Law School Outline - Business Tax Class Notes- Blasi

BUSINESS TAX 08/21/03 Dealing with business tax and partnership tax Limited Liability Company - LLC: Not a corporation or a partnership for legal purposes - Formed under state law - You can choose under the CHECK THE BOX Regulations whether you want to be taxed as corp or partnership - REG 301.7701-3: Check the box regulations – Simply put, you check the box on the IRS form. - A corporation cannot choose (all are taxed as corporations). For the most part a partnership cannot choose to be taxed as corporation. - LLC is kind of whatever you want it to be: Prepare an operating agreement where you structure it however you want it to be structured (the members are the owners) – as opposed to the articles of incorporations; - When we deal with partnership taxation we are going to assume we are dealing with LLC. - In Corp, we are assuming we are dealing with an incorporated company (not an LLC). C-Corporation - Taxed under §11 (the imposition section) S-Corporation - Not subject to tax but are corporations (entities that are incorporated) - Taxed under §1361, et al. and following (not imposed by §11). - Owners will be taxed on the income and no double layer of taxation (corporate and individual level) – Kind of like partnership tax. I. SUBCHAPTER-C CORPORATIONS INCORPORATIONS - We are looking at a rather simple transaction. - A is forming the company (A = Owner) entity is X, Inc. – X is just beginning (articles filed and that’s it). - Assume we have only formed it and not issued the shares. - THE TRANSACTION: A transfers to X some property and X gives stock in return – Probably a taxable event. - From A’s point of view = he has received property for the transfer (§1001): We have the other disposition of property here under §1001(a). In this context it is an exchange. (Other disposition is usually an exchange). §1001(c): It shall be taken into account except as otherwise provided some place. The entire amount will be recognized for tax purposes. This shall be a recognized gain or loss. - What about X? Now, it is a legal entity. Does it have to recognize gain and loss? There is a tax imposed under §11. So we have to see if X does. Each party has to determine the amount of any gain or loss – and except as otherwise provided the gain or loss has to be recognized (taken into account and reported on a tax return). - §1001(a): Gain = amount realized over the adjusted basis of the gain; Loss = adjusted basis over the amount realized. Amount realized being the amount of money + FMV of property received. - Tamara’s computer is $1600 (Cost basis) amount realized + FMV ($400) = $1200 is recognized loss for the deal with my computer. Recognized loss does not mean tax deduction. There has to be some § that allows the item to be deductible. Right now we say there is none. On my side, I have recognized gain of $200 where her FMV is $1200. §351 Exception under §351 to §1001(c) - Non-Recognition Provision for transfer to corporation controlled by transferor - This is an exception to the recognition rule that is limited in its scope. (Not to deal between Tamara and me). o Element 1: Corporation o Element 2: Control by the Transferor - This section looks at the exchange transaction from the point of view of the transferor (A in our example). We will refer to the corporation receiving the property as the transferee and not the transferor. What makes A the transferor IS A IS TRANSFERRING PROPERTY INTO CORPORATION IN EXCHANGE FOR STOCK IN THE CORPORATION. - - - §351(a): “solely in exchange for stock” Problems with §351 (complexity): THIS LITTLE SENTENCE IS LOADED o We already know that §1001 defines the amount of gain or loss. o When we read that we already determine that it exists o What does property mean? o What do they mean by “corporation? (What if LLC elected to be taxed as corporation? What if IRS says you are corporation?) Do they mean an incorporated entity? o One or more persons? Person = individual, could be an entity, juridical entity o Solely? Do they mean maybe? o What is stock? Some type of owner o Immediately? What time period is that?  