According to the U.S. Department of Commerce, about 17.5 million U.S. companies currently operate in this country. Business ownership In the United States takes one of three basic forms:
Beyond these basic descriptions, we will discuss each type more fully in later Chapters. The most prevalent type of business ownership in the U.S. is the sole proprietorship, trailed distantly by corporations and, finally, partnerships.
As an insurance agent who wants to enter or to grow in the business insurance marketplace, you must first of all know who your prospects are. Then, you must know what kinds of challenges each business prospect faces in order to identify needs that insurance can fill. And, you must have a working knowledge of the financial implications, including taxation, of various types of insurance solutions to business problems based on the type of business ownership.
As you penetrate the business markets, you are most likely to encounter sole proprietors by virtue of their greater numbers. And, as you will see, sole proprietors have unique problems not shared by other forms of business ownership. Some of these problems can be addressed by insurance products.
Corporations, the next largest group of business types, suggest bigness, but in fact, corporations can be any size in terms of numbers of people and production of income. Large or small, corporations also have unique insurance needs, some of which are related to the size of the business.
Partnerships may be comprised of as few as two people or an unlimited number. Some of a partnership's characteristics make it similar to a sole proprietorship, while others more closely resemble the corporate structure. Partnerships, too, are subject to unique needs for which insurance can provide solutions.
In the remainder of this chapter we will examine the financial and organizational implications of sole proprietorships and partnerships, in the next chapter we'll look at corporations. You will note many references to taxation throughout the text because forms of business ownership are inextricably linked to the Internal Revenue Code and Uncle Sam's interest in regulation and tax collection. After you have assimilated the basic concepts of each type of ownership, later chapters focus on identifying incentives for different types of businesses to purchase insurance and exploring the personal business, financial and tax consequences of a business owner's decision to act or not act on the needs identified
The sole proprietorship form of business ownership is not only the most popular in the U.S.; it is also the easiest to establish and to dissolve. A sole proprietorship also is usually the least costly in terms of start-up costs, aside from the costs of producing or acquiring inventory, buying or renting business real estate and other costs beyond simply establishing ownership. Depending on the type of business, a sole proprietor might pay local fees to obtain a retail merchant's license or perhaps a state board of health license for occupations such as cosmetology, food service and others. Sole proprietors, however, need not incur the legal costs that are associated with forming a partnership or a corporation. Both of which require preparation and filing of various legal documents.
By definition, a sole proprietorship is a business that has only one owner. In actual practice such a business may be owned by one person and his or her spouse who, if they file joint tax returns, are considered one person for taxation purposes. If even one additional person who is not a joint-filing spouse owns part of the business, however, it becomes a partnership, not a sole proprietorship. Others may work in the business, but they may not own any part of it if the business is to retain its sole proprietorship character. This section discusses unincorporated sole proprietorship.
Caution! In the following section and all parts of this text that deal with taxation, the material presents the basic and general tax applications for the situations being discussed as of this writing. The tax code is complex and changes frequently; it is subject to tax court rulings that clarify or, sometimes, further complicate the law. Within the past 8 years, there have been considerable changes in the tax laws, and these changes are addressed within the text where they are applicable.
Additionally, any individual business may be involved in a variety of transactions that are taxed differently (or not taxed), depending on unique circumstances. The purpose of presenting tax information in this textbook is not to make you an expert in tax matters, but to present the general taxing considerations inherent in each type of business. Your clients must consult with attorneys or other tax experts to determine the tax consequences of all business decisions, including those that involve insurance funding.
For income tax purposes, a sole proprietor is the business; the proprietor and business are considered one and the same. For this reason, a sole proprietorship is often characterized as a "conduit" through which income flows directly to the owner.
Because income flows directly to the sole proprietor, only the owner pays income taxes on business income. There is no separate taxation on the business itself, though special tax forms must be included when the business owner files his or her individual income taxes to show the source of the income and any business expenses, such as overhead and employee wages. Deductions for all business expenses are attributed to the individual proprietor rather than to the business as a separate entity.
Recently, Congress has repeatedly enacted temporary measures that significantly raised the applicable exemption amounts above the 2000 limits. The very recent data available (2008) indicates that this exemption expired in 2006, therefore the exemption for 2007 and beyond has reverted back to the levels that existing prior to 2001. For married filing jointly, the exemption is reduced to $45,000 (down from $62,550; for single/head of household the exemption is $33,750 (down from $42,000); and for married filing separately, the amount is $22,500 (down from $31,275).
Unless there is congressional action, there are going to be many more taxpayers subject to the AMT as the result of their inaction. As of the moment Congress is looking at it, and it behooves life insurance agents to check IRS Publication 553 (Highlights of 2007 tax changes) and it can be obtained on www.irs.gov. From there, one can access AMT Assistance for Individuals and enter specific information in order to determine the AMT for 2008.
