The net amount (profit or loss after offsetting income with deductions) is then reported as part of the income section on page 1 of your Form 1040. Such individuals may be able to use a simplified form for reporting business income and deductions: Schedule C-EZ, Net Profit From Business (see Figure 1.2). Individuals engaged in farming activities report business income and deductions on Schedule F, Profit or Loss from Farming, the net amount of which is then reported in the income section on page 1 of Form 1040. Individuals who are considered employees cannot use Schedule C to report their income and claim deductions. See page 28 for the tax treatment of income and deductions by employees.
Figure 1.1 Schedule C, Profit or Loss From Business
Figure 1.2 Schedule C-EZ, Net Profit From Business
Partnerships and Limited Liability Companies
If you go into business with others, then you cannot be a sole proprietor (with the exception of a spousal joint venture, explained earlier). You are automatically in a partnership if you join together with one or more people to share the profits of the business and take no formal action. Owners of a partnership are called partners.
There are 2 types of partnerships: general partnerships and limited partnerships. In general partnerships, all of the partners are personally liable for the debts of the business. Creditors can go after the personal assets of any and all of the partners to satisfy partnership debts. In limited partnerships (LPs), only the general partners are personally liable for the debts of the business. Limited partners are liable only to the extent of their investments in the business plus their share of recourse debts and obligations to make future investments. Some states allow LPs to become limited liability limited partnerships (LLLPs) to give general partners personal liability protection with respect to the debts of the partnership.
Example
If a partnership incurs debts of $10,000 (none of which are recourse), a general partner is liable for the full $10,000. A limited partner who initially contributed $1,000 to the limited partnership is liable only to that extent. He or she can lose the $1,000 investment, but creditors cannot go after personal assets.
General partners are jointly and severally liable for the business's debts. A creditor can go after any one partner for the full amount of the debt. That partner can seek to recoup a proportional share of the debt from other partner(s).
Partnerships can be informal agreements to share profits and losses of a business venture. More typically, however, they are organized with formal partnership agreements. These agreements detail how income, deductions, gains, losses, and credits are to be split (if there are any special allocations to be made) and what happens on the retirement, disability, bankruptcy, or death of a partner. A limited partnership must have a partnership agreement that complies with state law requirements.
Another form of organization that can be used by those joining together for business is a limited liability company (LLC). This type of business organization is formed under state law in which all owners are given limited liability. Owners of LLCs are called members. These companies are relatively new but have attracted great interest across the country. Every state now has LLC statutes to permit the formation of an LLC within its boundaries. Most states also permit limited liability partnerships (LLPs) – LLCs for accountants, attorneys, doctors, and other professionals – which are easily established by existing partnerships filing an LLP election with the state. A partner in an LLP has personal liability protection with respect to the firm's debts, but remains personally liable for his or her professional actions.
Alabama, Delaware, District of Columbia, Illinois, Iowa, Kansas, Minnesota, Missouri, Montana, Nevada, North Dakota, Oklahoma, Tennessee, Texas, Utah, and Wisconsin (to a limited extent) permit multiple LLCs to operate under a single LLC umbrella called a “series LLC” (each LLC is called a “cell”). (California doesn't allow the formation of a series LLC but permits one formed in another state to register and do business in the state.) The rules are not uniform in all of these states. If you are in a state that does not have a law for series LLC, in most but not all states you can form the series in Delaware, for example, and then register to do business in your state. The debts and liabilities of each LLC remain separate from those of the other LLCs, something that is ideal for those owning several pieces of real estate – each can be owned by a separate LLC under the master LLC as long as each LLC maintains separate bank accounts and financial records. At present, state law is evolving to determine the treatment of LLCs formed in one state but doing business in another.
As the name suggests, the creditors of LLCs can look only to the assets of the company to satisfy debts; creditors cannot go after members and hope to recover their personal assets.
Partnerships are pass-through entities. They are not separate taxpaying entities; instead, they pass income, deductions, gains, losses, and tax credits through to their owners. More than 27.7 million partners file more than 3.6 million partnership returns each year. Of these, 67.4 % are limited liability companies, representing the most prevalent type of entity filing a partnership return; more common than general partnerships or limited partnerships. The owners report these amounts on their individual returns. While the entity does not pay taxes (except to the extent of certain adjustments following an audit as explained in Chapter 33), it must file an information return with IRS Form 1065, U.S. Return of Partnership Income, to report the total pass-through amounts. Even though the return is called a partnership return, it is the same return filed by LLCs with 2 or more owners who do not elect to be taxed as a corporation. The entity also completes Schedule K-1 of Form 1065 (Figure 1.3), a copy of which is given to each owner. The K-1 tells the owner his or her allocable share of partnership/LLC amounts. Like W-2 forms used by the IRS to match employees’ reporting of their compensation, the IRS employs computer matching of Schedules K-1 to ensure that owners are properly reporting their share of their business's income.
NOTE
K-1s can be distributed to partners electronically if the partnership has the partners' consent. Obtain consent by sending instructions to partners on how to obtain, complete, and submit a consent form to the partnership.
Figure 1.3 Schedule K-1, Partner's Share of Income, Deductions, Credits, etc.
For federal income tax purposes, LLCs are treated like partnerships unless the members elect to have the LLCs taxed as corporations. This is done on IRS Form 8832, Entity Classification Election. See Figure 1.4. For purposes of our discussion throughout this book, it will be assumed that LLCs have not chosen corporate tax treatment and so are taxed the same way as partnerships.