IMMEDIATE: Not defined in the code; it is a temporal concept, but it is clear that if what you have is the situation where Blasi transfers in property and then takes stock and pursuant to a preexisting agreement, gets control. Not non-recognition. What if he does it differently and gets control the next week because he bought the stock? Non-recognition. IT IS SUBSTANCE OVER FORM. Decide what is really taking place. Either the transfer of property in which control was or was not acquired taking into account all of the facts surrounding the transaction. o What is control of the corporation? 51%? We don’t like to recognize gain but we like to recognize loss. We may not want it to be a non-recognition provision if there is a loss. THIS IS NOT AN ELECTIVE SECTION. The big picture – Finding a way around it to allow recognized loss. When you have words in a section that are well-defined there is nothing better for a tax planner because you know what you have to do to stay within or without that section. How to use the rule is what we are learning. This is a non-recognition transaction. Any transfer was going to trigger the operation of §1041 (transfer incident to marriage). There is also a provision that insures that the gain or loss is never excluded from taxation – It is simply deferred, pushed off, to the future. That provision is a basis rule. It will not be a cost basis. There is no basis rule in §351 BUT there is one in §358 for the transferor. §358: Basis for the Transferor - Distributee = Tranferor - Where there is non-recognition under §351, the basis in the “property”received will be the same as the basis as that of the property exchanged by Transferor: SUBSTITUTED BASIS RULE WHAT ABOUT X? We have just dealt with A, but what about the transferee. We have already said that it only applies to transferor. BASIS: Usually starts with cost basis (§1012) - What did it cost X to get that stock? Nothing – it just issued it. - X is getting property with FMV of $400 in exchange for property in which it has a zero basis. X would have a $400 gain on the transaction. - Does X have to recognize the gain? §1032: Non-Recognition Rule - No gain or loss shall be recognized in exchanging its stock for property. - This is the counterpart to §351 that applies to the corporate transferee. - X will not recognize the $400 of gain. THE GAIN AND LOSS IS REALIZED BUT NOT RECOGNIZED. First, determine the amount of realized gain or loss. Then, determine whether it is recognized. By virtue of §351 and §1032, the losses and gains, although realized, shall not be recognized. §362: Basis to Corporations - Dealing with the basis of the transferee corporation under §351 o Basis = Same as it would be in the hands of the transferor - TRANSFERRED BASIS RULE: The basis that X will have in the property received shall be the same as the basis that the transferor had in that property. A had $1600 basis and X has now a $1600 basis. CAVEAT: THESE ARE THE FOUR PROVISIONS AT THE HEART OF INCORPORATING. WHEN YOU CLOSE THE CORPORATION YOU ARE SOCKED WITH A TON OF BUSINESS TAXES THAT APPLY AT END. Computer hypo: I give computer and money ($400 computer and $800 cash) Tamara gives $1200 computer. Corporation hypo now: - A gives property to X and X gives stock in return. - Stock coming out of X is worth $1200. A would have to transfer in property worth $1200. - §317: Property means money, securities and any other property for purposes of this part = Judicial opinions have said that this definition should apply unless there is some provision in §351 to the contrary. - When A transfers computer and cash for the stock, A is transferring property solely in exchange for stock. - Compare Amount Realized with adjusted basis: o Amount realized $1200  $1000 basis §351: They’ll get you later. Non-recognition provision for now At one point you could get out OK too, but not anymore. Important to focus on the big picture A FMV of Computer = $1200 A/B of Computer = $1600   X $200 Cash $1000 Stock A would have $400 recognized loss. §351(b): If the transferor receives other property or money, then gain shall be recognized no greater than money or FMV of other property. Loss will not be recognized. - If we are excluded to §351(a) because we didn’t just get stock, we get re-caught by (b). - What does it do to the gain? It says that gain is going to be recognized. No more than the amount of money or FMV of other property. - Loss is not recognized no matter what. Facts change and instead we have FMV $1200 and A/B $1000  X  Stock $800 and $400 cash A FMV $1200 A/B $1000   X $800 Stock $400 Cash Now, through §351(b), realized gain is $1200 (amount realized) – ($1000 basis) = Realized gain of $200. - §351(a): Does it