If you operate a business as a sole proprietor, you must file Schedule C to report your income and expenses from your business. If you operate more than one business, or if you and your spouse owned separate businesses, a separate Schedule C must be filed for each business. This is of particular interest as full-time life insurance sales representatives, long with certain other "statutory employees" you are considered an employee for Social Security and Medicare purposes; however, federal income tax withholding is optional. A statutory employee must report his wages on Schedule C.
A sole proprietor files taxes as an individual on Form 1040. The advantages of a sole proprietor is that losses can be reported, and if there is a net operating loss, it can be carried back or carried forward to offset income in other years. Generally, a net operating loss can be carried back 2 years and forward for 20 years. There are exceptions, such as net operating losses occurring in 2001 and 2002 can be carried back for 5 years. Again, this is time for tax expertise.
Self-employment tax is composed of a Social Security tax of 12.4% and a Medicare tax of 2.9%—note that these percentages can change with new legislation. The maximum amount of wages and/or self-employment tax subject to the Social Security part of the self-employment tax is $97,500, but all net earnings are subject to Medicare portion of the self-employment tax.
This is not a "do-it-yourself tax manual," but to put taxation of self-employment in proper prospective, in a nutshell, filing taxes under the regular method would start by calculating the net self-employment income (generally the net profit from the business). Using Schedule SE, determine how much is subject to self-employment tax—usually 92.35% of net self-employment income.
Then the self-employment tax is calculated. For 2007, as an example, if net earnings and wages and tips are not more than $97,500, multiply the net earnings by 15.3% which will give you your self employment tax.
IF there are no wages or tips, and net earnings are more than $97,500, then the basic method is to multiply the net earnings by 2.9% for Medicare tax, add the result to $12,090 (12.4% of $97,500) and that is your self employment tax.
IF wages and tips were received in 2007 and net earnings from self employment plus wages and tips are more than $97,500, a different form is used. Subtract total wages and tips from $97,500 to find the maximum amount of earnings subject to 12.4% Social Security part of the tax. If more than zero, multiply the amount by 12.4%, which gives you the Social Security tax amount. Then multiply your net earnings from self employment by 2.9%, which gives you the Medicare amount. The total of the Social Security tax amount and the Medicare tax amount result in the self-employment tax.
There are also optional methods for certain situation.
Start-up expenses are the costs of getting started in business before you actually begin doing business, and may include such things as advertising, travel, utilities, repairs, or employee wages. Start-up costs also include what is paid for investigating a prospective business and getting the business started, such as feasibility studies, analysis of available facilities, travel for business purposes, and salaries and costs of consultants and other professional services.
These costs can be substantial and as such, must bear close scrutiny of the IRS. Plus, if you go into business, start-up expenses of a trade or business are not deductible unless they are deducted according to certain IRS rules, such as a current deduction can be elected for a limited amount (up to $5,000) of start-up costs occurred in the year when the business started. This amount is reduced, but not below zero, by the amount by which the cumulative cost of start-up expenditures exceeds $50,000. The remained of the start-up costs can be claimed as a deduction over the next 15 years. If start-up costs are $5,000 or less, these expenses can be deducted in full in the year the business actively begins.
As indicated, there are a lot of IRS regulations that pertain to business taxation, and to try to compare the individual tax return to that of a Sole Proprietor, while there are some similarities, would be meaningless. Start-up costs are just one area in which there are large differences. However, as a note of interest, according to Ernst and Ernst Tax Guide, 2008, there has been substantial litigation in respect to when a business begins. The IRS, as one would expect, takes a conservative stand, but they have been litigated on this point. The generally accepted rules seems to be that even though a taxpayer has made personal commitments to starting a business and has spend considerable sums of money to that end over a considerable period of time, the IRS takes the position that he has actually not engaged in carrying on any trade or business until such time as the business has began to perform as a going concern and has performed those activities for which it was organized.
These start-up costs incurred after the start-up decision has been made are classified as capital expenditures and may be deductible in the year in which the attempt to go into business fails.
The Tax Relief and Health Care Act of 2006 (TRHCA), and the Small Business and Work Opportunity Tax Act of 2007 (SBWOTA), will impact the amount of taxes paid by individuals. TRHCA reinstated a number of provisions that had otherwise expired and that offered tax relief, while extending other soon-to-expire tax incentives. This new law expanded the ability for some taxpayers who had previously paid alternate minimum tax (AMT) to recover part of that tax previously paid as a tax credit. The amount of the new AMT refundable credit may even exceed a qualifying taxpayer's total tax due for the year. The SBWOTA created a number of tax incentives for businesses, but also expands the reach of the kiddies-tax starting in 2008.
