I. Taxing Flow Through Entities
A. Entity reports no taxable gain or loss & pays no taxes.
B. All income and losses of the entity “flow through” proportionately to the owners of the entity for inclusion on each owner’s personal tax return
C. Flow Thru Entities Include …
1. General Partnerships
2. Limited Partnerships
3. Limited Liability Partnerships (LLP)
4. Limited Liability Company (LLC)
5. Subchapter “S” Corporation
D. Benefits:
1. Losses can flow through and be used by owners to reduce their other income.
2. Avoids double taxation. Overall, less in taxes is paid to the IRS.
II. PARTNERSHIPS – AN OVERVIEW
A. Advantages over corporation…
1. Less taxation
2. More flexible allocation of ownership
3. Tax free liquidations of assets
B. Disadvantage: Owners personally liable for company debts
C. Review types of partnerships (GP, LP, LLP): See chart of business entities handed out earlier in the course.
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III. PARTNERSHIP FORMATION:
A. Rule: Gain or loss recognized on contributions to the partnership
( compare what partner “paid in” with the value of the partnership interest received )
B. Non Recognition : (per § 721 – similar in some ways to § 351) – No recognition of gain where…cash and/or property is contributed. ( NOTE:
The 80% control rule does not apply to partnerships ).
C. Gain Recognition: Gain however WILL be recognized in any of the following circumstances…
1. Services are given in exchange for partnership ( treated as “salary”
= income to partner & deduction for the partnership )
2. Investment Partnership: (business will invest in stocks, etc.) where appreciated stock is invested – partner/stockholder must recognize a gain of stock.
3. Exchange Occurs: A contributes property ( e.g. land ) to partnership, then partnership distributes same asset to B. At the same time, B contributes property ( e.g. stock ) to partnership, then partnership distributes B’s property to A. What’s happened here is that A & B just exchanged non “like kind” property through the partnership.
Taxable exchange has occurred per Fed. Code.
4. Disguised Sale of Property: A contributes property and shortly thereafter receives a distribution of money.
D. Basis : Similar to corporations….If gain is deferred, use carryover basis on contributed p roperty to measure property’s inside basis to partnership and to measure partner’s basis in the partnership.
CASH + PROPERTY + SERVICES + PTSHP. LIABILITIES
(Basis - (FMV of svcs.) ASSUMED BY
Debt Relief) INCOMING PARTNER
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ALTERNATIVE WAY TO COMPUTE: If Partner contributes land with a liability (assumed by the partnership), you deduct the liability from the Property’s basis, BUT then you must “return” that partner’s share of the liability assumed as part of the “liabilities assumed by the incoming partner”.
Example: John contributes land with a Basis of $ 100K, FMV or $200K and a Mortgage of $ 30, to ABC Partners for a 1/3 share of the partnership. ABC assumes the mo rtgage. John’s Basis will be computed as follows…
PROPERTY + PTSHP. LIABILITIES
(Basis – Debt Relief) ASSUMED BY JOHN
$ 100 – 30 = 70 + 10K = $ 80k
Since John is a 1/3 partner, he “gets back” 1/3 of the mortgage he just unloaded (30/3 = 10).
IV. PARTNERSHIP OPERATION
A. Ordinary Income: Flows through proportionately to each owner.
1. Example : Partnership has net income of $ 100K and Partner A owns a
20% share = Partner A has 20K in income, whether or not he gets any of this money.
2. EXCEPTION: Guaranteed Payments (like a Salary) a. Partnership can deduct in computing its net income or loss b. Receiving partner = INCOME c. Example if Partner “A” (a 20% partner) got a $ 25,000 guaranteed payment and the p artnership income was $ 20,000, his “income” would be $ 20K (share of ptshp. Income) + $ 25K G.P. = $ 45,000 d. BASIS unaffected by Guaranteed Payment (not a distribution).
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B. Ordinary Losses: Also flows through proportionately to each partner…BUT 2 important limitations:
Note to Students : There will be no questions on the test dealing with
“non recourse” debt since in MOST partnerships, all debt is recourse debt. As such, you don’t have to know the difference between “Overall
Limitation” and “At Risk” limitation. For purposes of limitations on ordinary loss, just know 2: At Risk and Passive Loss.
1. At Risk : Losses for the year cannot exceed the Partner’s Beginning
Basis in the Partnership.
2. Passive Loss: If the partner is NOT actively involved in the business, he/she cannot deduct losses from other active ordinary income (only from other “passive” income). Some rules …. a. Income is divided into Active ( TP is involved in running the business ), Portfolio ( investment activity ) and Passive ( TP is not involved in running the business ). b. Basic Rule: Passive losses CANNOT be offset by Active or
Portfolio income. c. Rental Real Estate : Rule is modified….
