedule B is if you answer yes to all the questions you don't have to do page 5 but if you answer yes to any of the questions on a question 6 then you have to do page 5 and as you will see I'm gonna do page 5 for Dax LLC anyway because I personally find it is a way or a vehicle that I can use to make sure that I have not missed any income or deduction items for my clients return and in fact very often after completing the balance sheet or in the process of attempting to complete this balance sheet I determined that the client has way underreported income or way over reported expenses or way under reported expenses just noting AB is balancing at all and so I use this schedule to help me determine where my clients bookkeeping is falling short and more often than not their bookkeeping is really really inadequate and therefore not accurate so page 5 of form 1065 is comprised of a section that is used to report an analysis of net income loss and as well 3 separate schedules including schedule L + 1 and M 2 and you can see I've broken the form up into these component parts part one is analysis of net income or loss part two is schedule L which is the balance sheet per book schedule M one is a reconciliation of income or loss per company books with the profit or loss on the tax return and in part four we have scheduled M 2 which is an analysis of the partners capital account so we're going to take each of these sections in turn again beginning with Part one analysis of net income or loss the analysis of net income or loss section of page 5 of form 1065 is used to classify and allocate income of the partnership between general and limited partners and to identify income as either active or passive how income is classified is going to affect the tax treatment that is given to each individual partners share of income loss and deduction items that are shown on the form 1065 return on line one we combine the amounts that are shown on Schedule K lines 1 through 11 we then subtract out the amount shown on lines 12 through 13 D also line 16 L as well then on line 2 we have an analysis by partner type we either have general partners or limited partners and for each category of general or limited we need to identify who that empathy is is the general partner or corporation an individual and if that it is an individual is that individual active if it is not an active individuals at the passive individual and so forth so for line two for each type of partner shown and two the portion of the amount shown on line one that was allocated to that type of partner foreign government partners are treated as corporate partners report all amounts for LLC members on the line for limited partners that would be line to be the sum shown on line two must equal the amount shown on line 1 the M in addition the amount on line 1 must equal the amount on line 9 of Schedule M one if the partnership is required to file Schedule M 1 and if the partnership file Schedule M 3 the amount on line 1 must equal the amount in column D of line 26 parts choose passive or active income or loss partners who are individuals must be classified as either active or passive a partnership should classify each partner to the best of its knowledge and belief and it is assumed that in most cases the level of a particular partners participation in an activity will be apparent and obvious however if the following rules the following rules can be applied when classifying partners if the partnerships principal activity is a trade or business a general partner is classified as active if the partner materially participated in all partnership trade or business activities and a general partner will be classified as passive if the partner did not materially participate in all partnership trade or business activities if the interest is a working interest in a gas or oil well classify a general partner as active even if they are passive because oil well activities are always considered active rental real estate activity classify a general partner as active if the partner actively participated in all of the partnerships rental real estate activities otherwise classify a general partner as passive for rental activity other than real estate classify as passive all partners in a partnership whose principal activity is a rental activity other than a rental real estate activity and portfolio activity if the partnerships principal activity is portfolio income classify the partners as active you should classify as passive all limited partners in a partnership whose principal activity is the trait is a trade or business or rental activity and if the partnership cannot make a reasonable determination whether a partner's participation in the trade or business activity is material or whether a partner's participation in a rental real estate activity is active you should classify that partner as passive so the whole point of this section is a lot of rambling to get down to a very important bottom line the bottom line is that the IRS wants to know whether a partner's distributive share of income or loss from an activity is active or passive because you cannot use passive activity losses to offset non passive income so this income or loss from a partnership is going to flow through to the individual return where other things are going on and you cannot take a passive involvement in a particular partnership activity to offset say investment income or wage income that the partner has on their individual return so this section is used to determine whether the income is passive or non passive active is the same as non passive and IRS never uses the word active it uses the word non