It is important to note that many of the provisions in these bills will only be in effect for a short while as several of them are set to expire at the end of 2007 unless Congress acts to extend them…at this point no one can state for certainty what will happen. Therefore, these tax discussions may affect tax returns in the future by showing how new taxes may affect your individual tax situation.
Further, since this text addresses business use of life insurance, in-depth discussion of individual tax calculations are beyond the scope of this text, but basic are important nonetheless.
Continuing through 2010, the regular individual income tax rates above 10% and 15% are 25%, 28%, 33% and 35% (the top individual rates). However, unless Congress acts, these reduced rates will expire starting for tax years beginning after Dec. 31, 2010. These rates also pertain to trusts.
Alternate Minimum Tax will be discussed later in this text as there have been considerable changes in this tax and how it is applied.
The 2004 tax act extended the size of the 10% rate bracket through 2010. The size of this bracket is $7,000 for single individual, with annual indexing for inflation for all years after 2003 (in 2006 it was $7,550 and $7,825 in 2007). After 2010, the 10% bracket will expire entirely.
The top individual rate on long term capital gains which had been 20% (10% for taxpayers in the 10% and 15% bracket)—is 15% (zero for those in the lower brackets) for years 2008, 2009 and 2010. After 2010, these rates revert back to the old and higher rates. These rates apply to both the regular tax and the alternative minimum tax, and apply to assets held more than one year.
Certain dividend income, considered as "Qualified Dividend Income," is taxed at a maximum rate of 15%. The 2006 tax law extended this lower maximum rate through 2010—prior to 2003 both dividends and interest was taxed at ordinary income tax rates. The top tax rates on qualified dividend income (not including interest income) are now 15% for computing both regular income tax and the alternative minimum tax. For taxpayers with qualified dividends taxed in the 10% and 15% brackets, the tax rate on these dividends is zero in 2008, 2009 and 2010, after which dividends will be subject to tax at ordinary income rates.
For a dividend to be eligible for the 15% reduced tax rate, the underlying stock must be owned for more than 60 days during the 121 day period beginning 60 days before the "ex-dividend" date, the day on which the stock starts trading without its next dividend. In the case of certain preferred stock, the holding period is increased to more than 90 days during the 181 day period beginning 90 days before the ex-dividend date.
We've already touched upon the simplicity or ease with which a sole proprietorship may be formed. Essentially, an individual decides what type of business to operate, selects a location, pays any state or local charges for permits, inspections or other requirements, and the business becomes a business. Other forms of business ownership generally require significant legal paperwork and varying degrees of compliance with both state and federal laws.
The frontier spirit of "rugged individualism" associated with taking complete personal responsibility for one's fate are not only alive and flourishing, but also persistently pervasive if the sheer numbers of sole proprietorships can be used as an indicator. There's a certain charm (whether real or perceived) in being able to say, "I'm my own boss" and "I control my own destiny." Sole proprietors are, indeed, in charge of what occurs in their businesses. They decide what products or services to offer, establish the working hours, choose to hire or not hire helpers, and control the disposition of business income. As agreeable as this scenario appears, however, there are certain dangers inherent in being fully and personally responsible for a business. We'll look at some of the negative aspects soon.
Whereas a sole proprietor is the sole profit-taker after expenses are paid, other business forms require the sharing of profits among all whom own the business. Control of the profits can mean greater independence in business matters and is linked, of course, to taking personal responsibility for and controlling all aspects of the business.
The tax advantages of a sole proprietorship have been discussed above. Over the past 7 years, there have been considerable changes affecting taxation of businesses, primarily sole proprietorships and partnerships.
Sole proprietorships also escape some additional taxable events imposed on other forms of business ownership. While there are tax consequences for partnerships and corporations when the owners use personal assets in the business, this is not true for sole proprietors, since proprietors and their businesses are considered to be one and the same “person”. Therefore, a sole proprietor may funnel personal assets into and out of the business as desired without fear of triggering a taxable event under the Internal Revenue Code.
For example, a sole proprietor might want to take $3,000 from his retail store's business bank account to pay for a family vacation. Regardless of how the proprietor uses this money, taxation is the same as for any other funds the proprietor takes from the business. When a business is incorporated, however, the government requires that all funds paid to an owner must be specifically characterized as either a salary or a dividend, with different tax consequences. I f treated as a dividend, the same $3,000 taken by the owner will be taxed twice-first to the corporation and then to the owner. We'll discuss corporate taxation in more detail in the next chapter, but you can see from this example that a sole proprietorship is subject to simpler tax rules.