(1) Divide income into three categories: Active, Quasi-Active or
Passive . (Prof. Freixes’ classifications)
(2) Active : Only refers to “real estate persons” (developers & the like). Rule: All of these losses are active and can offset any type of income.
(3) Quasi-Active: If TP owns the property and manages it themselves (e.g. collects rents, makes minor repairs, etc), then:
(a) TP can claim up to $ 25,000 per year in passive losses as
“active” and offset from other active income.
(b) Remaining losses (>$25K) are “passive” and subject to the
Basic Rule in 2b above)
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(c) If TP has AGI of $ 100K or more, reduce the $25,000 by 50% of AGI above $ 100K ( net effect: If TP has more than
$150,000 in AGI, the $ 25,000 is eliminated and ALL losses from the rental real estate are considered “passive”)
(4) Passive: If TP has no management responsibilities with property (e.g. he/she has a management company run the property), then all losses are “passive” and subject to the Basic
Rule in 2b above
C. Tax Exempt Income & Expenses: TE items like Municipal Bond interest
(or expenses related thereto) are subject to the following two basic rules…
1. DO NOT include them as taxable income to Partners.
2. DO include them in Basis Calculation ( by increasing Basis for TE
Income and decreasing Basis for non-deductible exprenses )
D. Separately Stated Items: Since certain income and deductions are subject to limitations ( e.g. capital gains & losses, Sec. 1231 gains & losses, charitable contributions, etc.) and must be reported out separately from other income/expenses.
E. PARTIAL YEAR OWNERS: If a partner sells his/her share in the middle of the year, their share of income or losses must be pro-rated accordingly.
Example: Partnership had $ 100,000 in income for the year and
Partner A was a 20% partner until June 30, then sold his interest. His
“flow through income” would be $ 100,000 x 20% = $ 20,000 x 50% =
$ 10,000 .
V. PARTNERSHIP BASIS
A. Basic Formula to calculate Partnership Basis (after 1 st year)….
BASIS = Investment +/- Share of - Distributions + Share of
(or Beg. Basis) Income/Losses Liabilities
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B. Tax Exempt Items: Basis is increased/decreased by tax-exempt items.
So, if $ 2,000 is received in Municipal Bond Interest, then you increase partner’s basis proportionately. If non-deductible items included in the books, then you reduce the partner’s basis proportionately.
C. Capital Gains & Losses: Also increase or decrease basis, even though reported out separately and the gains are taxed at a different tax rate.
D. Other items affecting basis:
1. Post acquisition cash contributions INCREASE basis further ( partners is basically putting in more capital ).
2. Distributions also DECREASE basis (see next section on Liquidations)
PARTNERSHIP DISTRIBUTIONS
VI. Partnership Distributions: Basic Terminolgy
A. Non Liquidating: Distribution is made and the receiving partner continues in the partnership.
B. Liquidating: Final distribution made to a partner, either because he withdraws from the partnership or because the entire partnership has dissolved and been liquidated (wound up).
C. Inside Basis: The partnership’s basis in a partnership asset ( before it is distributed to any partner ).
D. Outside Basis : A partner’s basis in the partnership.
E. Disproportionate Distribution: Where a partner gets more than his/her
“fair share” of distribution. Rules are complex - not on the final exam.
F. Basis in the Received Asset: When a distribution is made to a partner, the basis of the distributed item to the partner. ( e.g. Partnership gives
Partner A a computerr…what is the computer’s basis to Partner “A”)
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VII. Easy Reference Chart for Partnership Distributions:
Type of
Contribution
Non Liquidating
CASH
What is the Basis in the
Received Asset?
Amount of the Cash
What is effect on the
Outside Basis?
Reduce O. B. by the amount of the cash
Non Liquidating
PROPERTY
Non Liquidating
COMBO
(Cash + Property)
Liquidating
CASH
Liquidating
PROPERTY
Liquidating
COMBO
(Cash + Property)
Lesser of
IB and OB
Treat as separate transactions but compute the cash first (and adjust basis accordingly)
Amount of the Cash
Equal to O. B.
Treat as separate transactions but compute the cash first (and adjust basis accordingly)
Reduce O. B. by the lesser of IB and OB
Treat as separate transactions but compute the cash first (and adjust basis accordingly)
Reduce O. B. to Zero
Reduce O. B. to Zero
Treat as separate transactions but compute the cash first (and adjust basis accordingly)
Is it Income to the Partner?
