Individual Tax Case Study
Facts
Age: 60
Marital status: Single
Bob recently retired from IBM and has $690,000 available from his 401(k) fund. He plans on using the money to open a used car business. The business will be located at 210 Ocean View Drive in Pensacola, Florida. The estimated taxable income from the business might be $300,000. Bob’s individual wealth including investments in stocks, bonds, and land is approximately $14,000,000. Last year, Bob reported a dividend income of $6,000 and an interest income of $20,000. The $14,000,000 comprises of land worth $9,000,000 that Bob bought for $450,000 in 1966. Bob wonders whether he should operate the used car business as a C corporation, an S corporation, a partnership, or a sole proprietor. Furthermore, in his new business, Bob is considering transferring a possible 40% interest to his daughter Mandy, age 23 and single.
Type of business entity
Before starting a business, owners must choose a business structure or a type of entity (Phillips, n.d.). The type of business entity determines how taxes are filed, who bears liability and the accounting methods to use for the business. Taxation, liability and recordkeeping thus determine the type of business entity you choose (IRS, 2012). Therefore, it is important to research the difference between the choices before making a decision since each choice has legal and tax implications.
A sole proprietorship is the simplest form of business entity to set up (Phillips, n.d.). It places all the liabilities for operations and finances on the business owner. If the business experiences financial hardships then the owner assumes the risk against his personal assets since his personal property is tied to the business. The business owner must file self-employment taxes and annual income tax returns on the Form 1040. Sole proprietors file Schedule C or C-EZ with their Form 1040 (IRS, 2012). The losses and profits of the business are taxed at the individual rate and are reported through the owner. In this business entity, for the owner to retrieve his investment, he must sell his business (Phillips, n.d.).
A partnership consists of two or more owners who have equal control unless the business structure is a limited partnership or the agreement states otherwise (Phillips, n.d.). The losses and profits of the business are taxed at the individual rate and flow to the partners. The operating partners assume the financial and legal risks. Existing debts can be collected from the partners’ personal property. The only way to get back an investment is to sell your interests (as a partner) in the business (Phillips, n.d.).
A corporation has an unlimited number of owners (shareholders) (Phillips, n.d.). This business entity is separate from the owners in financial and legal issues. The losses and profits of the business are taxed at corporate rates and not individual rates (Phillips, n.d.). In case the business realizes a profit, it is paid to the shareholders as dividend, who then report it as income and are taxed at the individual rates. To recoup an investment in a private corporation, a shareholder has to sell his interest while in a public corporation a shareholder can trade his interests in the open market (Phillips, n.d.).This type of corporation is also known as a C (chapter) corporation (Incorporate.com, n.d.).
An S corporation offers limitations on the number of possible shareholders (Incorporate.com, n.d.). Additionally, these shareholders have to be United States residents or citizens. Business debts are separate from personal assets. The tax and legal structures are independent and separate from their owners. However, the losses and profits of the business are reported on the owners’ personal tax returns, processed at individual rates (Incorporate.com, n.d.).
Despite these three structures, there is a Limited Liability Company (LLC) which is a hybrid between a partnership and a corporation (Phillips, n.d.). Like a corporation, the LLC protects the owner from personal liability and offers the tax advantages of a partnership. A single-member LLC uses sole proprietorship forms while multiple member LLCs use partnership forms. If an LLC elects to be treated as a partnership or corporation, a federal Employer Identification Number (EIN) is a prerequisite (1-2-Law.com, n.d). However, if it chooses to be taxed as a sole proprietorship a social security number is enough without necessarily producing the EIN (stateofflorida.com, 2015).
I recommend that Mr. Jones opens his new used car business as an LLC. This option protects his person assets (worth $14,000,000) which currently are worth more than his startup capital for his new business even if it is projected to grow. This will release him from any personal liability and taxation will be at the individual rates. An LLC is easy to form in Pensacola Florida since it requires minimal paperwork. And as a single member LLC, he is not required to obtain an EIN. It is easy to integrate his daughter Mandy at any time of his choosing since LLC allow for multiple classes of ownership interest. At this point the business may transform into a series LLC (1-2-Law.com, n.d.) or a multiple member LLC. Hence, he can elect to be treated as a partnership or an S or C corporation. Mr. Jones is required to fill Form 1040 for individual income tax return and attach schedule C since he is treated as a sole proprietorship. He is required to fill Form 1065 for return of partnership income (for information only) if the LLC has multiple members (Bizfilings, n.d.).
Accrual accounting set against cash basis
The aggregated results over time of accrual accounting and cash basis are the same (Bragg, 2014). However, these two accounting methods have a time difference in the recognition of revenues and expenses. In cash basis, the expenses are logged in only when cash is paid to employees and supplies and revenue is recorded after cash is received from customers. In accrual accounting, expenses are documented when consumed and revenues after being earned.
Revenue recognition on the sale of inventory.
Under the cash basis, recognition of expenses and revenue (sale of inventory) is delayed until for example a supplier invoice is paid or customers’ payments arrive (Bragg, 2014). The cash basis accounting can only be used by businesses whose sales per year do not exceed $5 million. It is the simplest and easiest method to use to account for transactions since it does not involve complex transactions such as accrual and deferrals. Therefore, it is broadly used by many small businesses. Nevertheless, the relatively random timing of cash expenditures and receipts results in unusually low and high profits.