When a business is new, the owner sometimes anticipates losses rather than gains in the early years of operation. If the business is a sole proprietorship, these losses flow directly through to the owner, just as income does. As a result, income from any source can be offset by business losses on the owner's individual tax return, resulting in less taxable income. Under corporate ownership, on the other hand, the loss remains with the corporation and is not available to offset the corporate owner's income as reported on an individual tax return.
Sole proprietors may establish for themselves and their employees, if any, qualified retirement plans, so-called because they qualify under Internal Revenue Code regulations for special tax treatment comparable to the tax breaks larger businesses enjoy. These benefits include tax-deductible contributions to the retirement plan and deferral of taxation on earnings during the years the contributions are growing.
Under a qualified plan, participating employees may defer taxation on an employer's contributions into their individual accounts or for their vested benefits in qualified plans until some future date of distribution. Additionally, the tax on the income the account generates may be deferred until the money is distributed to the employee. The same deferred taxation is allowed under a nonqualified plan as long as the employee's interest in the plan is simply an unfunded promise to pay by the employer and meets requirements under a 2004 tax law change.
Again though, for high-earning proprietors, OBRA '93 has moderated the appeal of such plans by reducing the maximum amount of compensation that may be considered for making a tax-deductible contribution to such a plan. As a result, non-qualified retirement plans-those that do not have special tax benefits-may be more attractive to higher income proprietors. Later chapters cover a number of non-qualified plans available to businesses.
As simple as a sole proprietorship is to form, it is even simpler to dissolve. The owner can close the doors forever any time he or she chooses or may sell the business to a willing buyer without consulting anyone else. As long as the business leaves no debts owing-a situation that would attract the attention of creditors and legal authorities-the closing of a sole proprietorship is no more than a tick in the country's financial heartbeat, from the perspective of the government and the law. As you'll see, other forms of business ownership are not quite so easy to dissolve.
While a sole proprietorship appeals to the entrepreneurial spirit and offers certain advantages not shared by other forms of business ownership, there are negative aspects to consider as well.
Because the business and the owner are considered one and the same, a sole proprietor is subject to unlimited liability for any type of claim against the business, from business debts to personal injury claims. Thus, if the business does not have adequate assets to meet legitimate claims against it, all of the owner's personal assets, including savings, bank accounts, investments, real estate, automobiles, jewelry and other items, may be attached to settle creditors, claims.
In addition to unlimited financial liability, the financial stability of a sole proprietorship can be troublesome. Owners generally must rely on their personal assets both to start the business and to keep it operating during times when business income is low. Borrowing from personal assets can place the owner in a precarious financial situation. Borrowing from lending institutions is possible, but the amount a lender is willing to offer usually depends on the value of the owner's personal assets since the business is not considered a separate entity. No additional investors may be brought into the business without losing the sole proprietorship characteristics. Doing so would require a partnership or corporate ownership not that this change is necessarily a negative. In fact, sole proprietorships sometimes voluntarily progress to these arrangements with advantageous results.
Additionally, the ongoing operation of the business that contributes to a sole proprietorship's financial stability usually depends solely on the owner. If the owner dies or if personal indebtedness is too high, the business can fail.
Sole proprietors take upon themselves all of the management responsibilities for the business. Whether the owner is or is not a skilled and competent manager contributes to the success or failure of the business. Few people are qualified to manage every aspect of a business, so some choose to hire experts to handle portions of the business. However, because smaller proprietorships may struggle financially, some owners will not hire others and the business may suffer where the owner's expertise is lacking. Finding high quality personnel to work as employees can also be a problem. Individuals who want a career rather than just a paycheck may find it difficult to remain in a sole proprietorship where chances for advancement are limited by the owner's desire, willingness and ability to provide opportunities for employee growth. Thus, the very people who could help the business become strong might be unable or unwilling to remain as employees. And without reliable employees, owners may be unable to take vacations or otherwise find time needed for relaxation and recreation the rejuvenation required remaining effective in business.
While we have discussed some possible tax advantages in the sole proprietorship arrangement, you’ve seen that they are tenuous since tax laws can and do change regularly. This year’s tax advantages may turn into tomorrow's disadvantages. If financial success means the owner’s marginal tax rate is higher than corporate rates, which will be true for some sole proprietors as the result of the 1993 tax law adjustments; this form of ownership becomes less attractive. Uncertainty about tax regulations and rates affects all types of businesses, of course, not just sole proprietorships.
A sole proprietor's income represents self-employment income that is subject to withholding for Social Security taxes. For a sole proprietor, self-employment taxes are not deductible as a business expense. Although sole proprietors generally work in the business just as if they were employees, owners may not pay themselves wages or salaries as they do for non-owner employees.