If Cash > O.B. = capital gain
(no loss can be recognized however)
NO INCOME OR
LOSS IS EVER
RECOGNIZED
Only the cash portion (if > O.B.) may = income; property is never income or loss
If Cash > O. B. = capital gain
If Cash < O. B. = capital loss
NO INCOME OR
LOSS IS EVER
RECOGNIZED
Cash > O. B. = capital gain, but no capital loss can be recognized where both cash & property are distributed (Cash +
Receivables=Loss OK)
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VIII. SALE OF PARTNERSHIP INTEREST
A. Sold to Partnership : Treat as a “Liquidating Distribution” as per our chart.
B. Sold to Third Party: Several Issues
1. Partial Year reporting of Income/Losses must occur for the outgoing and incoming partner.
2. Allocate the Gain or Loss as follows: a. Formula: Amount Realized – Outside Basis = Gain or Loss
(1) Amount Realized includes: Cash Received + Property Received
+ Liabilities Assumed (by buyer).
(2) Outside Basis = Partner’s Adjusted Basis as of the date of sale. b. Capital vs. Ordinary Gain/Loss: The Gain or Loss must be allocated to either Capital or Ordinary, as follows…
(1) “Hot Assets” ( Unrealized receivables or inventory ) = The
“realized gain” inherent in the sale is treated as ORDINARY.
(2) Remaining Gain/Loss = Capital c. Don’t need to know the effect sale if partnership has 1231 assets.
C. EXAMPLE: Ms. A owns 1/3 of ABC Associates, a general partnership.
Ms. A’s basis in the Partnership at year-end is $ 60,000, which includes
Ms. A’s 1/3 share of the Partnership’s $ 30,000 in liabilities. The partnership has “hot assets” ( unrealized receivables or inventory ) with a basis to the partnership of $ 10,000 and a FMV of $ 19,000. At year end,
Ms. A sells her share to Mr. X for $ 90,000. As part of the sale, Mr. X assumes Ms. A’s share of liabilities. What is her gain/loss from the sale?
1. $ 100,000 Amount Realized ($ 90,000 cash + $ 10,000 assumption of liabilities) - $ 60,000 Basis = $ 40,000 GAIN.
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2. Ms. A’s share of the appreciation in hot assets (1/3 of the $ 9,000 difference between Hot Assets basis & FMV) = $ 3,000.
3. The $ 40,000 gain is split. $ 3,000 will be “ordinary income” and the remaining $ 37,000 will be “capital gain”.
IX. TERMINATION OF PARTNERSHIP
A. For tax purposes, termination occurs if…
1. Partnership business ceases.
--or--
2. Sale of 50% or more of partnership interests.
B. EXAMPLE: Assume 3 partners: A owns 20%, B owns 30% and C owns
50%. If A or B sell their interest to a third party = not a terminating event.
But if C sells her share, then Partnership considered “terminated” for tax purposes.
X. LIMITED LIABILITY COMPANIES: Treat for all intents and purposes
(formation, ordinary income or loss “flow through” allocation, distributions, sale of interest) as Partnerships. There are some special rules, but largely these are the same rules as Partnerships.
[continues on next page]
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I. LLC Legal Issues
G. Basic Attributes: LLC combines best of partnership & corporation…
1. Limited liability for owners.
2. Flow through taxation.
3. Few formalities – there are only two: a. Filing of Articles of Organization b. Preparing an Operational Agreement.
4. Direct management by owners (“members”)
5. Restricted transferability
H. Advantages:
1. Treats owners as partners for tax purposes. ( this generates a variety of benefits including flow through taxation, basis determination, deferral of gains for contributed property, property distributions are tax free ).
2. Limited liability
3. No restrictions on types or number of owners.
4. More flexible capital structure than a corporation ( no restrictions on classes of ownership, no consideration required to invest, allocation can be disproportionate to contributions.
5. Few formalities and simple direct management.
I. Disadvantages:
1. Some tax aspects are NOT favorable (see taxation discussion below).
2. Self-employment tax of 15.3% is imposed on all income to member.
3. Pension plan rules are less flexible ( contributions more limited than corporations and borrowing against one’ spension plan is severely restricted ).
4. Transferability is more restrictive than corporations.
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J. LLC Taxation Issues: In most respects, LLC is like a partnership
1. Formation: No gain or loss on investment of property or cash
( services would be taxable, same as partnership ).