passive so it can be confusing when you're hearing it so at any rate let's take a look at the analysis of net income that we would prepare for Docs LLC Kira and jizya are active 50 5050 partners in Dax LLC and because Dax LLC is an LLC they are automatically deemed to be limited partners also we're going to be looking at the net income of the business including how things were reported on Schedule K so remember when we looked at the front page of 10 sixty-five we came up with a profit of 90,000 why isn't that number the number that's here because when we get to line one we are going to factor in those other pass-through items such as the charitable contributions the interest income but we are going to still disallow about 50% of meals and entertainment so ultimately the profit per book is seventy nine thousand and fifty and the profit per the return overall is seventy nine thousand five fifty and so seventy nine thousand five fifty s they not entered on line one and the amount entered on line one is going to need to equal another line that we're going to enter a little bit farther down the return you'll see how this line one is going to match up with another line on the return in just a minute and then because their own LLC they're automatically deemed to be limited partners but they both actively participate in their partnership and so we're going to say that their individual active not individual passes and again how we arrive at this number that we've entered here we take the ninety thousand dollars of income from page one we add in the interest we subtract out the section 179 deduction and we subtract out the charitable contributions let's move on now to the schedule L which is the balance sheet per book schedule L is used to show the balance sheet of the partnership or LLC books the balance sheet is divided into four separate columns showing beginning and ending balances for the year and you should note that schedule L is optional and does not need to be completed if you answered yes to all four of the following questions on line six of Schedule B that the partnership total receipts were less than two hundred and fifty thousand that the partnership assets were less than a million that the K ones were filed and issued to the partners on time and the partnership is not filing and is not required to file Schedule M 3 so let's take a look at the balance sheet for DAX LLC we have a balance sheet as the of the end of 2013 and we have another balance sheet for the end of 2014 and we're gonna transfer these balance sheets which are per company books over to the schedule L and you can see that we have cash on hand at the end of the year was eleven thousand for 2013 and by the end of 2014 it was nine 50 and we're gonna show that the assets at the beginning of 2013 in the end of 2013 the assets were twenty thousand dollars the the appreciable assets were twenty but they were fully depreciated and for 2014 we added ten thousand dollars at their peaceable assets we're claiming a section 179 deduction on them and so they are fully depreciated as well we then show total assets for each of the the end of 2013 in the end of 2014 we can see that at the end of 2013 there was a liability of a thousand dollars that's been cleaned off the books for 2014 and so we end up with total liabilities and capital at the end of 2013 that were eleven thousand at the end of 2014 there were nine thousand and fifty dollars next step is to do the schedule m1 and this is a reconciliation of income or loss per books with the income or loss per the return now in most instances the net income or loss of the partnership or LLC will be different than the net income per books the difference comes from a variety of expense items that are not deductible by the partnership schedule m1 is used to explain these differences and common items appearing are reported in this section include 50% of meals entertainment as well as differences in depreciation frankly Mitchell am-1 is where I usually find my mistakes I've got the P&L that I'm working on from the the partnership and when I'm done with the partnership return this schedule m1 should balance and if it doesn't balance it's because I have an error somewhere and this is where I find it so a line one should equal the net income per book and line nine should equal that analysis of net income or loss from the top of the form so let's go back here right here this is a lot this line one that should equal line nine of schedule m1 and so ultimately schedule m1 align nine represents the profit or loss per the return and the line 1 represents the profit or loss per book and the lines in between are used to explain or describe why they are different because they would almost never be the same usually the profit per turn is gonna be different than the profit for books and why is there a difference we're gonna use these lines to explain that let's look at an illustration here for Dax LLC income Products LLC books is seventy nine thousand and fifty dollars but the income per the tax return from line one of the analysis of net income is seventy nine thousand five hundred and fifty and the five hundred dollar difference is attributable to the non-deductible meal and entertainment expense so we're gonna show the profit for books is seventy nine thousand and fifty we're gonna show the profit for the return of seventy nine thousand five fifty and the difference of five hundred dollars is explained right here on line four B travel and entertainment five hundred dollars next we're going to move on to schedule MT which is the analysis of the partners capital account if question six has been answered no