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American Taxation – Filing of Returns – Classification of Tax Payers

It happened at Kalkaji Extension, New Delhi, India on a sunny day with a kid of 8 years named Haruto, sometime in 2016, in our central park, a park which has blossomed into a huge and popular one inviting all types of birds, people of various ages, and also my dog Yuma enjoying a peaceful ride with his cool demeanour derived from golden retriever pedigree. As shown in the past, I was always inquisitive as if the whole world had changed since the previous day. I enquired from the kid his ambition in life so that his failing the question, I would start my sermon. Lo! The kid pitied my memory, since three months ago, he had told me that he would manufacture cars in the country. I tried to check the veracity of his statement with the trading of cars as his statement. No, he was emphatic to produce cars in India.

Then suddenly he enquired whether I would answer his questions, instead. Yes, I agreed with his feelings. Surprisingly, he asked me whether his friends could join his company and if so, who would control his company. He also remembered that his father had mentioned some big company who regularly paid dividends to his parents, some of them he had seen in the post. Can he have one big company with him as the Chairman?  Nowadays, the kids do observe everything closely and assimilate as much as they can. The recent win of an international master (boy) of 11 years in Chess from Tamilnadu, India, over the grand master of great reputation, from Russia, an event that had never taken place in history, is an instant to be remembered at this moment.

Obviously Haruto got his technical advice from me which can’t be explained to readers due to client related secrecy rules.

Now the question arises: (Related to America)

  • What is the classification of Taxpayers for U.S. tax purposes?
  • What are the advantages and disadvantages of each one of them?
  • Is there any risk assessment related to them?
  • Can one minimise the risk personally in business but running successfully or otherwise?

(Many brilliant Chartered Accountants have answered above questions related to India many times in the past in Tax Guru and hence the writer only deals with American situation. Why America? Many of our successful companies/entrepreneurs eventually go to U.S.A. for expansion or raising of resources)

Classification of Taxpayers

U.S. law treats U.S. persons and foreign persons differently for tax purposes. Therefore, it is important to be able to distinguish between these two types of taxpayers.

United States Persons

The term ”United States person” means:

  • A citizen or resident of the United States
  • A domestic partnership
  • A domestic corporation
  • Any estate other than a foreign estate
  • Any trust if:
    • A court within the United States is able to exercise primary supervision over the administration of the trust, and
    • One or more United States persons have the authority to control all substantial decisions of the trust
  • Any other person that is not a foreign person.

Foreign Persons

A foreign person includes:

  • Nonresident alien individual
  • Foreign corporation
  • Foreign partnership
  • Foreign trust
  • A foreign estate
  • Any other person that is not a U.S. person

Generally, the U.S. branch of a foreign corporation or partnership is treated as a foreign person. Refer to Internal Revenue Code section 7701(a)(31) for the definition of a foreign estate and a foreign trust.

Let us analyze every one of this category in detail for tax purposes.

Sole proprietorship

One of the commonest form of doing business is as an individual. Enormous time was spent in explaining its usage under form 1040 under schedule C, F or E in my earlier article under the title “ U S Taxation – Filing of Returns – Individuals”. One can read the same for deeper understanding.

Disadvantages of Sole Proprietorship:

  • Personal liability towards business including personal assets even if not collaterally mortgaged. A simple line of credit without any collateral for business may attract any asset towards its liquidation.
  • Unlike LLC or Corporation, the business does not exist separately

This aptly explains to any- one who wants to be a loner, the perils of doing business.

Partnership

Internal Revenue Instructions on Form Number 1065 regarding Partnership is quoted as under:

“A partnership is the relationship between two or more persons who join to carry on a trade or business, with each person contributing money, property, labor, or skill and each expecting to share in the profits and losses of the business whether or not a formal partnership agreement is made. The term “partnership” includes a limited partnership, syndicate, group, pool, joint venture, or other unincorporated organization, through or by which any business, financial operation, or venture is carried on, that is not, within the meaning of the regulations under section 7701, a corporation, trust, estate, or sole proprietorship.” Or in a simple language, two or more persons join together to conduct business. Every state of U.S.A. has its own act on Partnership and this article clearly follows the instructions from IRS.