Businesses that follow federal regulations concerning employee fringe benefits (in addition to retirement plans) may take tax deductions for paying for those employee benefits. For example, many employers pay part or all of the insurance premiums for life and/or health insurance plans and then take a tax deduction for the premiums as a business expense. While sole proprietors may pay for and deduct such benefits for employees, any insurance premiums paid for the sole proprietors themselves as employees are not tax deductible as a business expense. For a period of several years, sole proprietors (and partners) have been allowed to deduct 25% of premiums paid for health insurance for themselves, spouses and dependents. This provision has expired, then been extended on several occasions.
People who want to join together to do business may form a partnership. Although they represent the smallest number of business ownership types in the U.S. Partnerships of various kinds that are described in this section include many business owners. You'll see that partnerships share some of the same characteristics as sole proprietorships.
Two or more owners must be involved for a business to be considered a partnership. The Uniform Partnership Act that governs whether a business is in fact, a partnership or some other type of entity uses a simple definition:
"An association of two or more persons to carry on a business for profit as co-owners."
The term "persons" may be deceptive because the law differentiates between a "natural person" who refers to an individual human being, and an "artificial person" who refer to a legal entity such as another business or a trust. Thus, a partnership could be comprised of two corporations or an individual and a corporation or an individual and a trust or some other coupling.
This places no cap on the number of partners that may be involved, but as practical matter if there are numerous partners the business is more likely to be incorporated rather than to operate as a partnership.
Like a sole proprietorship, a partnership acts as a conduit for income tax purposes as illustrated using a retail store with two partners as an example. Earnings flow through the partnership entity directly to the partners, who then report income, expenses and losses on their individual income tax returns using special tax forms for partnerships.
The amount of money each partner puts into the partnership is often termed the person's "basis." For example, if a new business is started with $50,000 from Partner A and $100,000 from Partner B, Partner A's basis in the business is $50,000 and Partner B's basis is $100,000. The extent of deductions each partner may take for business expenses and losses is generally proportionate to each partner's investment or basis. If a deductible loss occurs, Partner A may deduct one-third of the loss and Partner B may deduct two-thirds because of the proportion of each partner's basis unless the partners have agreed to some other means of allocating profits and losses. Basis does not mean cash only: the value of property a partner contributes to the business also adds to the basis. For example, if Partner A also contributes $50,000 worth of real estate to the business, A's basis is also $100,000.
While only the individual partners-not the partnership entity itself-must pay income taxes, the partnership itself must file a tax return showing how income, expenses and other items are allocated to the partners. The higher individual tax rates imposed by OBRA '93, discussed previously, apply to the individual partners.
As is true for sole proprietors, partners may not legally pay themselves wages or salaries as if the partners themselves are employees of the business. This is true whether or not the partners act as employees by working in the business. Any income partners received was traditionally viewed as a portion of each partner's distributive share of the partnership's income, based on how the partners have decided to share profits. Eventually, however, the law was changed to recognize that partners might give themselves a stipulated income regardless of whether there are profits to share. That is, even if the business has little or no profits to distribute, the partners might receive the equivalent of a salary. However, this is called a guaranteed payment, not a salary, for tax purposes.
While this arrangement might appear to be quibbling over semantics, there can be different tax consequences for guaranteed payments and salaries, as well as for guaranteed payments and distributive shares of partnership profits. If the guaranteed payment were simply salary, the partner could report it as income in the year received, as is the case with any other income individuals receive.
In the case of a partnership making guaranteed payments to partners, however, the partner must report the payment as income in the year the partnership's tax year ends and the partnership reports the payment, even if that year is different from the partner's tax year. While the two tax years may be the same, a business could have a different tax year. When the partnership reports the payment to the partner is important because, even though the partnership's income is not taxed, the partnership may deduct the payment as a business expense, thus reducing the income that flows through to the individual partners as distributive shares.
For the individual partners, guaranteed payments and distributive shares of profits are taxed the same as ordinary income. The primary difference in tax treatment occurs in a limited partnership (discussed below), where the limited partners' earnings are not generally considered self-employment income subject to withholding unless the income is a guaranteed payment.
Legal Requirements
A partnership may legally be formed simply on the basis of an oral agreement between two or more parties. However, such an arrangement is risky since an oral agreement is nearly impossible to prove if there is a dispute about it later. Therefore, although there is generally no legal requirement to do so, most partnerships are based upon a written contract called the articles of partnership. Properly prepared by an attorney, the articles of partnership should very specifically set forth factual data about the business, such as the following:
While the articles of partnership may be prepared and signed informally by the partners, it is usually wise to use the services of an attorney who is experienced in drawing up such agreements.
Many states require partnerships to register with or otherwise notify certain state and/or local officials that a new partnership has been formed. Sometimes this requirement depends on whether the business is a general or a limited partnership.