2. At Risk & Passive Loss Restrictions apply if a member is NOT active.
3. Distributions: Rules are the same as Partnerships NOT like a corporation (many distributions are tax free).
4. Income & Losses – Flow through proportionately.
5. Partial Year and Separately Stated both apply.
6. Basis = Investment +/- Share of Income/Losses – Distribution
K. Differences with Partnerships : There ARE several key differences…
1. Limited Liability for company debts.
2. Formalities are necessary ( Articles of Organization and Operational
Agreement mandated by state law)
II. S CORPORATION:
D. Formation: It is a corporation In most redpects remember.
1. Requires: a. 100% shareholder approval required b. Must file election within 2 ½ months – by March 15.
2. Restrictions… a. No > 100 Shareholders b. Only 1 class of stock allowed c. No foreigners as shareholders. d. No entitites (other corporations, partnerships, trusts, ect.) can own stock in a subchapter S. e. No Banks or Insurance Companies can be Subchapter S.
3. Formation and Taxation: Same rules as Partnerships
E. Operation:
1. Income Flows through proportionately.
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2. Losses flow through as well but with Passive Loss and At Risk restrictions where applicable.
3. Basis calculation is similar (but not identical) to a partnership: a. BASIS = Investment +/- Share of – Distribution
Income/Loss
4. Partial year and separately stated item rules of partnerships also apply.
5. Municipal Bond Interest & other Non-Taxable Events = Calculate it when computing basis by decreasing or increasing Basis by these income. ( but don’t add MBI to gross/net income of the company ) .
F. Distributions:
1. Nonliquidating Cash Distributions: S corporations are very much like Partnerships in that cash distributions are not taxed as income, unless the distribution exceeds the SH’s basis.
2. Nonliquidating Property: Here, rule is different and much more like a C corporation. Where an S corporation distributes property… a. Appreciated Property: The S corporation must recognize an immediate gain on sale ( which naturally flows through to the
Shareholders ). b. Depreciated Property; Where property has gone down in value, the S corporation cannot take a loss ( same rule as C corporations ).
3. Special Problem, S corporations that were formerly C corporations and have Accumulated Earnings & Profits (AEP). a. Where no AEP exists, then treat distributions as indicated above ( tax free until basis is exceeded by cash distributions ).
These distributions reduce SH’s basis in Sub. S corp. stock.
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b. Where former C Corporation AEP exists, then distributions must be taxed as ordinary income to the extent of AEP.
These distributions which are taxed as ordinary income DO
NOT reduce basis. c. Accumulated Adjustment s Account (“AAA”): Special order exists for taxing and for basis adjustment ( see below ). An S corporation has AAA where income was earned by the corporation ( and thus “flowed through” to the shareholders ) but was NOT distributed.
4. Accumulated Adjustment s Account (“AAA”): Gain recognition and basis adjustments are made in the following specific order. a. FIRST: Apply any distribution FIRST to AAA as a tax free distribution, until basis is exceeded ( the distribution allocated to offset AAA DOES reduce SH’s stock basis ). b. SECOND: Next, apply remaining portion of distribution to AEP as a taxable dividend (ordinary income to SH). This DOES
NOT reduce basis.
c. THIRD: Allocate remainder as a tax free distribution, until basis is exceeded. This remainder DOES reduce basis.
5. Suspended Losses: What happens when losses exceed basis and therefore cannot be fully taken due to At Risk restrictions? a. Excess losses are suspended to subsequent years. b. Before suspending losses, use losses to REDUCE STOCK
BASIS of shareholder to Zero, and then use excess to
REDUCE LOAN BASIS of loans made by that shareholder, and THEN tax the rest as a capital gain. Note however the following…
(1) Only ordinary flow through losses reduce both Stock
Basis and Loan Basis.
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(2) Distributions also reduce Stock Basis, but DO NOT reduce Loan Basis.
(3) If a loan basis is reduced to Zero and then the loan is repaid to the shareholder by the corporation, then the money is deemed income to the receiving shareholder.
(4) The following year, if there is income, we first allocate that income to restore Loan Basis then increase Stock
Basis
G. Basis Calculation: Some other issues….
1. Reducing Basis…FIRST reduce basis by Distributions, then by losses.
2. Don’t need to know other rules of Built In Gains, nor PTI, etc.
H. Terminations:
1. S Corporations terminate in one of TWO ways… a. Voluntary – by majority vote of shareholders. b. Involuntary – If any of the following occurs…
(1) A restriction is violated ( e.g. 101 st SH, foreign shareholder, etc.
)
(2) More than 25% of the S corporation’s income is passive for 3 years.
2. If during any one year, the S corporation’s income is >25% Passive
Income, then S corporation must pay a penalty tax of 35% on that excess Passive Income. After 3 years of this excess income, S status is lost altogether.
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