Advantages of formation of Partnership firm   

  • Flexibility – A partnership easily makes special allocations among the partners for non-pro-rata shares of income and deductions
  • Flow through income – Income and deductions from a partnership firm easily flows through to the partners and are distributed by K-1 schedule.
  • Various partnership firms like LLC, General partnership, Limited Partnership, Husband/Wife Partnership, and Large Partnership can be easily formed by following simple procedures
  • Liability – A partner is liable for debts incurred by the firm including the debts not necessarily incurred by him. Mostly the disputes arise because of debts not authorized by one but falling on him unknowingly. Many partnerships clearly lay down the rules defining the role of each partner to avoid smooth sailing of the firm. With the introduction of LLC, it is the most popular way of doing business since it restricts the liability of the members.
  • Self- employment Tax – The distributive share of income for general partners attracts SE tax.

Filing requirements

Every Partnership firm that engages in trade or business is expected to file an information return on  Form 1065 which is due by the 15th of the fourth month following the end of tax year, which is naturally April 15 for calendar year partnerships.

The penalty is $195 for each month or part of a month (for a maximum of 12 months) the failure continues, multiplied by the total number of persons who were partners in the partnership during any part of the partnership’s tax year for which the return is due. Internal Revenue Service (Federal Government of U.S.A) instructions have been quoted to show the cost of failure to provide information to federal authorities on timely basis. We can easily find ourselves in uncomfortable position when we make whine about every- thing related to Income tax department of Government of India, particularly when they just the international standards on penalty, and interest.

Failure to Furnish Information Timely

“For each failure to furnish Schedule K-1 to a partner when due and each failure to include on Schedule K-1 all the information required to be shown (or the inclusion of incorrect information), a $260 penalty may be imposed for each Schedule K-1 for which a failure occurs. The maximum penalty is $3,178,500 for all such failures during a calendar year. If the requirement to report correct information is intentionally disregarded, each $260 penalty is increased to $520 or, if greater, 10% of the aggregate amount of items required to be reported, and the $3,178,500 maximum doesn’t apply. Trust Fund Recovery Penalty”.

Since this information is enough to propel any one to file tax returns on timely basis, let us move on to other forms of entities like S Corporations, Tax-exempt organizations, and others.

S Corporations 

A Corporation may be treated as a S corporation only for those days for which eligibility requirement has been met and the required election is effective and applicable. It depends upon the nature of corporation, its stock and shareholders. It can have only one type of stock. The following matters do invite some attention:

  • Only one class of stock has been permitted
  • Rights to profits and assets on liquidation is kept as identical
  • Debt is kept as a disqualifying second class stock

The number of shareholders may not exceed 100. A husband and wife are treated as one shareholder and non-resident shareholder fails and is not eligible to own even a single stock. An individual, a single-member LLC, an estate or a qualified trust may be shareholders. Partnerships, Charitable Remainder Unitrusts, or Charitable Remainder Annuity Trusts are ineligible to own any stock. The corporation has to be a domestic and an eligible one.

Election

An eligible Corporation is expected to make an election for S corporation status. Consent of all members of the corporation at any point of time of the year has to be taken. If the election has been revoked, new election can- not be made again for 5 years without the consent of Internal Revenue Service.

Termination

An S corporation is terminated by any one of the following events:

  • Majority of the shareholders, inclusive of voting and non- voting, consent for termination
  • Any eligibility requirement not being satisfied on any day
  • Passive investment income(P2) termination

Taxes

Most businesses need to register with the IRS, register with state and local revenue agencies, and obtain a tax ID number or permit.