then the partnership is required to complete schedule m2 if the question is answered yes you're not required to prepare it but again I prefer to do it the amounts shown on schedule m2 should equal the total amounts reported on all of the partners schedule k-1 the capital account is used to track partners basis amounts in the partnership or LLC and basis and the partnership is increased by capital contributions and taxable net earnings of the partnership basis is reduced by distributions to partners and by deductible losses of the partnership so let's take a look at how we would use this for Keira and Jadzia was showing on the balance sheet that they had an opening equity of ten thousand dollars their net income for the year with seventy nine thousand and fifty they took distributions of eighty thousand dollars for the year and their ending balance is shown on the balance sheet of 9,000 at fifty at the end of the year so we're gonna complete schedule m2 for them as follows the beginning of the year balance ten thousand net income per book seventy nine thousand and fifty we're gonna add those lines up and we get eighty nine thousand and fifty we then showed distributions going out to the partners in the form of cash and that leaves us with a year-end balance of nine thousand and fifty dollars cost of goods sold once we're finished preparing all of the other forms where we actually finished everything we can do for Jadzia and Kyra in tax LLC but there is still some additional discussions to give you and one of those is cost of goods sold I have really put an illustration in here that involves cost of goods sold but we should still talk about this form a little bit form 1125 a replaces Schedule A which was previously included on page 2 of form 1120s and 1065 four years prior to 2011 in those earlier years both form 1065 and 1120s were actually four-page forms and they increased the forms to be 5 pages so that they could actually include additional Schedule B questionnaire information and then they took the cogs off and stuck it on its own forum form 1125 a business is involved in the manufacture or sale of goods must generally keep track of inventory purchases labor and other costs relating to cost of goods sold examples of businesses that should track cogs include restaurant and food service businesses retail stores wholesalers and manufacturing businesses cogs do not apply to certain service oriented businesses though cost of goods sold does not generally include supplies and materials that are used by service oriented businesses like medical offices lawyers and accountants also contractors who purchase materials to provide construction construction services and are not otherwise manufacturing a product or holding inventory for sale will generally not need to track cogs or complete form 1125 a generally inventories are required at the beginning and end of each tax year if the production purchase or sale of merchandise is an income producing factors but certain small businesses are allowed to treat cogs as a supply expense if a partnership is a qualifying taxpayer or a qualifying small business taxpayer it may adopt or a changes accounting method to account for inventory items in the same manner as materials and supplies that are not incidental a qualifying small business tax payer is a tax payer that for each prior year ending on or after December 31 of 2000 danuel gross receipts of 10 million dollars or less for the 3 year period ending with that prior year and whose principal business activity is not an ineligible activity under this accounting method inventory cost for raw materials purchased for use in producing finished goods and merchandise purchase for resale are deductible in the year that goods or merchandise are sold but not before the end of the year that the business paid for the raw materials or a merchandise if it was also using the cash method for additional guidance on this method of accounting for inventory items you can refer to IRS Publication 538 accounting periods and methods now let's take a look at schedule k-1 we finished the 1065 including the schedule k as a 1065 but we still need to take the information from the schedule k if at 1065 and divide it between the partners and we do that with schedule k-1 schedule k-1 is given to each partnership partner or LLC member and information reported on schedule k of form 1065 flows through to each partner on his or her k-1 income is divided according to each partner share of income or loss items and generally you must report partnership income items shown on Schedule K in the same way that the partnership treated the items on its return and you can refer to the instructions for schedule k-1 for certain exceptions to that general rule page 1 of schedule k1 is used to report each partners share of the partnership income loss deduction and credit items it also reports items that affect partnership basis such as tax exempt income investment income and expenses distributions of cash into the property contributions of cash or other property and non deductible expenses page 2 of schedule k-1 contains a summary of codes and descriptions which are used to interpret information that is reported on page 1 including where on the personal return each partner should report items shown on page 1 so let's look at the schedule k-1 and you know even if you've not ever prepared a partnership return you've probably seen lots of k1 because your clients bring moves in and so understanding how to complete a schedule of k1 can certainly help you determine how to take information from that k1 and put it on the personal return but we're not going to