Change of Business Entity Type

Tax in Small Business

Amy Gothard, E.A.Senior Training Developer

Learning Objectives

▪ Explain reasons for changing an entity type.

▪ Determine the process of closing the original business entity.

▪ Explain the process of opening and operating a replacement business entity.

Small Business Entities

■ Sole proprietorship is the most common type.

■ Reasons for a change:□ Liability

□ Change in ownership

□ Taxation

Liability Considerations

Separate financesLimited Liability Company (LLC)

Protect personal assets

Change in Ownership

■Retirement

■Adding owners

■Removing owners

■Replacing owners

Short Headline

■ Sole proprietor: 100%

■ Partnership: by agreement□ Guaranteed payments

□ Ordinary income

■ S corporation:□ Wages

□ Ordinary income

Allocation of Profits

■ Schedule C (Form 1040) net profit:□ Ordinary income tax

□ Self-employment tax

■ Adjustments to income:□ One-half of self-employment (SE) tax

□ Self-employed health insurance

□ Self-employed retirement contributions

■ QBI deduction

Taxation: Sole Proprietor

■ Ordinary income from Schedule K-1 (Form 1065)

□ Ordinary income tax

□ SE tax

■ Guaranteed payments□ For services: Ordinary income tax and SE tax

□ For capital: Ordinary income tax

■ Adjustments to income□ One-half of SE tax

□ Self-employed health insurance

□ Self-employed retirement contributions

■ QBI deduction□ Not on guaranteed payments

Taxation: Partnership

■ Wages (reasonable salary)

■ FICA tax paid by the employer and employee

■ Adjustment to income□ Health insurance for a more than 2%

shareholder

■ Ordinary income from Schedule K-1 (Form 1120-S)

■ QBI Deduction□ Only on Schedule K-1 income

Taxation: S Corporation

Example

Irene is a sole proprietor or only shareholder of an S corporation.

Her business had a 2020 profit of $75,000.

S corporation reasonable salary = $50,000.

Irene: Schedule C

Net profit $75,000

SE tax $10,597

Adjustment for ½ SE tax $5,299

AGI $69,701

Standard deduction $12,400

QBI deduction $11,460

Ordinary taxable income $45,841

Ordinary income tax $5,872

Total tax paid $16,469

Irene: S CorporationSchedule C S Corporation

Net profit $75,000 $21,175

Wages $50,000

SE/FICA tax $10,597 $7,650

Adjustment for ½ SE tax $5,299 $0

AGI $69,701 $71,175

Standard deduction $12,400 $12,400

QBI deduction $11,460 $4,235

Ordinary taxable income $45,841 $54,540

Ordinary income tax $5,872 $7,786

Total tax paid $16,469 $15,436

■ Ordinary income taxed to the entity at a 21% rate

■ Distributions are taxable dividends

■ Wages (reasonable salary)

■ FICA tax paid by the employer and employee

Taxation: C Corporation

Short Headline■ Books and records

■ Time and effort

■ New location

Time for a Change?

Polling

Entity Options

■ Sole proprietorship

■ Partnership

■ S corporation□ U.S. citizens/residents

□ Trusts

□ Nonprofits

□ Other S corps

□ Limit of 100 shareholders

■ C corporation

■ Close the old entity.

■ Create a new entity.

■ Transfer assets.

■ Recognize changes in how the entity operates.

■ Monitor closed business for fraudulent activity.

Entity Transition

Closing a Business■ File final payroll, Forms W-2

and 1099.

■ File final tax return.

■ Close or transfer bank accounts and credit lines.

■ Cancel EIN and IRS business accounts.

■ Retain records.

■ Stop doing business.

■ File the final tax return.

■ Check with the state.

Closing a Sole Proprietorship

■ Check with the state.

■ File the final return and close the business with the state.

Closing a Single-Member LLC

■ Dissolve or transfer.

■ Business should:□ Obtain qualified legal advice.

□ Review the partnership agreement, check state requirements.

■ Dissolve:□ Liquidate assets.

□ Pay debts.

□ Recognize gain or loss.

■ Transfer:□ Assets and basis transfer to the new entity.

Closing a Partnership

■ Revoke the S election or dissolve.

■ Business should:□ Obtain qualified legal advice.

□ Review bylaws, check state requirements.

■ Revoke:□ File a statement with the IRS.

■ Dissolve:□ Liquidate assets.

□ Pay debts.

□ Recognize gain or loss.

Closing an S Corporation

■ Make the S election or dissolve.

■ Make the S election:□ File Form 2553.

□ Rev. Proc. 2013-30.

■ Business should:□ Obtain qualified legal advice.

□ Review bylaws, check state requirements.

■ Net operating losses

■ Dissolve:□ Liquidate assets.

□ Pay debts.

□ Recognize gain or loss.

Closing a C Corporation

Polling

Creating the New Business

■ Apply for a new EIN.

■ Choose the tax year and accounting method.

■ Register with the state and local agencies.

■ Start working.

Creating a Sole Proprietorship

■ Partnership agreement

Creating a Partnership

■ Stock□ Number of shares

□ Initial stock price

□ Types of stock

■ Business documents

■ File Form 2553 for S corporation election

Creating a Corporation

Short Headline

■ Process varies for different entities.

Transfer Assets and Liabilities

■ Assets belong to the person, not the business.

■ Determine which assets will be transferred.

■ Contribute assets to the LLC.

■ Contact lenders about debts.

Sole Proprietor to Single-Member LLC

■ Determine adjusted basis and FMV.

■ Options:□ Convert to personal use.

□ Sell to an unrelated party.

□ Sell to the new entity.

□ Contribute to the entity.

Sole Proprietor to Entity

■ Rev. Rul. 84-111

■ Assets over

■ Assets up

■ Interests over

Partnership to Corporation

■ Assets over□ Partnership contributes assets to the

corporation for shares.

□ Partnership distributes stock to partners.

■ Assets up□ Partnership distributes assets to the partners

(liquidates).

□ Partners contribute to the corporation.

■ Interests over□ Partners transfer partnership interests to the

corporation for shares.

□ Corporation dissolves partnership.

Rev. Rul. 84-111

Operating a New Business

■ Share management decisions

■ Bookkeeping and accounting

■ Due date of returns

Polling

Session Objectives

▪ Explain reasons for changing the entity type.

▪ Determine the process of closing the original business entity.

▪ Explain the process of opening and operating a replacement business entity.