All states do not tax S corporations equally. Most recognize them similarly to the federal government and tax the shareholders accordingly. However, some states (like Massachusetts) tax S corps on profits above a specified limit. Other states don’t recognize the S corporation election and treat the business as a C corporation with all of the tax ramifications. Some states (like New York and New Jersey) tax both the S corporations’ profits and the shareholder’s proportional shares of the profits.

Your corporation must file the Form 2553 to elect “S” status within two months and 15 days after the beginning of the tax year or any time before the tax year for the status to be in effect.

Advantages of an S Corporation

  • Tax Savings. One of the best features of the S Corp is the tax savings for you and your business. While members of an LLC are subject to employment tax on the entire net income of the business, only the wages of the S Corp shareholder who is an employee are subject to employment tax. The remaining income is paid to the owner as a “distribution,” which is taxed at a lower rate, if at all.
  • Business Expense Tax Credits. Some expenses that shareholder/employees incur can be written off as business expenses. Nevertheless, if such an employee owns 2% or more shares, then benefits like health and life insurance are deemed taxable income.

Tax year

An S corporation generally adopts a calendar year. It is not required to use the accrual method for accounting. At the corporation level, the tax treatment of income, loss, deduction, and credit is determined. S corporation files tax return under form 1120S. S corporation reports separately items like Sec 1231 gains/losses, net short term gains/losses, net long term gains/losses, dividends, charitable contributions, tax-exempt interest and expenses and others which are passed on to shareholders who report them in their tax returns and pay the required taxes if any.

Since coverage of S Corporation requires a long space and can even be written as a separate article, the writer drops down to other entities.

Non Profit Organizations

It was a freezing cold day with chill factor reaching – 62 degrees Fahrenheit, when my friend informed me of her falling into a gorge totally made of ice, in 2009, in Minneapolis, Minnesota State, USA. As I was struggling with my CPA business, my mind got confused by an offer of the post of a Treasurer of a Non- Profit Organization which was only on volunteer basis with no income. Yes, CPAs pride themselves in USA being associated with NGOs on voluntary basis. But typically, these positions offer dignity but fiduciary responsibility which entails one even prison term if not fulfilled as per legal expectations. Even many Indians get excited overtly to read about Income tax authorities coming heavily with fines or legal action when the financial statements are not filed on time by NGOs. Even politicians or their spouses face the fire unwittingly when they get entangled with NGOs. India too witnessed steamy situations in the past. Why these controversies and what is the position in USA, the harbinger of NGOs and social service?

There are three key components for an organization to be exempt from federal income tax under Sec 501(c)(3) of the IRC. A non- profit organization must be organized and operated exclusively for one or more exempt purposes.

Federal law imposes the following responsibilities on organizations receiving Sec 501(c)(3) status:

  • Recordkeeping- to keep records of both financial and non- financial particularly its sources of funds to keep its private foundation status.
  • Disclosure requirements- to make available the records for public inspection
  • Substantiation and disclosure-to give a donor a written acknowledgement for charity for any single contribution of $250 or more. And to give a written disclosure to a donor who gives $75 partly as charitable contribution in cash and also in the form of services

In a country as U.S.A., it is not unusual to emphasize social service as a way of life. I saw this attribute while attending a marriage in Chennai, India too when young professionals, in a hush manner, explained how they contributed nearly 10% or more of their salaries every month towards helping poor people. Yes, Mahatma Gandhi in a photo in the wall beamed happily with his warm laugh.

Internal Revenue Service, the Income tax department of the American Government raised alarming bells when the form 990, Return of Organization Exempt from Income Tax consisting of 11 pages with 16 schedules was introduced. This was done with the nobler intention of more transparency, promotion of more compliance and to weed out non serious NGOs.

Form 990-N, e-Postcard was intended for those falling with annual gross receipts of $25,000 or less. This could be filed only by electronically. Those falling with gross receipts less than $500,000 and total assets less than $1.25 million could easily choose 990-EZ.