apply? NO, not solely for stock. - §351(b): Does it apply? YES, recognize the entire $200 because it is not in excess of cash received. A   X FMV $1200 $800 Stock A/B $ 100 $400 Cash Amount realized = FMV of property and cash received = $1200 and therefore $1100 with be realized gain. $700 with be non-recognized which $400 will. Congress in these transactions sees sale and exchange. A transfers (sells) a piece of its property for cash and exchanges the other piece for stock. §351: Deals with changing form of ownership, but no cashing out, you don’t have to recognize. BASIS UNDER §358 of the problem that was $400 cash and $800 stock and $1200 FMV and $100 A/B problem FOR NEXT WEEK’S CLASS Very major change in Taxation of Corporate Earnings - Double-taxation in US o $100 earned by corporation where corporation would pay $35 in taxes and then $65 is distributed to shareholders with $26 tax under §1. So total amount left is $39 so the effective rate of tax is 61%. o Recently, this occurred - $100 corporation pays $35 for §11 and now the dividend is only taxed at 15%. So effective rate of tax is only 45%. - So when a corporation now earns income will only be taxed at 45% instead of the original 61%. Now, greater interest has appeared in corporate. The cost is not so great anymore. There will be less of an impediment to operate in corporate form now than in the past. - If we compare that with partnership: o $100 earned by partnership with no tax. $100 goes to individual who is taxed at 35% so the effective rate of tax is 35%. o There is still a significant advantage of partnership taxation over corporate, but not nearly the advantage as in the past. 08/28/03 ANSWER TO MY PROBLEM: BASIS: §358: A $1200 FMV A/B of $100 AMOUNT REALIZED Realized Gain = $1200 (-) A/B = $100 Amount Realized = $1000 So, We must recognize the gain only to the extent that we receive cash. $400 recognized gain on the transaction The basis in the property received is substituted so it would be $100 BASIS = Original Basis was $100 Decreased by FMV of other property received by the taxpayer (other boot – not there) Decreased by Money received by the taxpayer: $400 Decreased by Recognized loss: N/A Increased by amount treated as dividend N/A Increased by amount of recognized gain $400 So basis will remain at $100 despite recognized gain of $400? §358 (a): The basis of the property shall be the same as the property exchanged (A) decreased by (i) the FMV of any other property received by the taxpayer; (ii) the amount of any money received by the taxpayer; AND (iii) the amount of loss to the taxpayer which was recognized on the exchange AND (B) increased by (i) the amount which was treated as a dividend; AND (ii) the amount of gain to the taxpayer which was recognized on the exchange. SEE WORKSHEET FOR ADDITIONAL INFORMATION: STEPS FOR ANSWERING X $800 stock $400 cash 1. 2. 3. 4. 5. 6. FIRST: IS THERE A SALE OR EXCHANGE? Is there any realized gain? (§1001) a. The amount received + money - $100 = $1100 realized gain b. Except as otherwise provided the amount of realized gain must be recognized (Recognized = taken in to account – reflected on a tax return) Is there a non-recognition provision? Yes, §351 = not recognized if exchanged for stock in the corporation; $400 of the $1000 shall be recognized. What is the effect on tax basis generally? If there is no boot (Why we had a transferred basis and not cost basis? We have to somehow account for the unrecognized gain or loss (deferred) so we preserve the old basis. a. Cost Basis: generally under §1012 b. Substituted Basis: Under §351(a), the transferor gets a substituted basis. §358 c. Transferred Basis: Under §351(a), the transferee gets a transferred basis. §362 d. Stepped-Up Basis: Estates In a §351(b) transaction, there will be partial recognition of gain. So we deal with §358 for basis – The property permitted to be received (permitted property) shall be the same as the basis of property exchanged: decreased by any other property; money and loss recognized and increased by the gain recognized. IN ORDER TO CHECK, PRETEND YOU SOLD THE PROPERTY THE MINUTE AFTER YOU RECEIVED IT. a. In the problem – Sell $800 which has $100 basis so $700 realized gain and we would now recognize the $700 that we didn’t at the time of the original transaction. Now, we have taken care of A: Now we have to deal with how X is taxed = §1032 – The corporation does not recognized gain