Federal Taxation of Individuals

Sole Proprietorship, Partnership, S Corporation, and C Corporation

A partnership is an agreement signed by two or more parties to manage a business as co-proprietors. An organization is a business with different proprietors, each of whom has put resources into the market. A few associations incorporate people who work in the industry, while some firms use accomplices who have restricted interest for the obligations and claims against the business.

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Under the partnership contract, investors and shareholders settle the company’s tax treatment while its profit and loss are shared among the parties based on their agreement. Establishing an S company boosts customer’s confidence, provider’s efficiency, and the conduct of financial specialists by displaying the proprietor’s formal assurance to the organization. As an advantage of the S organization, it is excluded from government charges. Getting a good deal on corporate charges is vital, particularly when the business has just been settled. Under the arrangement (S entity), investors can be workers who collect salaries and get corporate tax exemptions if the distribution does not surpass their stock value. If the benefit exceeds an investor’s stock value, the profit is burdened as capital gains. Classifying distributions as compensation or profits may enable the proprietor to reduce taxes while creating an operational expense and wage deductions. The benefit of registering a business under the S corporation hinges on its single dimension of taxation. The S corporation’s income is taxed on the number of stocks they acquire.

Investors under the C entity are taxed before spreading the balance to stakeholders as dividends. Business owners are then subjected to annual taxes on revenues. Although a twofold tax collection is a troublesome result, the capacity to reinvest benefits in the organization at a lower corporate expense rate is an advantage. Choosing to work as an S company gives proprietors an alternate method for tax treatment contrasted with a conventional C organization. A C partnership is treated as a different entity by the IRS because the enterprise is taxed at corporate and individual levels when profits are made to the investors; this explains why C organizations are known for having double taxation. However, as an S entity, the profit and loss of the organization are divided between investors and shared as expenditures.

Capital Gains and Taxation of Gross Income

Based on the case study, Bob acquired a property in 1996 and sold the asset in 2018. The property is valued at $9,000,000 after 22 years of depreciation and appreciation. It is important that Bob has a single tax identity status. Therefore, his capital asset can be defined as properties used for personal endeavors, recreation, or investment. Based on this context, capital assets could be household products, coin collections, gold, ornaments, stock, bonds, or building. An individual could have capital gains or loss when he or she sells a capital asset. Therefore, the capital asset is the value gotten from the basis in the asset and the cost of sale. It implies that Bob will have capital gains if the property or equipment is sold at a value higher than the basis. Bob’s capital gains could be long-term and short-term, which depends on the length of ownership. Capital asset sold after one year is categorized as long-term gains, while properties sold within 11 months are called short-term gains. Thus, Bob’s case study shows that the sale would cause a long-term gain or loss because the property was acquired in 1966 and sold in 2018.

Computing Capital Gains and Taxation of Gross Income

Bob’s capital asset = $ 450,000 in 1996.

The capital asset was sold in 2018 = $ 9,000,000.

The disposable property gain or loss of the capital asset = Cost of an asset – Basis cost. The basis cost is the value of the time acquired in 1996 = $ 450,000.

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Therefore, disposable capital gain or loss of Bob’s asset = 9,000,000 – 450,000 = $ 8, 550,000.

The disposable asset gain is computed from the difference in its current value sale and initial basis. Therefore, the value accrued is called the income.

The disposable income is based on generated revenue. Therefore, Bob’s disposable income is fixed at 20%.

Thus, Bob’s asset generated capital gains of $ 8, 550,000.

Bob’s taxable income can be computed on the following assumptions.

  1. Value of 401K funds.
  2. The status of the business entity is an S Corporation.

Therefore, 401 K funds = 690,000.

Interest income = 20,000.

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Dividend = 6,000.

Capital gain = $8, 550,000.

Total gross income = 9, 266, 000.

Bob’s exemptions = 10,300.

Taxable income = 9, 266, 000 – 10,300 = $ 9, 255, 700.

Tax Consequences on the Sale or Exchange of Land

This paper defined capital gains or loss as the value generated from the sale or exchange of one’s property. Therefore, when the value is higher than the cost of acquisition, it is classified as capital gains. Based on IRS guidelines, the price of purchase includes sales tax, revenue stamps, excise tax, recording fees, and settlement costs (“26 U.S. Code § 1366,” 2016). Settlement fees or closing costs include the cost of surveys, legal fees, transfer tax, and insurance fees. However, the closing cost of the property does not include insurance premiums, utility charges, or mortgage premiums.

When assets are moved subject to the rights in the transferor, the tax treatment might be uncertain. The sale of vacant land should be treated as capital gain or loss. Therefore, if the transaction is classified as a deal or trade, the transferor’s value is balanced against the sum acknowledged and the distinction can qualify for capital gains or loss treatment under the IRS. However, if the exchange is delegated a permit or rent, the transferor must report the sums as reasonable profit based on its depreciation or amortization. Related issues in ordering property sales are experienced in different territories of the tax law. However, the difference between sales and exchange is challenging when citizens suggest capital gains treatment for sums generated from transactions of licenses, copyrights, establishments, and other impalpable assets if the income is subject to the transferee’s utilization of the property and are not constrained in sum.

Based on the case study, Bob would gain $8, 550,000 for the capital asset.