Filing has been made compulsory and is expected to be done by May15 for calendar year organizations. Organizations which failed to file consecutively their annual filing requirements for 3 years lose their exemption status.IRS action under this condition is a routine feature in USA and one can no longer sympathize with those Indian NGOs when they scramble to file US returns when they avail US grants or aid, but show total ignorance towards Indian tax returns.

   Under section 6652(c)(1)(A), a penalty of $20 a day, not to exceed the lesser of $10,000 or 5% of the gross receipts of the organization for the year, can be charged when a return is filed late, unless the organization shows that the late filing was due to reasonable cause. Note that the amounts under section 6652(c)(1)(A) are adjusted for inflation annually. Organizations with annual gross receipts exceeding $1,015,500 are subject to a penalty of $100 for each day failure continues (with a maximum penalty for any one return of $50,500). The penalty applies on each day after the due date that the return is not filed.

Stringent conditions contribute towards emergence of tax exempt organizations to be properly organized and worked for the purpose for which they were established. Historic misuse of tax exempt organizations has forced tax authorities’ world over to tighten the norms and stricter implementation of rulings and norms.

Having explained extensively the types of entities normally unheard of in India, the writer invites you to have a glimpse at other types of entities:

  • Limited Liability Companies – They combine the tax aspects of partnerships with liability protection of corporations. Each state has its own rules allowing the creation and functioning of LLCs.
  • Trusts and Estates – Legal entities defined by the assets they hold. These assets produce income. This income popularly known as fiduciary income attracts income tax. Trusts like simple, complex or grantor are popular. An estate which arrives after the death of a tax payer invites separate tax treatment. Ideally, form number 1041, U.S. Tax return for Estates and Trusts must be used. Detailed instructions will be used in future by another article.
  • C corporations which are other than S Corporations, Limited Liability Partnership, Personal Service Corporation and Personal Holding Company are other types of entities which invite separate tax forms and calculation of tax. In future, the writer intends writing separately on these tax entities.

Conclusion

But for Mr Haruto, the beaming young kid who shook me out of my slumber, this article on various tax entities in U.S.A., tax administration would not have arisen. Starting with sole proprietorship, partnerships, tax exempt organizations, estates and trusts followed by others echoed the minds of readers. The treatment is inadequate and does not fulfill their expectations.

Frankly, though the writer during the last decade of his international professional life as a CPA has actually handled all types of entities, every tax return required constant reference to IRS codes, adherence to latest guidelines and a passion to do the best job to satisfy the tax clients. Being American in tax matters, many nights disturbed my sleep. American/Indian clients dealing with tax matters treat 24 hours clock to deal with their tax professionals.

 In a lighter vein, even if you could recollect some of the names of tax entities, the writer has served his purpose. For serious treatment of your US tax problems, please consult the nearest CPA professional for timely help and mental peace.

Reference

From the famous IRS website,

https://www.irs.gov/

  • Sole proprietor, single member LLC, and husband/wife business, schedule C Form 1040
  • Partnership, Form 1065, U.S. Return of Partnership income: IRS publication 541
  • Corporation, Form 1120S, U,S. Tax return for S corporation
  • C Corporation, Form 1120, U.S. Corporation Income Tax return, IRS publication 542

About the author:

 Subramanian Natarajan C.P.A. (USA), M.Sc., CAIIB took voluntary retirement in 2000 from Punjab National Bank after handling various facets of banking like deposit mobilization, foreign exchange, auditing and borrower accounts. After living in USA for 12 years during which period he worked in international auditing firms specializing in international tax, auditing, IFRS etc, he continues his practice in New Delhi, India. He can be reached at subcpa@gmail.com. Tel: 7503562701, 9015613229. He currently lives in Delhi. His name appears as tax consultant in web site of American embassy, New Delhi. He is thankful to various suggestions received from readers and is delighted to hear the enormous enthusiasm of readers.

Categories: Income Tax
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