or loss. - What is X’s basis? Realized gain of 1200 (FMV + Money – A/B) - What is X’s basis in the goods received? §362: Under 100 + 400: $500 basis PROBLEM: 1. §1001 amount realized (Must be a sale or other disposition of property!!! FIRST MAKE SURE YOU HAVE A SALE OR OTHER DISPOSITION OF PROPERTY – $200 of realized (Amount realized – adjusted basis = Realized gain) – Amount realized for all is $1000 A: $200 realized gain; 0 recognized gain; substituted basis - $800; B: -$100 realized loss; 0 recognized loss; substituted basis - $1,000; C: $0 realized loss; 0 recognized gain/loss; “cost” basis - $1,000; X: No recognition of gain or loss; transferred basis in machinery is $800; in vehicle $1000. If A transfers his property on 1/1 and B on 1/31 – There could be a §351 transaction. A is in control on 1/1 so there is §351 with deferral of all of A’s gain. B transfers his property on 1/31 and gets ½ - Then B is not “in control” because he doesn’t have 80% of the control. So he gets to report his loss Machinery sold 3 months after transfer for $1000 with $800 basis – Corporation will be recognized gain of $200. When A, B and C transferred their property and gotten equal amount of stock DIFFERENCE HERE IS BETWEEN CORPORATE TAXATION AND PARTNERSHIP TAXATION If corporation sells the machine, it has $200 of gain and pays (just a number) $60 in tax. A, B and C are actually paying the tax. A has shifted a tax liability of $40 to B and C. (In partnership law they say that you can’t do that – you can’t shift gain among the other partners and they can’t take place in any loss.) Don’t forget ethics in tax law: How would you deal with A coming to you and putting the gain on the corporation so that he can shift the tax consequences? D held the corporation to 3 other people he no longer had control and none of the factions would be in control A: $200 realized gain; $200 recognized gain; cost basis is $800 B: -$100 realized loss; $100 recognized loss; cost basis is $1100 C: $No loss or gain and nothing to be recognized; cost basis is 0 2. - - 3. X: Corporation has cost basis in everything. §357: Assumption of Liability – - If individual is incorporating sole proprietorship or someone is transferring property to corporation subject to liability, what happens? - Look at assets and liabilities when determining income. - If the property transferred to the corporation subject to the mortgage, it is like you have gotten money in return for the mortgage. - §357(a): If person gets stock in exchange for assumption of liability OR taking property subject to liability by the stock issuer, such assumption shall not be treated as money or other property and shall not prevent the exchange from being under §351. Otherwise, §351(b) would be triggered. - §357(c): In a §351 exchange, if the liabilities assumed is greater than total of adjusted basis transferred pursuant to such exchange, then such excess shall be considered a gain from sale or exchange. - Lessinger: Tax avoidance under §357(c) – Supposedly he transferred the property and promissory note with $13 million promise. The court accepted that a promissory note was really transferred at the time the property was transferred. Was there any basis in the promissory note? The 2 nd Circuit said that the face of the note was equal to its tax basis. The IRS said that the case was decided wrongly, but it still remains there. - §357(b): If it appears to be for tax avoidance or not a bona fide business purpose, the assumption will be money received on the exchange by the taxpayer. They are talking about: A says he needs cash and decides to mortgage and then transfers to corporation. A $1000 $300 liability $500 A/B   X - No recognition under §357(c) But if it is only for the transfer to run the corporation then it is OK. Treated as money received - §351(b): Gain has to be recognized to the extent of the boot. §357(c): The excess shall be recognized gain. §357(b): It is money received if it is for tax avoidance. A A/B $900 Liability $300 No problem under §357(c) – Proscribed purpose makes the money received to be $300. There would be $100 realized gain and it would be completely recognized because it is up to $300. §357(b) and (c): (c) is nothing more than a trap for the unwary; but (b) when you are bad is not so bad.  $1000  $1000 stock X - §358(d): Assumption of Liability - Basis - §358(d): Where as part of the consideration to the TP, the corporation assumed a liability such assumption shall for purposes of this section (only §358) be treated as money received by the taxpayer under §358(a). - We go to §358(a) – Increased by and decreased by – Money received = Liability assumed in full amount and then follow the rule under §358(a). - NEW PROBLEM A $1000 A/B $900 Liability $600 1. 2.  X $400 Was there a sale or exchange? What is the adjusted basis? We have received the $400 + $600 liability so amount received is $1000 – A/B which is $900 so realized gain is $100. 3. 4. 5. Do we have to recognize the realize gain? Is there an exception to recognition? The exception is now a mixture of §357 and §351. Under §357(a), liability is not treated as money received so all is permitted property. (So far we are good under §351(a)). So, nothing need be recognized - §357(b) and (c) do not apply here either (liability does not excess basis and there is no bad stuff going on). This is a non-recognition transaction. What is the basis for A? § 358(a) – it is $900 – FMV of other property – amount of money received which is $600 under §358(d) – amount of loss + amount of gain recognized = $900 - $600 = $300. Liability only affects A. What is X’s basis? $900 NEXT CLASS – Look at §248, 195 and then we are going to move into Assignment 3. e-mail notes esm@esmsolutions.net 09/04/03 Problem 6: Alternative 1 – For A: Amount realized is $1000 – A/B = Realized gain = $200 Recognized Gain = none because under §351 Basis of A’s property = $800 (adjusted basis in the property given up) Basis of X’s property = $800 (transferred basis) For B: Amount realized is $1000 – A/B ($1100) = Realized loss of $100 Recognized loss = none because of §351 Basis of B’s property = $1100 (adjusted basis in the property given up) Basis of X’s property = $1100 (transferred basis) For C: Step 1: Is there sale or exchange under §1001? Yes Step 2: Is this §351 sale or exchange? Yes – solely for stock, control Step 3: What is realized gain? See §357: Realized gain is amount realized (FMV + other property) – A/B= $900 Step 4: Does the gain have to be recognized under §351? No. Only has to be recognized if the basis is exceeded by the liability. The liability is $1000 and the basis is $1100 unless it is not bona fide. Step 5: What is the basis? Basis is substituted basis of $1100 – FMV of other property (0) – amount of money received which is $1000 – amount of loss (0) + amount of gain (0) = $100 Step 6: What is X’s basis? $1100 (transferred basis) (DO NOT LUMP THE TWO TOGETHER Amount realized – If we allocate compensation based on FMV, so if we get $2000 - Building is $500 and Land is $1500; Mortgage is $250 and $750.) The assumption of the liability shall not be treated as money or other property under §357 and therefore §351(a) will apply. §357(b): Tax avoidance purposes §357(c)(1)(B): If liability exceeds basis – You aggregate the §351 property’s basis in order to determine if liability exceeds basis. Basis: §358 for A, B, C and §362 for Corporation - §358(d): Tells us how to deal with assumption of liability. It is treated as money received. - §358(a): Tells us that the receipt of money decreases the basis. Alternative 2 – Step 1: Is there sale or exchange? Yes. Step 2: Is this §351 sale or exchange? Yes. Step 3: What is realized gain? Amount realized (FMV ($2000) + other property) – A/B = $1100 Step 4: Does the gain have to be recognized under §351? Yes, to the extent of the excess of the liability because the liability exceeds the original basis ($1000 - $900 = $100). $100 has to be recognized. (YOU COULD HAVE A REALIZED LOSS, BUT IT CREATES GAIN INDEPENDENTLY – DOES IT HAVE ANY EFFECT ON THE §351 TRANSACTION) Step 5: What is the basis? Substituted basis of $900 – FMV of other property (0) – amount of money received ($1000) – amount of loss recognized (0) + amount of gain ($100) = $0 Step 6: What is X’s basis? $1000 (transferred basis + the amount of gain recognized by transferor) Alternative 3 – Step 1: Is there sale or exchange? Yes. Step 2: Is this §351 sale or exchange? Yes. Step 3: What is realized gain? Amount realized (FMV ($2000 + other property) – A/B which is $1100 = $900 - Cannot net the assets – Do we have to do per asset? YES, probably. - So we have $1000 gain and (-$100): So, we have $1000 gain to recognize to the amount of gain under Step 4: Does the gain have to be recognized under §351? Yes to the extent of the boot (money received) so he