be using today's class to in any way talk about the personal return we're using today's class to show how to prepare the schedule k-1 for the partnership that the partnership will then issue to each partner so we're going to take a look at schedule k-1 for dax LLC in just a minute that you can see that the lines on the schedule k-1 pretty much coincide with the lines appearing on schedule k but there's not a perfection of the reporting in other words there are some differences in addition you can see that there's space that is where we provide information about the partner we describe the type of partner that we have the partners share profit loss and capital the partner share of liabilities whether those liabilities are recourse non-recourse qualified non-recourse also the partners capital account analysis there's space for that and then there are instructions or brief instruction codes for the schedule k-1 and i'm not going to read these to you go nuts listening to me talk about them but i have highlighted the ones that are relevant to today's illustration because these are the lines where we're going to be entering a code or a number relating to dax LLC you can see that we're going to be reporting an amount on line one ordinary business income or loss also that's going to be a non passive form of income we're going to show information relating to interest income I didn't give them any guaranteed payments but if they had a guaranteed payment that would be on line four section 179 deduction and other deductions such as the cash contribution the self-employment earnings then we've got other non deductible expenses we also have line 19 distributions and finally line 20 other information so these are the lines or the codes that are really relevant to Jax LLC and on the next page I've got the completed K ones for Dax LLC this is a relatively simple division because I decided to make both these partners 50/50 so all of the numbers on the schedule K are going to divide 50/50 between the partners the scheduled cash of business income of $90,000 so the 50-50 split will be 45 thousand dollars each to Judd Xia and to Kira then the $50 of interest income will be divided 50/50 twenty-five dollars to each we can see that the section 179 deduction is ten thousand dollars it's going to be divided 50/50 to each the other deduction which would be charitable contributions is five hundred dollars and that will be the 250 between each of them also I told you that they took a distribution of 80 thousand dollars from the partnership and I I just explained it that was an even distribution so each of them is going to show 40 thousand dollars as their respective share the other persons of interest is this part to information about the partner and we've entered the partners identifying information we should have an address in here as well I've just simply described it as jazia or Kiera but you are supposed to enter their full name and address and then we describe the type of partner this is Jadzia is a general partner or LLC member manager she is also a domestic partner she is an individual she was and is 50% ownership in profits loss and capital and then we go down to the partners capital account this is going to correspond to information that was reported on Schedule L and it should be that the sum totals of the hey ones should coincide to the totals entered on schedule L and can see right here the ending capital account of the partner should equal the amount shown on line 9 of schedule M 2 and if we take schedule M 2 and show that it's 9000 and $50 this is where we get 5050 to each of them in this particular case but there's no rule that says they're going to be 50/50 on their schedule L on their k1 so it just happens to be in this illustration that they are that takes us in the next topic which is adjusted basis in the partnership a partnership interest is an item of property and like any other form of property it has a basis for tax purposes a partner's basis and his or her partnership interest is referred to as outside basis initial basis and a partnership can be established in the following ways upon formation of the partnership a partner's initial outside basis will generally equal the amount of money and the adjusted basis of property contributed if the partner purchases his or her partnership interest and the outside basis will equal the purchase price a partnership interest may be acquired by means of an inheritance or a gift outside basis is made up of two components tax capital accounts and the partner share of partnership liabilities generally the sum of the partners outside basis will be equal to the partnerships inside basis in its asset on a balance sheet asked equal liabilities plus owner's equity and in the partnership assets equal liabilities plus the partnerships tax capital accounts inside basis although inside basis generally equals total outside basis some distributions of property from the partnership or transfers of partnership interest can disrupt this equality and by applying procedures provided for under Internal Revenue Code section 754 the partnership can make upward or downward adjustments to the basis of its assets in order to restore normal equality in the balance sheet and thus recreate the equality between inside and outside total basis adjustments to basis a partner must report his or her tribute of share a partnership income in his or her taxable year in which or with which the partnership taxable year ends that may or may not be the same year in which he or she receives a distribution of cash or property in other words a partner must report his or her distributive share of