A partnership formed to operate a typical retail clothing store, a neighborhood restaurant, a consulting service, or an independent pharmacy, to name just a few examples, is most likely to be a general partnership. General partners are those who may obligate the business to perform certain actions, incur debt, and otherwise make decisions about how the business operates decisions that require the business to perform even if only one general partner makes the decision on behalf of the business. This is known as joint and several liabilities.
Let's use a retail clothing store as an example, with Creighton and LaVelle as the general partners. Without getting LaVelle's formal agreement, Creighton enters into a contract to purchase inventory from HKB Manufacturing Company, thus obligating the clothing store to pay for the HKB items. Creighton could not then claim that, because LaVelle did not join Creighton in ordering the inventory, the agreement with HKB is not valid. The fact that Creighton, as a general partner, executed a contract on behalf of the partnership to purchase the inventory obligates the business to fulfill the contract with HKB. Likewise, LaVelle could act on behalf of the partnership without Creighton's approval or knowledge, incurring obligations the partnership must fulfill. The principle of joint and several liabilities gives creditors the right to bring suit against all partners jointly, as a group, or against each partner severally, or separately.
A business venture may instead, be formed as a limited partnership, which must include at least one general partner and one or more limited partners. The general partner (or partners) can be considered most responsible for what happens in the business because only general partners may be active in managing the business. Limited partners provide investment money and share in the business earnings, but are prohibited from actively engaging in the business operations. Doing so changes the nature of the business from a limited partnership to a general partnership, which has different legal and tax consequences to the partners. A limited partnership is often used instead of a general partnership when a general partner needs investment capital, but does not want to have working partners.
Likewise, limited partners enter into such an arrangement because they have money to invest and see the partnership as a growth instrument, rather than as a business they want to participate in. In the heyday of tax shelter investments, limited partnerships burgeoned in industries ranging from real estate ventures to oil drilling to cattle breeding. Tax law changes in 1986 eliminated some of the most alluring features of such arrangements, many of which offered significant tax breaks for investors. However, the limited partnership concept continues to provide attractive investment opportunities.
General and limited partnerships share some of the same advantages and disadvantages, while each arrangement also has unique positives and negatives to consider.
The Simple Start-Up
A partnership can be nearly as simple to form as a sole proprietorship. In some states, counties or cities, formal registration may be required, but that is generally no more complicated than for a proprietorship. Partners may even choose to forgo the formal writtenarticles of partnership, but as indicated earlier, a contract prepared with the advice of an attorney is recommended. Some government authorities impose special requirements on limited partnerships. Limited partners, especially, are advised to have a written contract since they are not active in the business and have no authority to decide how the business will be operated.
Sharing of Monetary and Management Burdens
While operating a business solo has some appealing features, a sole proprietor also must bear the money and management burdens alone. A partnership, on the other hand, spreads the burdens among two or more people. As a result, more capital may be available to start the business and to prop it up when earnings lag. Having more partners may also increase the likelihood of diverse skills and knowledge and greater potential for success. Whereas a proprietor must be all things to the business, a partner with sales talent but minimal accounting skills, for example, can turn the accounting details over to another partner.
Under a limited partnership, the limited partners have limited liability. Legally, a limited partner's liability for any type of debt is no more than the amount of his or her investment in the business. When we look at the negatives, you'll see this is not the case for the general partner.
The partnership's earnings are taxed only as personal income to the partners. No separate income tax is due from the partnership entity. As is true for proprietorships, the 1993 tax law influences whether this is viewed as an advantage or a disadvantage, based upon the level of taxable income.
Because the partnership is a conduit, each partner's taxable income may be offset by his or her share of any business losses. While this can be advantageous, there is a limit on the amount of loss that may be claimed. The maximum is the amount the individual invested plus any additional amounts for which the partner is “at risk.” Amounts at risk refer to any amounts the partner could lose. For example, if the partnership has outstanding debt of $10,000 for which each of two partners have 50% liability, an individual partner is at risk for $5,000 plus the amount invested in the business. If losses are greater than the total amount at risk, no more than that total may be used to offset income in anyone a tax year. However, the remainder of a loss may be carried over for income reduction the next year and following years if necessary. In a limited partnership, other restrictions apply to loss deductibility as we'll discuss under tax disadvantages.
Like proprietorships, partnerships may establish qualified retirement plans for themselves and their employees, resulting in tax-deductible contributions and tax deferral on plan earnings.
However, partnerships, like sole proprietorships, are subject to the 1993 tax law changes that reduced the amount of compensation that may be considered for deduction purposes.
When all partners agree to dissolve the business, dissolutions can be as simple as for a proprietorship. There are no tax consequences to the partnership entity since any income or loss resulting from the dissolution flows through to the partners. On the other hand, if one partner wants out of the business and others want to continue the business, dissolution is not so simple. Under tax disadvantages, we'll discuss why this can be a problem.