would have to recognize the $900. Step 5: What is the basis? Substituted basis of $1100 – FMV of other property – amount of money received ($1000) – amount of loss recognized (0) + amount of gain ($900) = $1000 Step 6: What is X’s basis? $1100 Alternative 4 – Same as 2 09/04/03 General Rule of §357(a): Provides that the assumption of a liability by a corporation in connection with a §351 transaction will not be treated as money or other property. §358: Has different rule – Assumption shall be treated as money received for purposes of basis. This is engrafted onto §1001: When you are relieved of a liability it is going to be treated like you received money. Alternative 4 §357(c)(3): Liabilities = trade payables (owe people money in connection with the business) - We ignore those trade payables (liabilities) – reason if we count them in the excess determination in many incorporating transactions there would be excess. - We don’t count these (salaries, utilities, short term liabilities, etc.) – Business expenses (would give rise to a deduction). - §357(c): Deals with mortgages and not trade payables. §317(a): Property means money, securities and any other property exception being not stock in the corporation making the distribution. - What about services performed for stock? Nope (§351(d)) - If 1/3 of receipt is received for property, control is not obtained for property so it takes it out of §351. SITUATION: A  $Property (30) B  $Property (30) C  $Property & Services (25) (5)  1/3  1/3  1/3 Above, we have control without stock received for services. A  $Property (30) B  $Property (30) C  $Property (10) & Services (20)  1/3  1/3  1/3 Limited Rule = You can count stock received for services if it does not amount to more than 10% of the stock received by that shareholder. (RR 77-37) General Rule = STOCK RECEIVED FOR SERVICES IS NOT STOCK RECEIVED FOR PROPERTY UNDER §351. Special Rule = If it dropped the amount of control under 80%, §351 would no longer apply and they must recognize. §83: Property transferred in connection with performance of services – Ties in to the above - Deals with when you have income o When you receive the stock? o Or at a later date (sale of stock)? o When a substantial restriction on the transfer of the stock expires? - This section deals with incentive stock options or when you receive stock when the corporation was formed. - GENERAL RULE: The excess of the FMV of the property at the time the rights are transferable or not subject to a substantial risk of forfeiture OVER the amount paid for such property = YOU DON’T HAVE IMMEDIATE INCOME. - ELECTION: Any person…may elect to include in gross income for the year in which such property is transferred the excess of the value over the amount paid. You can choose to include that in your income. o If you go along with General Rule of A, the full amount is going to be like salary income but any further appreciation to the date of sale shall be capital gain. o If you elect, however, you have gross income = to the value of the stock at that day. It could be a very small number (all subsequent appreciation will be capital gain). o RISK: If you make the election and include the stock in their income, it then goes down and they could not deduct the loss. (Dotcom people did this) o II. CAPITALIZATION OF THE TRANSFEREE CORPORATION - Significant tax bill enacted this year with one of the salient components being the reduction in the rate of tax imposed on dividends – down to 15%. - There had been a sharp bias in favor of a corporation issuing debt to raise capital instead of issuing equity to raise capital in the past. The corporation could deduct interest payments on the debt but not deduct the amount it paid as dividends. To the investor it was neutral (they were taxed at the same rate). - Under the old law we had this situation: INTEREST Deductible (§163) Income (§61) (40% tax) DIVIDENDS No deduction Income (§61)(40% tax) Corp Individual Under the new law Corp Individual INTEREST Deduction (§163) Income (§61)(40% tax) DIVIDENDS No deduction Income (§61)(15% tax) - - - - - - - - From the individual point of view it was taxed the same. From the corporation point of view it was better for debt instruments. New law: Corporation doesn’t change. New law: Individual is taxed a great deal less under dividends. If you step back and say corporate earning are taxed twice, once when it is earned and second when it