partnership income regardless of whether that income is actually distributed now as a general rule when a partner transfers property to a partnership gain or loss is not recognized additionally a partner does not generally recognize gain or loss upon receiving distributions from a partnership unless the distribution is a cash distribution that is in excess of the partners basis in his or her partnership interest also called the outside basis it is considered to be the responsibility of each partner to maintain records which show his or her basis in the partnership however the partnership also can track the partnership basis and this is where things can get complicated for the tax preparer because if we're not preparing the partnership return we don't know if the partnership has been accurately tracking that partners basis and the odds are that the partner doesn't know either so there should be some discussion going on about the partnership basis how a partner acquired an interest in a partnership and you really need to be hearing from the partner that they contributing to toxa belabor to the partnership for which they were paid but the money stayed in the partnership and we wouldn't have been paid but at any rate they were given an interest in the partnership in exchange for their work the partnership kept the money and gave him the interest and then that would have been treated as payments to them those are things that would increase their basis so a partners basis is increased by the following items the partners additional contributions to the partnership including an increased share or assumption of partnership liabilities the partners distributed share of taxable and non-taxable partnership income the partners distributive share of the excess of deductions for depletion over the basis of the depletable property unless the property is an oil or gas well whose basis has been allocated to the partners and a partner's basis in the partnership will be decreased but never below zero by the following items the money including the decreased share of partnership liabilities or an assumption of the partners individual liabilities by the partnership and adjusted basis of property distributed to the partner by the partnership the partners distributive share of the partnership losses including capital losses the partners distributive share of non-deductible partnership expenses that are not capital expenditures this includes the partner share of any section 179 expenses even if the partner cannot deduct the entire amount on his or her individual tax return and finally the partners deduction for depletion of any partnership oil and gas wells up to the proportionate share of the adjusted basis of the wells that are allocated to that partner now the IRS does provide a worksheet for figuring the adjusted basis of a partner's interest in the partnership and there are some basis rules that I will leave you to read on your own but if you're trying to determine a partner's basis in a partnership this worksheet is provided for helping you to do that and then there are some rules and explanations on how to do the worksheet and I've done a worksheet for Jadzia and Kyra each of them and we're going to determine the basis that each of them has index LLC as we see here you can see I've listed the name of the partner and I begin by showing that partners adjusted basis at the end of 2013 and for Kyra that was $5000 then on line three through five I show Kira's 50% share of amounts that are flowing through to her on Schedule K firstly her share of the business income her share of the portfolio in can we add those amounts to her opening basis and were left with 50,000 and $25 we then subtract out distributions she received during the year of 40,000 we also subtract out her 50% share of non deductible expenses and when we do that we're left with ninety seven hundred and seventy-five dollars and and down here at the bottom of line ten we enter on line ten H $250 which is her 50% share of the amount contributed to charity as well as five thousand dollars which is her fifty percent share of the section 179 deduction these further reduced her basis in the partnership because they are going to be allowed as deductions where should be allowed as deductions on her return and so they further reduced her basis in the partnership down to forty five hundred and twenty five dollars we have a similar worksheet following all of the similar line of reasoning for Jadzia and then down at the bottom the software that we use Drake software actually produces a reconciliation worksheet and you just want to see that the amount showing for each partners basis actually equally not shown on the tax return and then partnership portfolio income and rental income we're really at the end of today's class but I've got to two additional items that I wanted to talk to you about briefly before we wrap it up and I think with ten minutes we actually have enough time for that which is good on portfolio income and rental income as you recall I told you the page one of form 1120s and 1065 these are used to report income from the business activity of the S corporation or partnership and in most interest instances the business activity will not include income from rental real estate activities or from portfolio income each of these items are treated and reported separately on the S corporation and partnership returns so what is portfolio income well generally portfolio income includes all income other than income derived in the ordinary course of a trade or a business that is attributable to interest dividends royalties income from a real estate investment