Characteristics of Sole Proprietorship - Essay Example

Finance and accounting PART I Sole proprietorship It is a business that is owned by one individual, and it does not require any charter (Bandy, 2011). Characteristics of sole proprietorship It is owned by one person: sole proprietorship being small in size and it is sufficiently managed by an individual him/herself. At will, a person can pay workers to assist him in the running f the business. The source of starting capital for a business is from an individual’s income. However, he/she can borrow from friends and family members or even borrow from banks. The individual bears all the risks that are in the business. The business owner has unlimited liabilities as he is liable for the debts of the enterprise. If his business cannot sufficiently clear the debts, his personal property such as land, car or houses can be used to remove the loan. The sole trader keeps a close relationship with his/her customers. A sole proprietor is not subjected to formalities so he can start a business at any point in time. The sole trading is easy to as the decision is made without any consultation with another party. Liability The sole trader is liable for the misconduct or violation of laws and regulations whereby hi/she is sued. The sole trader is liable to all other claims that against the business. Computation of taxable business The total revenue of the business XX Less: the total cost of the goods that were sold (XX) Gross profit generated XX Less: the allowable business deduction (XX) The adjusted profit or loss for the enterprise XX Revenue for the business XX How much to report on the income tax return A sole proprietor, the amount of tax that will be levied depends on the business income. Depending on whether the annual revenue is more or less than a million, he/she will have to report a 2-line statement or a 4-line statement on their income tax return. Flow-through Entities Are legal entities whereby the income flows to owners or investors; implication that income is treated as either income of the owners or revenue for the investors (Siegel & Shim, 2010). Basing on the local tax regulations, the structure can avoid dividend tax and even the double taxation since only investors and owners are always taxed on the income. They are usually considered as non-entities for tax purposes since they are not taxed but taxation flow through to other tax returns. Types of flow through entities include limited partnership, general partnership, scheme corporations, limited liability companies and master limited partnerships. General partnership It is a partnership where all members have a responsibility of managing a business and are in a personal capacity liable to all obligations and debts of the enterprise. Characteristics Partnership is terminated by the death, withdraw or disability by one partner. Each partner is deemed as the agent of the entity and, therefore, held liable for the dealings with any other party outside the partnership. The partnership profits are shared equally among the members. No one is entitled to become a member without the consent of all partners. Limited partnership This is a partnership where some of the partners are general whereby they are entitled to manage and control business while other partners are limited to the contribution of capital only. A legal document that stipulates specific requirements are usually drawn up for limited partnership. Limited liability partnership It a partnership whereby almost all partners has gone limited responsibilities depending on the jurisdiction. In this partnership, no single partner is held responsible for another partner’s misconduct or rather negligence. Characteristics There is mutual contribution of starting capital for the flow through the entities to meet all the expenses. The flow through entities has a limited life in that it may dissolve upon the death, incapacity, withdrawal of a partner or insolvency of the partnership itself. There is mutual agency within the flow-through entity in that a partner can bind the other to contract if he/she is acting within implied or expressed authority. There is a share of profit/loss equally according to the contributions made to the venture. There is co-ownership of the contributed assets in that any property contributed by a partner is owned jointly in a particular sense. Computation of taxable income from the flow-through entities For the calculation of taxable income, the following statement formula is used as shown below: The total revenue xx Less: the cost of revenue (xx) The gross profit/loss xx Less: Salaries to partners’ (xx) Bonuses to partners’ (xx) Allowances to partner’s (xx) Partners CPF contribution (xx) Share of interest on capital to partners’ (xx) Expenses paid on behalf of partners’ (xx) Divisible profit/adjusted xx It should be noted that pass through entities pass profit/loss to owners/investors/shareholders and therefore do not pay tax on its income. The owners of the pass-through entities move items on their income tax return. Partners in their individual capacity are subject to tax as per their distributed shares through the net income of the entity. The corporation When it comes to corporations, taxes are charged differently for other kinds of business structures. A corporation is the only business type that must pay its income tax on the profits generated during a particular fiscal period. Insights of corporate taxation It should be noted that corporate is a separate entity from its owners; the tax is charged on all profits than cannot whatsoever be deducted as business expenses. The taxable profits comprise of money kept by respective companies for their expenditure in the form of retained earnings, and dividends distributed to the shareholders. Tax deductible expenses For the purpose of reducing the profit taxed on profits, the company can deduct its expenses for pursuit of profits. Examples of such deductible expenses include operating expenses, start-ups, advertising expenses, medical allowances and retirement plans for its employees. Corporate tax payments Each corporation is required to file a corporate tax return (IRS Form 1120), and consequently pay taxes at corporate tax rate on profits. In case, a corporation owes tax at the year end; it shall estimate the tax amount due for respective year and b required to make quarterly payments to IRS. Shareholders tax payments When a corporation has shareholders, they carry a liability of paying individual income taxes just like ordinary workers of any other company. The bonuses and other salaries are deductible and therefore do not call upon the business to pay the taxes on them. Tax on dividends A corporation distributes its dividends to the owners and makes a report and makes a payment of any personal income tax on these amounts. Dividends unlike the bonuses and salaries, they are tax deductible. This clearly states that they are double taxed one on corporation and the gain to shareholders. Scheme corporation taxes The system