distributes it as a dividend. (Double taxation under both laws) Double-taxation in US o $100 earned by corporation where corporation would pay $35 in taxes and then $65 is distributed to shareholders with $26 tax under §1. So total amount left is $39 so the effective rate of tax is 61%. o Recently, this occurred - $100 corporation pays $35 for §11 and now the dividend is only taxed at 15%. So effective rate of tax is only 45%. This assumes that the amount is distributed as a dividend. Corporations have not been paying much by way of dividends knowing that the effect imposes on those earnings a second level of tax of 40%. Investors would rather let the stock appreciate in value as the firm retained those earnings and then at a later date let it be sold and taxed as capital gains. Closely held corporations find dividends even more offensive. They looked for ways to avoid double tax on corporate earnings (paying out the earnings as interest in which case there is no corporate tax in the amount paid out; other ways available = salaries, rent to owners, pay principal back on debt). So, knowing that when we speak of the rules associated with the capitalization of a corporation, most corporation would be capitalized just with debt if they possibly could. They can’t be so there would be some equity but mostly debt. THE DEBT-EQUITY RATIO Situation: Helping new firm to begin – They decide they will make $100s of $1000s per year. They want to distribute it to the owners. You would propose that they capitalize it in part with debt by paying interest to the owners (like salaries) thus avoiding tax at the corporate level. IRS knows about this and promulgated some proposed regulations dealing with what is debt and what is equity. They said that if there is too much debt relative to the value of the equity, the debt would be recharacterized as equity meaning that the corporation would not get tax deduction from the debt distribution. When the regulations were promulgated, there was no difference in the rate of tax paid by individual on interest or dividends. The revenue service believed that the only effect would be on the corporation. If the recharacterization of the distribution as equity will apply for purposes of the holder of the instrument then the holder can subject it to the more favorable 15% tax rate. There is no guidance on this now for the purposes of the holder of the instrument. For the purposes of the distributee it should also be characterized as equity. §385: Treatment of certain interests in corporations as stock or indebtedness - First successful effort to define DEBT and EQUITY (corporation has always preferred debt; IRS has preferred equity) - (a): Secretary can prescribe regulations determining whether for the purposes of the Title interest in a corporation is stock or debt: The regulations are legislative regulations because of this section – It is close to a statutory provision. Although this was granted to IRS, they constrained that authority by listing the factors required to be taken into account when drafting the regs. - (b) FACTORS: o (1): Written unconditional promise to pay on demand or specified date to pay sum certain and fixed rate of interest (FIXED: The rate is set in some way either stated in the instrument or it is determined by reference to some objective floating rate). Does this thing look like a debt instrument? o (2): If the instrument has priority or not preferred – If there is debt outstanding, or does it start looking like equity (PREFERRED STATUS UPON LIQUIDATION GOES TO DEBTORS AND THEN PREFERRED SHAREHOLDERS AND THEN COMMON SHAREHOLDERS) – If it is subordinated, it looks more like equity. If it is not subordinated, it is more like debt. o (3): The Ratio of Debt and Equity to the corporation – There are some safe-harbors – If you have entity that is 1:1 you are probably OK. If you have more than 5 parts debt to 1 part equity then you could be in trouble. (5:1). There is no absolute rule here and would depend on the entity (type and where it is in its life). A newly formed entity may have more debt than equity (hard to raise capital by issuing shares, but there may be a creditor status that people would invest in). o (4): Convertibility into the stock of the corporation – This is a hybrid instrument or flavored by equity. If you have convertibility the instrument starts looking more like equity and less like debt. - (5): Relationship