trusts a regulated investment company a real estate mortgage investment conduit a common trust fund a controlled foreign corporation or a qualified electing fund or furtive or income from disposition of property that produces income of a type that is defined as portfolio income and income from the disposition of property that is held for investment so how do you report portfolio income will you report portfolio income on form 1065 page for Schedule K on lines 5 through 10 and on form 1120s you reported on page 2 of Schedule K lines four through nine do not include portfolio income on page 1 of either form 1065 or 1120s if the corporation or partnership sold capital gain or lost property during the year you should attach Schedule D and/or form 47 97 as required net income from capital gains is not included in the ordinary income of the business and do not include capital gain income on page 1 a form 1065 or 1120s reporting rental income and expenses of an LLC or S corporation in most cases rental income is a passive activity not included in an ordinary income of the business rental income and expenses are therefore not reported on page 1 instead follow these instructions to report rental income and expenses of a partnership or S corporation in step 1 you will attach Form 88 25 to the S corporation or partnership return 2 separately report income and deductible expenses from rental real estate activities and the net income or loss from rental real estate activities that flow through from partnerships estates or trusts you will report net rental real estate income on form 1065 or 1120s on schedule K line 2 then in step 2 you will report on form 1065 or 1120s schedule K line 3 see the net income or loss from rental activities other than those reported on Form 88 25 and this includes the gain or loss from line 17 of formed 47 97 that is attributable to the sale exchange where involuntary conversion of an asset that was used in rental activity other than a rental real estate activity you would need to attach a statement passive activity lost rules passive activity loss rules apply to rental losses of S corporations and partnerships and those shareholders or partners who actively participate in a rental realistic tivity may be able to deduct part or all of their rental real estate losses and the deduction equivalent of rental real estate credits against income or tax from non passive activities net income or loss from rental activities of an S corporation are reported on form 1120s schedule K lines 2 through 3c and net income or loss from rental activities of a partnership are reported on 1065 schedule k also on lines 2 through 3c net income or loss from rental activities then flows through on a pro-rata basis to form 1120s schedule k-1 or 1065 schedule k-1 and then on to each partner or shareholder and generally the combined amount of rental real estate losses and the deduction equivalent of rental real estate credits from all sources of each individual partner or shareholder are going to be subject to the rules affecting passive activity lost income that is that passive activity losses must be offset by passive activity income but in certain situations individual partners and shareholders may be able to select up to 25,000 the rental real estate activities on their individual returns and we get into passive activity loss of limits and another course that I teach called at-risk limits and passive activity loss limits I also have another course I teach on rental property so those are the courses where I really talk about these types of activity lost rules you can take those courses you can read up on them on your own but the bottom line is the reason that the IRS has you divide out and separately report rental real estate income is because that income is automatically deemed to be passive income or loss and as such it can only be used to offset other passive activity income or loss unless that partner is deemed to be an active participant in a rental real estate activities and their income is low enough that they qualify to deduct certain amounts with a maximum of 25,000 per year now if you are reporting rental real estate income you're going to need to complete form 88 25 you can see it's rising up here at the bottom of the screen net income or loss from form 88 25 is shown on line 2 of the schedule K you report credits related to rental real estate activities on line 15 C and 15 D of Schedule K you report low in come housing credits online 15 D of schedule K and K 1 and online 13 B 13 C and 13 D if the k1 is for an S corporation rather than a partnership so let's take a look at a late 25 if you're thinking and you have an image in your head of Schedule E which is used on individual returns you'll recollect that Schedule E actually has room to enter three separate properties that 88 25 actually has room for eight properties there are four on each of its two pages so page one has room for four properties and then page two has room for more properties and then forum 88 25 if you run out of space you just keep adding additional forms now there are some other rules to be aware of the number of columns to be used for reporting income and expenses on this form can differ from the number of rental real estate activities the partnership or S corporation has for purposes of passive activity limitations for example a partnership owns two apartment buildings and each is located in a different City for purposes of passive activity limitations the partnership grouped both buildings into a single activity although the partnership has only one rental real estate activity for purposes of the passive activity