Accrual accounting is used by large companies for tax reporting for sales that exceed $5 million. Additionally, this method is preferred by large businesses because it is the only way their financial statements can be audited, their financial statements have to be prepared using accrual basis. Accrual basis allows these companies to truly discern their profitability since it mostly offers matching expenses and revenues for the same reporting time period. Nevertheless, without inclusion of cash flow statements in the financial statements, this technique does not reveal the ability of a business to make money (Bragg, 2014).
Economic impact and potential tax liability
An LLC offers its owners limited personal liability for the actions and debts of the LLC (IRS, 2012). This is important to the economy because it encourage investments. People will invest in the form of limited liability companies because of the separation of business and personal assets. This means that the personal assets of an individual are not at risk owing to the actions of the LLC because they are regarded as different entities. This characteristic encourages investments because people know that their personal assets are safe. Furthermore, it provides the benefits of pass-through taxation and management flexibility. The protection against double taxation also has potential benefits to the economy. Contrary to the argument that the economy taxes in the short-term, the long-term perspective holds that the money can be invested back into the economy to benefit from a multiplier effect.
The tax consequences of the exchange or sale of the land
Land meets the aspects of the definition of capital assets. This means that sale of land is subjects to the capital gains rules with regards to the tax treatment of the income of such a sale. The capital gains in the sale of the land would be the price for which he bought the land subtracted from the price for which he sold the land. The capital net gains are the difference above minus the fees of the brokers and the costs associated with selling the land. It is upon the net capital gains that the taxes are applied.
Limited liability protection
It is important that the client chooses a business entity whose legal structure provides him a limited liability protection. The personal wealth of the client is more valuable than the investment he is making in the business and the taxable income. It is important that the personal assets and business assets are regarded separately. This is because all business are subject to uncertainties and market dynamics that may result in the seizure of his assets to meet any liabilities they business incurs as would be in a sole proprietorship. Additionally, the division of the profits between the client and the daughter would be subject to their unique criteria because limited liability companies do not issue stocks like other companies do. So, the division of profits is not done on the basis of the quantity of stock.
Tax effects and personal tax return
Even though the limited liability companies are regarded as different entities with the owners with regards to liabilities, their tax treatment of this entity does not assume the same concept. The limited liability companies do not remit taxes to the government as distinct business entities (Fishman, 2016). Instead, the profits and losses of the limited and liability company are reported on the personal tax return forms of the members who own the limited liability company.
In this case, the tax treatment of a limited liability company is similar to that of a sole proprietorship where the owner pays for the taxes depending on the total income including that from the business (Fishman, 2016). However, this is dependent on the quantity of the members who own the limited liability company. With regards to the effect of the tax treatment on the personal tax returns of a member of the limited liability company, the said member reports the profits and losses that the limited liability company made within a particular fiscal period on the individual’s personal income tax return. This form is them filed together with the 1040 tax return (Fishman, 2016).
References
1-2-Law.com. (n.d.). Frequently Asked Questions about a Limited Liability Company (LLC) in Pensacola, FL. Retrieved from: https://www.12law.com/article/city-pensacola-fl-frequently-asked-questions-about-a-limited-liability-company-llc.aspx, 21st February 2016
Bizfilings. (2015, January 09). Tax Year and Accounting Method Choices Affect Your Tax Picture. Business Owner’s Toolkit, Business Filings Incorporated. Retrieved from: http://www.bizfilings.com/learn/taxes-business-types.aspx, 21st February 2016.
Bizfilings. (n.d.). Compare Tax Considerations by Business Type. Business Filings Incorporated. Retrieved from: http://www.bizfilings.com/learn/taxes-business-types.aspx, 21st February 2016.
Bragg, S. (2014, February 10).Cash Basis vs. Accrual Basis Accounting. Accounting tools. Retrieved from: http://www.accountingtools.com/questions-and-answers/cash-basis-vs-accrual-basis-accounting.html, on 21st February 2016.
Fishman, S. (2016). Tax deductions for professionals. Berkeley. Carlifornia.
Griffin-Spalding Chamber of Commerce. (2013). A Guide to Starting a Business in Griffin-Spalding County. Retrieved from: http://www.griffinchamber.com/wp-content/uploads/2012/04/Griffin-Spalding-Business-Guide2.pdf, on 21st February 2016.
Incorporate.com. (n.d.). Business Entity Types. The Company Corporation. Retrieved from: https://www.incorporate.com/business_structures.html, on 17th February 2016.
Internal Revenue Service. (2011). Ten Important Facts About Capital Gains and Losses. Retrieved from https://www.irs.gov/uac/Ten-Important-Facts-About-Capital-Gains-and-Losses on 21st February 2016
IRS. (2012, August 17). Choosing a Business Structure. Retrieved from: https://www.irs.gov/uac/Choosing-a-Business-Structure, on 17th February 2016.
Phillips, C.(n.d.). The Three Types of Business Entities in Accounting. Demand Media. Houston Chronicle, Small Business Retrieved from: http://smallbusiness.chron.com/three-types-business-entities-accounting-10242.html, on 17th February 2016.
stateofflorida.com. (2015, January 01). How to Start A Business In Florida. Retrieved from: http://www.stateofflorida.com/corporations.aspx, on 21st February 2016.
