impact on the tax consequences of the sale. The sale of a sole proprietorship is viewed as a sale of the underlying assets of the business; some may produce ordinary income while others trigger capital gains. In contrast, the sale of qualified small business stock, which is stock in a C corporation, may result in tax-free treatment under certain conditions. Sales of business interests are discussed in Chapter 5.
If the termination of the business results in a loss, different tax rules come into play. Losses from partnerships and LLCs are treated as capital losses (explained in Chapter 5). A shareholder's losses from the termination of a C or S corporation may qualify as a Section 1244 loss – treated as an ordinary loss within limits (explained in Chapter 5).
If the business goes bankrupt, the entity type influences the type of bankruptcy filing to be used and whether the owners can escape personal liability for the debts of the business. Bankruptcy is discussed in Chapter 25.
Forms of Business Organization Compared
So far, you have learned about the various forms of business organization. Which form is right for your business? The answer is really a judgment call based on all the factors previously discussed. You can, of course, use different forms of business organization for your different business activities. For example, you may have a C corporation and personally own the building in which it operates – directly or through an LLC. Or you may be in partnership for your professional activities, while running a sideline business as an S corporation.
Table 1.4 summarizes 2 important considerations: how the type of business organization is formed and what effect the form of business organization has on where income and deductions are reported.
Table 1.4 Comparison of Forms of Business Organization
Changing Your Form of Business
Suppose you have a business that you have been running as a sole proprietorship. Now you want to make a change. Your new choice of business organization is dictated by the reason for the change. If you are taking in a partner, you would consider these alternatives: partnership, LLC, S corporation, or C corporation. If you are not taking in a partner, but want to obtain limited personal liability, you would consider an LLC (if your state permits a one-person LLC), an S corporation, or a C corporation. If you are looking to take advantage of certain fringe benefits, such as medical reimbursement plans, you would consider only a C corporation.
Whatever your reason, changing from a sole proprietorship to another type of business organization generally does not entail tax costs on making the changeover. You can set up a partnership or corporation, transfer your business assets to it, obtain an ownership interest in the new entity, and do all this on a tax-free basis. You may, however, have some tax consequences if you transfer your business liabilities to the new entity.
But what if you now have a corporation or partnership and want to change your form of business organization? This change may not be so simple. Suppose you have an S corporation or a C corporation. If you liquidate the corporation to change to another form of business organization, you may have to report gains on the liquidation. In fact, gains may have to be reported both by the business and by you as owner.
Partnerships can become corporations and elect S corporation status for their first taxable year without having any intervening short taxable year as a C corporation if corporate formation is made under a state law formless conversion statute or under the check-the-box regulations mentioned earlier in this chapter.
Before changing your form of business organization, it is important to review your particular situation with a tax professional. In making any change in business, consider the legal and accounting costs involved.
Tax Identification Number
For individuals on personal returns, the federal tax identification number is the taxpayer's Social Security number. For businesses, the federal tax identification number is the employer identification number (EIN). The EIN is a 9-digit number assigned to each business. Usually, the federal EIN is used for state income tax purposes. Depending on the state, there may be a separate state tax identification number.
If you are just starting your business and do not have an EIN, you can obtain one instantaneously online using an interview-style application at www.irs.gov (search “EIN online”) or by filing Form SS-4, Application for Employer Identification Number, with the IRS service center in the area in which your business is located. Application by mail takes several weeks. An SS-4 can be obtained from the IRS website at www.irs.gov or by calling a special business phone number (800-829-4933) or the special Tele-TIN phone number. The number for your service center is listed in the instructions to Form SS-4. If you call for a number, it is assigned immediately, after which you must send or fax a signed SS-4 within 24 hours.
If you change your business entity (e.g., from a sole proprietorship to an S corporation), you usually need to obtain a new EIN. You can determine whether you need a new EIN at www.irs.gov (search “do you need a new EIN?”).
SPECIAL RULES FOR SOLE PROPRIETORS
Because sole proprietors report their business income and expenses on their personal returns, they may not be required to use an EIN. Instead, they simply use their Social Security number for federal income tax reporting.
A sole proprietor must use an EIN if the business has any employees or maintains a qualified retirement plan. A sole proprietor may need an EIN to open a business bank account (it depends on the institution). An EIN can also be used in place of a Social Security number by an independent contractor for purposes of Form 1099-MISC reporting (a consideration today with concerns about identity theft). A sole proprietor should use an EIN as a way in which to build a business credit profile in order to qualify for credit without relying entirely on the owner's credit history and personal guarantee.
A single-member limited liability company, which is a disregarded entity taxed as a sole proprietorship (unless an election is made to be taxed as a corporation) for income tax purposes, must obtain an employer identification number and use the number issued to the entity (and not the EIN issued to the owner's name).
CHAPTER 2
Tax Year and Accounting Methods
Alert
At the time this book was completed, Congress was considering important tax changes that could affect 2017 tax returns and planning for 2018. Check the online Supplement in February 2018 at www.jklasser.com or www.barbaraweltman.com to see what changes have been enacted and when they are effective.
Once you select your form of business organization, you must decide how you will report your income. There are 2 key decisions you must make: What is the time frame for calculating your income and deductions (called the tax year or accounting period), and what are the rules that you will follow to calculate your income and deductions (called the accounting method). In some cases, as you will see, your form of business organization restricts you to an accounting period or accounting method. In other cases, however, you can choose which method is best for your business. Depending upon circumstances, you may want to need to change your accounting method. Sometimes making a change is easy, with automatic procedures; other situations require IRS consent, as you will see later in this