Under a general partnership, every general partner is responsible for all of the partnership's obligations. This means general partners have unlimited liability for claims against the business, just as is true for proprietorships. So, while a benefit of being a limited partner is having limited liability, the general partners have no such protection and are liable jointly and severally as described earlier.
Remember that limited partners are forbidden to participate in the management of the partnership. As a result, limited partners have no control over how the business is operated. For some people this is a disadvantage because limited partners may disagree with how the business is managed, but legally they may not become involved even if they could do a better job than the general partners.
A partnership may be more financially stable than a proprietorship because additional people can provide more capital and capital-raising abilities. However, the partnership is really only as solid as the partners. The personal worth or wealth of each partner often limits the partnership's ability to obtain financing or additional capital to help the business.
While it is relatively easy to put money into a partnership, it is much more difficult to withdraw any part of the investment without causing tax consequences or affecting the financial underpinnings of the partnership. Loans or other means of withdrawing funds from a partnership, while legally permissible, can be considered taxable transactions. This is different from a sole proprietorship, where the proprietor and his or her business are considered one and the same, allowing the proprietor to invest in and withdraw personal funds from the business at will.
Under tax advantages, we said that each partner's taxable income maybe offset by a share of any business losses. The disadvantage for a partnership is that such losses are deductible only up to each partner's amount at risk, though excess losses carry over to other tax years. This is in contrast to a sole proprietorship, for which no limit is imposed on the amount of losses used to offset income.
Additionally, under a limited partnership where limited partners do not participate in the business, losses are considered "passive" for the limited partners because losses result from a business in which the limited partners do not actively work. Likewise, income for the limited partners is considered passive. The tax code allows passive losses to be deductible only against passive income. Thus, a passive loss may not be used to offset the limited partner's other income, such as earnings from the individual's employment. The tax code concerning what qualifies as passive income and loss is considerably more detailed than the information provided here, which gives you just a general idea of how passive income and losses affect taxpayers.
Just as was true for proprietorships, the marginal tax rate at which any partner's income is taxed may be either an advantage or a disadvantage, depending on the person’s total taxable income.
Income that general partners receive from the partnership is considered self-employment income subject to withholding taxes. We said earlier, though, that such income is not self-employment income for limited partners', so taxes are not withheld from limited partners' earnings unless any limited partner receives guaranteed payments for services actually performed. Guaranteed payments are considered to be self-employment income subject to withholding. Of course, all income must be reported by the limited partners and, whether or not subject to withholding at the time of payment, the income is taxable along with all other ordinary income.
Partners who provide and pay for certain fringe benefits for their employees may deduct any such payments from the partnership income. However, like sole proprietors, partners may not deduct any such payments made to provide benefits for themselves except for the 25% health insurance premium deduction discussed earlier.
Involuntary dissolution of the business has negative tax effects. By law, a partnership must be dissolved when one of the principals leaves the partnership under most circumstances, even if the remaining partners want to continue in business. Thus, the partnership suffers involuntary dissolution from the standpoint of the remaining partners. On the other hand, if all partners elect to discontinue the partnership, the dissolution is voluntary. When a partner is removed from the picture voluntarily or by death we'll discuss at length in a later chapter-the partnership legally ceases to exist. An exception is the death of a limited partner, which does not generally terminate the partnership.
For general partnerships, involuntary dissolution means a new partnership must be formed if the business is to continue with different partners, resulting in the creation of a new tax year with new tax consequences. The law requires that, if 50% or more of a partnership interest is transferred to a new partner within any 12-month period, the partnership is legally terminated. This triggers a number of tax consequences concerning depreciation, tax elections and other factors, essentially causing the partners to start over for tax purposes as if a completely new business had been formed. For example, the tax year ends at dissolution. Even if the business continues to operate with some of the same owners, the remaining partners must include in their individual tax returns the income from two partnership tax years. Tax regulations may also require additional taxation when the partnership's tax year is different from the individual partners' tax years.
While it's beyond the scope of this text to discuss the details of the scenario mentioned above, termination of the partnership in the eyes of the law is something to be avoided when some partners want the business to continue because the tax consequences can be severe. In another chapter you'll see how life insurance can help a partnership avoid legal termination when a partner dies. Briefly, life insurance can fund an agreement, made in advance of death, legally avoiding the partnership dissolution that would otherwise occur under law.
In this section, we'll briefly review several other ”partnership” forms of business ownership. This general knowledge has informational value for you even though you are not likely to prospect these partnership arrangements specifically to provide the types of insurance we'll discuss later in the text.
A potentially more complex form of ownership is a publicly traded partnership, sometimes called a master limited partnership. The tax code defines a publicly traded partnership as one whose interests are either:
Traded on an established securities exchange or market or readily tradable on a secondary market (or the equivalent of such a market where liquidity is readily accessible).
