Entities and Corporations in Terms of Their Liability and Computation of Taxable Business Income - Coursework Example

Taxation project Task Introduction This paper contains two parts. Part one presents the following: first, a comparative study of sole proprietorship, flow through entities and Corporations in terms of their characteristics, liability and the computation of taxable business income. Second, an explanation of the tax effects of changing a business form from a partnership to various forms of corporations. Third, an assessment of the tax consequence if a partner sells his partnership interest to a third party after the allocation of partnership loss. Part two contains an advice to Fatma regarding the form of business to consider. PART ONE Question one The characteristics of a sole proprietorship A sole proprietorship is a form of business that is owned by one person. The source of capital for this form of business could be from savings or borrowings. The owner of the business is responsible for all the decision making regarding the strategy implementation in the business. This form of business requires less formal procedures during the start-up. In addition, it is subject to fewer restrictions as compared to limited liability companies (Sitarz, 2011). The following are the main characteristics of a sole proprietorship: first is the business ownership. A sole proprietorship is owned by one person. This implies that the preliminary start-up procedures are taken care of by the owner, who also is responsible for obtaining the requisite amount of capital. Second, is the business management control. A sole proprietorship is considered small in size compared to other forms of businesses such as the partnership. Therefore, the owner is responsible for managing the daily operations. Although the business could have some employees, all decision making and strategy formulation and implementation are the sole responsibility of the owner (Sitarz, 2011). The third characteristic is the source of finance. The source of finance for a sole proprietorship is the owner. The owner may save some money from his previous employment with a primary intention to set up a sole proprietorship. However, the owner could also seek financing from other sources such as friends, family members and borrowing from the bank. The fourth characteristic is the risk. In a sole proprietorship, the owner bears all the risk like losses caused by perils such as fire. The reason is, the owner has an exclusive share ownership in the business, thus, enjoys all the benefits and bears all the risks (Sitarz, 2011). The fifth characteristic is the legal status. A sole proprietorship and the owner are the same before the law. That is, the law considers a sole trader and the business as one thing. Therefore, before the law, all the properties (assets) and obligations of the business are also the property and obligations of the owner. The sixth characteristic is the customer relationship. In a sole proprietorship, the sole trader directly comes into contact with his customers, which improves the relationship between the customers and the business (Sitarz, 2011). The seventh characteristic is the legal procedures. In a sole proprietorship, the business set-up or wind-up can be easily done as there is no special act of law that regulates such processes. The owner’s decision either to set-up or wind-up the business is sufficient. Therefore, compared to the limited liability company, a sole proprietorship has fewer legal formalities (Sitarz, 2011). The liability of a sole proprietorship and the computation of business taxable income The liability of a sole proprietorship is unlimited. That is, in case of a default in debt payment, the creditor is entitled to claim the property of the business to cover for the debt. In case the property of the business proves insufficient to cover the entire debt, the creditor is entitled to claim the properties (cars, furniture and other valuable properties) of the business owner. Since a sole proprietorship and the owner are one in the same before the law, the income from the business is also the income of the owner, thus, is taxed once. The taxable income is computed by subtracting the operating expenses from the gross income (Sitarz, 2011). The advantages and disadvantages of a sole proprietorship The following are the advantages of a sole proprietorship: first, a sole proprietorship is easily formed compared to corporations. The formation begins with the decision of the owner to set up a business. Legal procedures during the formation are very few. Basically, the owner would only require the local authority permission before commencing the operation. Second, a sole proprietorship enjoys tax benefits. That is, a sole proprietorship is taxed based on the personal income tax rates for the business and the owner are one in the same. Therefore, a sole proprietorship is not taxed like the corporations. Third, the management of a sole proprietorship, the strategy formulation and implementation and the all decision making are the responsibility of the owner. Therefore, the time taken to conduct the mentioned responsibilities is shorter as compared to the time taken to carry out the same responsibilities in a partnership (Sitarz, 2011). The following are the disadvantages of a sole proprietorship: first, the sole proprietorship is liable for any obligation or financial losses caused by legal suits. That is, in case of default on debt payment, both the properties of the business and those of the owner will be claimed by the debtor to settle the remaining portion of the debt. Second, a sole proprietorship has no indefinite life span. The business operations end when the owner is incapacitated or his life comes to an end. Upon death, the business properties are distributed to the owner’s beneficiaries like the off springs. Third, a sole proprietorship is not legally allowed to raise capital from the public by issuing initial public offering (shares). This makes it difficult for this form of business to easily raise capital (Sitarz, 2011). Characteristics of a flow through entity Flow through, also known as the pass through entities can be one of the following: limited partnership, limited liability partnership, general partnership, and limited liability companies. The following are the characteristics of the entity: first, the entity’s income is taxed once, not twice as is the case with the personal service