taxation applies to almost all organizations. Any business that chooses this system corporation status has to pay taxes like Limited Liability Company or like partnership. All the profit/loss generated pass through the enterprise and consequently reported on personal income tax returns. The company taxable income computation Gross sales of the company (Forms 1120 and 1065) xx Less: the cost of goods sold (xx) The gross profit xx Add back The dividend income xx The interest income xx The gross rents xx The total royalties’ xx The capital gain income xx Other income xx The total income xx Less: Salaries and wages (IRS Forms 1120) (xx) Repairs and maintenance (xx) Bad debt expense (xx) Rents (xx) Taxes and licenses (xx) Interests’ (xx) Charitable contributions (xx) Depreciation (IRS Form 4562) (xx) Depletion (xx) Advertising (xx) Pension, profit-sharing plans (xx) Any other deductions (xx) Total deduction (xx) Taxable income xx Question two Revenue rule 84-11, the IRS permits taxpayers to choose their suitable tax treatment in partnership transactions by structuring transactions in one of the following methods (Gelfand et al., 2007). Asset over transaction This is the first method in revenue rule. In this method, the partnership is required to transfer assets to the new corporation. Tax effects on transfer of assets to a corporation There is no gain or loss recognition by partnership during the transfer and assumption of liabilities according to section 351. The partnership holding period for stock that is received in exchange entails holding period in the capital assets according to section 1223 (1) of the revenue rule. The partnership stock basis received from the corporation is same as the basis of the partnership assets transferred to the corporation under section 358 (a). Asset up approach Under this method, the partnership is first required to liquidate by distribution of its assets and liabilities to the partners. The following step calls for the transfer of assets by partners from the partnership to the corporation in the exchange for the stock of the corporation. Tax effects Section 731 (a) states that there will be no gain/loss to be realized by the partnership upon liquidation with certain exceptions. Section 731 (a), section 731 (1) and 731 (c), a gain is acknowledged to an degree that partners share of cash and with certain exceptions, market securities, disseminated to him/her exceeds their attuned basis in the partnership. Under section 732(b), the assets to be distributed to partners shall be on the adjusted partnership interest basis than the prior partnership interest. Tax effects of partnership The partnership can be terminated under section 708(b)(1) upon distribution of partnership’s assets. The partnership does not recognize a gain or loss on liquidation distribution of the assets to partners. Interest over approach This is the third method set forth in the revenue rule 84-111. In this method, the partners first of all are required to transfer interests from partnership to the corporation in the exchange of company stock then the partnership dissolves. Tax effects for partners Section 351 stipulates that there is no gain or loss recognition by partners when there is a transfer of partnership interests. Question three Any partner who at will sales or exchanges partnership interest is required to make recognition of the loss or gain first. This is because the partnership interest is deemed as an asset except otherwise as stipulated in the IRC section 751. Since the partner sold the company yet had been allocated a loss, results in a capital loss (Porcano, 2009). According to article 751 of IRC, capital loss treatment is not applicable to the extent of partner’s shares that might generate ordinary income if sold. Therefore, in this case, the partner will be required to dispose of his/her interest in regular income-producing assets. PART II In this case, there are two business entities that are available for Ms Fatma to invest. These are sole trader and partnership. To sufficiently understand the kind of business entity, Fatma need to understand in depth the characteristics, liability, advantages, and disadvantages of different entities. I will first of all discuss the sole trader. Sole proprietor is a business that is always owned by one person. The sole proprietor requires small starting capital from friends, family or even borrows some loan from the bank. The sole trader has a full control of the business; he takes all the profits that are generated by the enterprise, and he/she can hire other people to assist in the control of the enterprise. The trader has a mandate of making decision without consulting any outsiders, there exist no formalities for the start of the business, and he can end the business at any point in time. However, the sole trader has unlimited liabilities in that in case the business does not fully remove the debt owed to him/her, then his personal property can be sold to recover the debt. The trader carries all the risks and losses that the business may incur. The second type of entity available for Fatma is partnership. Partnership is a group of more than two individuals that work in union to achieve the same goal. In partnership, there is a mutual contribution of starting capital hence reducing the burden to one individual. The profits and losses are shared equally; each partner is accountable for the debts of the partnership and all partners have a responsibility of managing and controlling the partnership. The four friends to Fatma contribute towards the capital outlay of the business. In this case Fatma says that for the first two years, the business will have losses and profits thereafter. Of course, the first two years will experience losses because a business requires time before it fully develops and start generating profits. After two years, the business will have developed and, therefore, more sales and a consequent increase in the profits will be realized (Luttman, 2007). On the other hand, though her friends reduce the capital outlay burden that could have been felt by one individual, there is a share of profits that might not have been generated by all partners. Each partner is answerable for the negligence of the other partner hence this can bring internal conflict between members. Therefore according to my opinion, Fatma should choose a sole proprietorship in order to have full control of the business and earn all the profits that will be generated from the enterprise. References Bandy, G. (2011). Financial management and accounting in the public sector (5th ed.). Abingdon, Oxon: Routledge. Gelfand, M. D., Mintz, J. A., & Salsich, P. W. (2007). State and local taxation and finance in a nutshell. St. Paul, MN: Thomson/West. Luttman, S. (2007). Advances in taxation. Greenwich, CT: JAI Press. Porcano, T. M. (2009). Advances in taxation (4th ed.). Bingley: Emerald Group Publishing Limited. Siegel, J. G., & Shim, J. K. (2010). Accounting handbook. Hauppauge, NY: Barrons Educational Series. Read More