Historically, the primary benefit of this type of partnership has been that the partnership acts as a conduit for income and avoids the separate taxation corporations are subject to, while enjoying limited liability, an "unlimited" life that doesn't stop if a partner leaves, and easy transferability of ownership-the latter two features generally benefitting corporations rather than partnerships.
However, the tax code requires that any business enterprise displaying many characteristics of a corporation will be taxed as if it were a corporation no matter what it calls itself. The type of taxation that applies depends on whether an organization has several of the corporate characteristics defined in federal tax regulations. Here are the characteristics the tax regulations describe:
Most of these features can be avoided by all partnerships, including publicly traded partnerships. However, a 1987 change in the tax law requires that all new publicly traded partnerships be taxed as corporations after that year unless 90% of the company's income is passive. Passive income results from business activities in which the taxpayer does not "materially participate.” Material participation is defined in considerable detail, but in general means the taxpayer is actively involved in the day-to-day business operations that result in income production. Common examples of passive income include income taxpayers receive from investments in mutual funds or certificates of deposit. Partnerships that were already in existence when the 1987 law was enacted received a ten-year grace period, which means corporate taxation for those partnerships begins for tax years after 1997.
Note, however, that most other types of limited partnerships, as discussed in the previous section, are treated as partnerships, largely because of legal battles that resulted in adoption by most states of both the Uniform Partnership Act and the Uniform Limited Partnership Act. These state laws are written to require federal tax treatment of most limited partnerships as partnerships rather than as corporations.
As indicated earlier, the Uniform Partnership Act defines what constitutes a partnership. In addition to the forms we've discussed, the definition also includes joint ventures and other unincorporated organizations. A joint venture may appear to be just another partnership. However, joint ventures differ in that they are formed only to fulfill a specific purpose. As soon as the purpose is accomplished, the venture is dissolved. This differs from a more typical partnership that is formed for an ongoing business purpose, such as to operate a chain of supermarkets. For example, an architect and a builder might enter into a joint venture to create a new museum. During the life of the joint venture, the two enjoy the tax benefits of a partnership. When the museum is completed, the architect and the builder dissolve the venture and each of these independent business people goes his or her separate way rather than continuing in business together.
Various types of unincorporated organizations might receive partnership treatment. Examples include groups of people or businesses that might pool their resources and work together to earn income in a certain enterprise only, but who have different jobs or businesses that provide a more steady flow of income. Sometimes business entities form a syndicate, using their combined wealth and or leadership skills and clout to accomplish a specific purpose. There are a variety of means to organize and receive the tax benefits of a partnership, but unincorporated businesses must be careful to avoid taking on too many characteristics of a corporation, as discussed previously, or they will be taxed as corporations.
Chapter 1 Review Questions
1. Because income from a proprietorship "flows through" the business to the proprietor for tax purposes, this form of business ownership is sometimes referred to as:
A. a limited venture.
B. an income conduit.
C. a syndicate.
D. a top evasion organization.
2. By definition, a sole proprietorship is a business that has:
A. two or more employees.
B. only one owner.
C. limited credit.
D. less than 1000 shares outstanding.
3. As a result of OBRA ’93 ________ earning significant incomes are subject to a _______ marginal tax rate.
A. sole proprietorship, higher
B. partnerships, lower
C. corporates, higher
D. corporates, lower
4. Life insurance premiums paid by a sole proprietor on his/ her life are
A. tax deductible.
B. tax deductible if the policy is “whole life.”
C. not tax deductible.
D. tax deductible up to 3% of the proprietor’s total income.
5. “An association of two or more persons to carry on a business for profit as co-owners” is a A. sole proprietorship.
B. close corporation.
C. syndicate.
D. partnership.
6. The value of money or property a partner contributes to a partnership is the partner’s:
A. passive income.
B. guaranteed payments.
C. basis.
D. down payment.
7. A partnership may
A. be formed by an oral agreement or a written contract.
B. be formed by a written contract only.
C. not be formed by a husband and wife.
D. only be formed by filing the “articles of partnership” with the Secretary of State.
8. The fact the Partner X may incur legally enforceable obligations on behalf of the partnership and all other partners is known as:
A. unlimited liability.
B. joint and several liability.
C. limited liability.
D. discretionary liability.
9. What type of partnership arrangement provides limited liability for some partners?
A. general partnership.
B. cash basis partnership.
C. joint venture.
D. limited partnership.
10. A partnership’s earnings are taxed
A. to the partnership and the partners.
B. to the partnership only.
C. only as personal income to the partners.
D. at a higher rate than the partners other income.
ANSWERS
1B 2B 3A 4C 5D 6C 7A 8B 9D 10C