corporation. That is, all the company’s profits are distributed to the shareholders who then pay taxes based on the levels of their income. Second, the company would be eligible to deduct the cost of equipments purchased, fringe benefits paid to employees and operating costs (Johnson, OBrien, Campbell, Grange & Johnson, 2008). Third, the rates of tax applicable to the shareholders vary depending on the level of income of the shareholders. It is important to note that flow through entities have similar characteristics to S corporations. The liability of Flow through entities may either be limited or unlimited depending on the type of flow through entity. As mentioned above, pass through entities don’t pay taxes. Taxes are paid by shareholders after receiving their share of the company’s profit. The taxable income is computed by subtracting operating expenses from the gross revenue (Johnson, OBrien, Campbell, Grange & Johnson, 2008). Characteristics of a Corporation Corporations are business entities that are considered as persons before the law (legal persons). On that note, the Corporations are different from the owners before the law. An entity can only be considered as a separate entity after incorporation. The process of a company formation can be classified into four broad categories. They are the promotion, the registration, the capital subscription and the commencement of the business. A private corporation will be required to go through the first two stages for the reason that as soon as it is issued with the certificate of incorporation, it may start operating (Palmiter, 2009). The following are the primary characteristics of the Corporations: first, a Corporation’s liability is limited. Since a Corporation is a separate person from the subscribers to its memorandum, the company’s debts are not the subscribers’ debt. For instance, if a corporation borrows a loan for any purpose, the loan repayment together with the interests is exclusively the company’s obligations. In case the company is unable to pay the loan, the creditors may seek for a court order to dissolve the corporation. During the dissolution, the member of the company will be required to pay up the unpaid amount on shares, if a corporation is limited by shares, or pay the amount fixed by the memorandum, if the corporation is limited by guarantee (Palmiter, 2009). Second, a Corporation has an indefinite life. The life of the corporation is independent of the life of its members. The indefinite life is also made possible by the fact that the stakeholders can be changed without interfering with the company’s life span. Third, the shares can be transferred from one member to another. When that happens, the company’s ownership also changes. Fourth, corporations are legally entitled to enter into any contract. Last, corporations are centrally managed. The owners and shareholders bestow the management authority on managers appointed by them (Palmiter, 2009). Corporate liability and computation of taxable income The Corporation’s liability is limited. That means the corporations debts are not its members’. Corporations can either be limited by shares or by guarantee as mentioned above. The taxable income is computed by subtracting the operating costs from the gross revenue (Palmiter, 2009). Question 2 There are two types of corporations. S or a C corporation. If a partnership is changed to an S corporation, there will be no effect on the taxation system since in both cases, the business income is taxed after being distributed to the partners or shareholders. In this case, the partners or shareholders are responsible for filing the tax returns (CCH Incorporated, 2010). On the other hand, if a partnership is changed to a C corporation, the business income will be taxed based on corporate tax rates 35%, which could be higher than in the case of S corporation above. Therefore, in the case of a C corporation, double taxation is possible if the corporation declares dividend payment to its shareholder. In this case, the income is taxed at a corporate tax rate (35%), thereafter; the portion of the net income allocated to fund dividend payment is also subject to tax at a similar rate as capital gains (15%). In this case, both tax returns are filed by the company (CCH Incorporated, 2010). Question 3 The partnership loss reduces the share of a partner in the entity. If a partner sells his partnership interest to a third party after the partnership loss has been allocated, the book value of the interests will reduce. However, the market value could be higher than the book value leading to a capital gain. The capital gain would be taxed at 15 % (Morse, 2010). PART TWO She is considering setting up a new business entity. For the first two years, she anticipates to make losses. However, she expects the business to be profitable afterwards. The profits are to steadily grow in the future years. Fatma will not make cash contribution toward the business start-up, but will dedicate 50 or more hours per week to run the business. The other four friends with whom she wishes to jointly own the business have made cash contribution. Fatma anticipates seeking additional funding in order to fund the business growth in three years. Based on the short narrative, a recommendation on appropriate form has been provided as below. Based on the above case, Fatma should consider partnership due to the following reasons: first, the form of business is easier to form as compared to corporations. Second, in a partnership, the profits and losses are shared among the partners. Third, Fatma did not make monetary contributions toward the starting of the business, but has promised to dedicate her skills and time to manage the business. Under the partnership, any form of contribution is recognized, therefore, a partner is entitled to a share of the entity’s profit, unlike in Corporations where Fatma would only be a member (without monetary benefits) (Morse, 2010). References CCH Incorporated. (2010). 2011 U.S. master tax guide. Chicago: CCH. Johnson, Linda M., OBrien, Linda, Campbell, Alan D., Grange, Janet, & Johnson, Linda M. (2008). Federal Tax Course 2009. Cch Inc. Morse, G. (2010). Partnership law. Oxford: Oxford University Press. Palmiter, A. R. (2009). Corporations: Examples and explanations. New York: Aspen Publishers. Sitarz, D. (2011). Sole proprietorship: Small business start-up kit : the ultimate guide to starting a sole proprietorship. Carbondale, Ill: Nova Pub. Co. Read More