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Therefore, the selling cost of the property is computed at 5% = 5/100 x 9, 000, 000 = 450, 000.

Tax treatment = 20% of the cost of the property = $9,000,000 x 20% = 1, 800,000.

The assumption suggests that the broker’s fee ranges from 6% to 10 %. The capital gain for this asset is high; therefore, the broker’s fee will be computed at 10%.

Broker’s fee = 10/100 x 9, 000, 000 = 900,000. The actual profit or income for the property = $5, 400,000.

Bob will need Schedule D (1040 and 8949) form to fulfill the business requirement.

Tax Effects of Bob’s Cash Flow

The land sale generated $9,000,000.

The tax effect of Bob’s income depends on the business entity.

Selling cost and closing cost = 5,000.

Cost of land in 1996 = 450,000.

The long-term capital gain from the capital asset = 9,000,000 – 5000 – 450,000 = 8, 545, 000.

The tax treatment of 20% = 20/100 x 8,545,000 = 1,709,000.

Medicare tax at 3.8% = 3.8/100 x 8,545,000 = 324,710.

Thus, Bob’s after tax effect on cash flow = 8, 545,000 – 1,709,000 – 324,701 = $ 6, 511, 290.

The benefit of registering a business under the S corporation is its single dimension of taxation. The S corporation’s income is taxed on the number of stocks they acquire. Consequently, losses caused by the S corporation are shared among investors. An investor’s capital asset increases and decreases at his or her risk. However, sales made by an S corporation are nontaxable and cannot reduce the investor’s capital gains (Kieso, Kimmel, & Weygandt, 2015). When corporations evaluate their income, losses, derivations, and credits, an S entity should be considered because the distribution is shared among investors before tax deductions (Pope, Rupert, & Anderson, 2019). The corporation’s income is absolved from the corporate income tax. Revenue could be significant on paper; however, the client must consider the after-effect on cash flow. In this case, Bob should deduct devaluation from the income to determine the after-tax effect and afterward add the depreciation value since devaluation cannot be classified as cash flow.

Capital gains are revenues generated by sales of real estate parcel and are viewed as taxable income. A great deal relies on the extent the asset is held before selling. Capital gains tax rules are classified as long-term and short-term. Short-term tax treatment is a charge on capital assets held for one year or less, while long-term tax is an expense on properties owned over a year. The long-term tax rate ranges from 0% to 20%, depending on the pay and status. The tax rates for long-term capital gains are lower than short-term income on capital assets.

Salary or Cash Distribution

The recommendation depends on its effects on the taxable income. Since the client wants to save more than pay tax, it is important to understand the outcomes of each option under the IRS code and regulations. If the client and his daughter allocated wages as salaries to themselves, it would allow the investor to make tax claims to lower the tax deductions. However, the tax treatment process depends on the mode of the cash distribution (cash or accrual method). The cash basis describes the purpose of reporting an investment inflow. With a cash basis, the management must fill the income statement sheet when funds are received. It is important to note that IRS regulations recommend the accrual accounting methods for some specific businesses. Thus, Bob should complete form 3115 to get recommendations based on the investment.

Besides, the business owner will also report when funds are removed from its account. However, with the accrual method, the business owner must fill the income statement sheet when a deal is reached even without payment. Therefore, Bob can claim tax deductions when payment is received during the fiscal or current year. The tax claims will reduce the after-tax effect on Bob’s cash flow. I will recommend the client and his daughter to take a salary.

Cash distribution does not exclude the investor from tax deductions. Thus, Bob will pay taxes even with the cash distribution method. However, if the client is the sole owner of the business, the company will be excluded from direct tax. The client will pay tax on personal benefits, income, wages, and revenue because income and expenditures are documented on the Schedule C form (Form 1040). If the business is a partnership, the investors will share the profit or loss burden. As a result, the after-tax effect on cash flow will be moderate. The S and C corporation entity describes the bearer of poor investment. If the business is classified as an S entity, the client will be excluded from taxes. However, a C business entity will be taxed based on the fillings in the form 1120.

If Bob and his daughter take a salary, it should be reasonable under the IRS regulations. The measure of the pay will not surpass the sum received by the investor, either lawfully or indirectly. If money, property, or the privilege to get money and property go through the investor, a compensation sum must be resolved, and the dimension of pay must be rational and appropriate. There are no rules for remuneration in the Code or the Regulations. The courts have put together their conclusions concerning the certainties and conditions of each case. Therefore, it is difficult for tax agencies to institute a claim against the client concerning the salary amount.

References

26 U.S. Code § 1366. Pass-thru of items to shareholders. (2016). Web.

Kieso, D., Kimmel, P., & Weygandt, J. (2015) Accounting principles. Hoboken: Wiley.

Pope, T. R., Rupert, T. J., & Anderson, K. E. (2019). Pearson’s federal taxation 2019 (32nd ed.). Boston, MA: Pearson Education.

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StudyCorgi. (2021, July 18). Federal Taxation of Individuals. Retrieved from https://studycorgi.com/federal-taxation-of-individuals/

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"Federal Taxation of Individuals." StudyCorgi, 18 July 2021, studycorgi.com/federal-taxation-of-individuals/.

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StudyCorgi. 2021. "Federal Taxation of Individuals." July 18, 2021. https://studycorgi.com/federal-taxation-of-individuals/.

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