limitations it must report the income and deductions for each building in separate columns of form 88 25 you should see passive activity reporting requirements in the instructions for form 1065 form 1065 b or form 1120s for more information you should complete lines 1 through 17 for each property but complete lines 18 a true 21 only on one form 88 25 because these figures should be the combined totals for all of the forms do not report on Form 88 25 any income or deductions from a trade or business activity or rental activity other than a rental real estate activity cuz V diet these items are reported elsewhere also do not report portfolio income or deductions the section 179 deduction other items that must be reported separately to the partners or shareholders or commercial revitalization deductions and finally we're going to close out this lecture with a discussion of the grouping of activities when you are preparing a partnership return you should be aware that you are allowed in certain situations to group activities but only if the grouping of those activities does not in any way disguise or hide passive activities inside a non passive activity or vice-versa so generally one or more trader business activities or rental activities may be treated as a single activity if the activities make up an appropriate economic unit for measurement of gain or loss under the passive activity rules whether activities make up an appropriate economic unit depends on all of the relevant facts and circumstances the factors given the greatest weight in determining whether activities make up an appropriate economic unit are the similarities and differences in the types of the trades or businesses the extent of common control the extent of common ownership the geographical location and the reliance between or among the activities for example ten-forward LLC owns a hotel and a restaurant in Eugene Oregon and a hotel or end restaurant in Vancouver Washington ten-forward might group the business activities in any of the following ways a single activity a hotel activity and a restaurant activity a Eugene activity and event Coover activity or four separate activities ten-forward LLC can select any grouping that accurately reflects income and expenses of his business activities once it chooses a grouping it must continue using that grouping in later tax years unless a material change in the facts and circumstances makes it clear that a change in grouping is appropriate the IRS make regroup the Corporations activities if ten forwards grouping fails to reflect one or more appropriate economic unit and one of the primary purposes of the grouping is to avoid the passive activity limitations the limitation on there is a limitation on the grouping of certain activities though the following activities may never be grouped together a rental activity with a trade or business activity or an activity involving rental of real property with an activity involving the rental of personal property and that's it for today's class I'm going to put up the final password I'm going to put a link in the chat box so that you can go take the password test because you do need to take the password test now as I'm signing off with you today I did want to point a classic assignment and this classic assignment is going to be how we open the second part of this course when we get into introduction to F corporations and LLC's part two I'm gonna open that session by completing this classic assignment with you so if you're gonna be coming back for part two of this course that is where we're going to do a review of this assignment and the answer key for this assignment can be found inside the LMS but you will learn more if you work your way through it so I encourage you to use the time between this class and the next class to read through this classwork assignment and then prepare a tax return for then Foley LLC part two of this class is going to be all about the S corporation return but we are going to open up part two with a review of a 1065 return because that is the return that you're going to prepare for then Foley LLC as a part of this class work assignment and then after we've done the then Foley exercise we're gonna do the comparison of 1065 to 1120 F and then we're gonna burrow into 11 20s and do a whole bunch of illustrations of how to complete form 1120s all right thank you for participating in today's class and I hope to see you again soon bye bye password number 3 is Android a and D are o ID Android we hope you've enjoyed this tax education class Pacific Northwest tax school is approved as a CD provider by the IRS and the states of Oregon New York and Texas we have been awarded the quality assurance standards by NASA and meet the sea Eirik wireman for CPAs in most US states and territories tax clients demand knowledge and experience Pacific Northwest tax school provides the in-depth practical education needed to improve your understanding of tax law and to meet the demands of the competitive tax preparation industry

Channel: Pacific Northwest Tax School

Views: 213,635

Keywords: IRS CE, How to prepare form 1120S, How to prepare Form 1065, What form does LLC file?, H&R Block Tax Course, WesternCPE, AICPA, Certified Public Accountant (Profession), IRS enrolled agent course, CPE for EAs, NASBA, QAS, checkpointlearning.thomsonreuters, mypescpe.com/, cpenow.com, S corporation tax course, partnership tax course, s corporation tax class, partnership return tax class, S Corporation (Organization Type), Limited Liability Company (Organization Legal Structure)

Id: gP5oRk2YNyk

Length: 205min 51sec (12351 seconds)

Published: Sat Oct 10 2015