between holdings of stock and holdings of the interest in question (Proportionality). If you have 5 shareholders and their equity interests in the corporation are as follows: This is also an indication that the debt is equity  A: 20 – Promissory notes in the same proportion as their equity interests) ($20K)  B: 40 – ($40K)  C: 20 – ($20K)  D: 10 – ($10K)  E: 10 – ($10K) o If you have all of them, the corporation would not be able to deduct because it would then be equity. When the corporation repays the debt, it may be considered a dividend distribution instead of interest. In 1980, regulations were proposed but never finally adopted and those regulations are often still regarded as containing the IRS position on the characterization of instruments as either debt or equity: INSTALLMENT SALES: When you capitalize, you should get back some debt. Can you sell property to a corporation by installment note? YES. Instead of contributing property to a corp you can get stock and a promissory note (form of debt – must bear interest, deducted by the corporation and when debt is repaid, the individual holding the debt will have no income). However, because it is an installment sale, the income would be taken in as payments are received. (Sell piece of machinery and take back $100K promissory note – basis was $90K and the machinery is worth $100K with reasonable rate of interest and $10K of gain. The note provides that you will receive $10K over next 10 years where you will report $1K over the next 10 years). ANOTHER WAY OF CAPITALIZING IS TO TRANSFER PROPERTY AND RETAIN A PROMISSORY NOTE. o §1244: LOSSES ON SMALL BUSINESS STOCK - The other problem is that loss is capital loss only up to $3K per year. - This section changes the rule with respect to small business stock allowing the loss on the taxable sale or other disposition of small business stock to be characterized as an ordinary loss. - LIMITATIONS ON TYPE OF QUALIFYING COMPANY: - 2 important reference times that you have to be aware of in determining whether the corporation is a small business corp.: o AT FORMATION (initial capitalization) o AT SALE OF STOCK - If it does satisfy the rules that we aren’t getting into, then the loss on the sales will be treated as an ordinary loss. §1202: EXCLUSION FOR GAIN FROM SMALL BUSINESS STOCK - GENERALLY: Allows you to exclude a portion (permanently) of the gain that you recognize when you sell small business stock. (From an investors point of view, having a capital loss is unattractive – if you sell stock at a gain, you have this added provision that allows a 50%-60% exclusion of the gain that you recognize when you sell the stock.) Pay capital gains tax on 50% and nothing on the other 50%. - Definition of Small Business in this section and the other section is not the same. - CONSTRAINTS exist §243: DIVIDENDS RECEIVED BY CORPORATIONS - There is a deduction for dividends received (exclusion) - Corp A pays Corp. C a $100 dividend A  $100 dividend  B No deduction Treated as Gross Income §243: Allows deduction which depends on B’s ownership interest in A  B gets 70% dividends receipt deduction (owns less than 20% of A)  B gets 80% dividends receipt deduction (owns between 20-80% of A)  B gets 100% dividends receipt deduction (owns 80-100% of A)  Only 30% gets taxed. Congress was trying to ensure that corporate earnings would not be triple taxed. If you own more than 20%-80% then you get an 80% dividends received deduction. If owns less than 20%, it gets 70% deduction If owns more than 80% it gets 100% deduction - - A corporate investor would rather buy shares of stock than the debt instrument because their after tax return will be much higher on dividends than interest. (Aside: TRUST PREFERRED STOCK: A forms DBT (Delaware Business Trust). DBT issues preferred stock. DBT gives proceeds from sale of preferred stock to A for promissory note. The rate on the preferred stock is 9%. A deducts the interest it pays to DBT because A is allowed to treat the note as a debt instrument. It is treated as paying interest to the investors in DBT. DBT has no income for tax purposes. - A has been able to deduct a dividend distribution because it is deducting the interest paid to DBT. A Note  DBT  SH Preferred Stock at 9%  Cash from SH  Money from stock 09/11/03 DISTRIBUTIONS - Publicly held companies almost always have dividends. - A distribution can take different tax forms – may not be a dividend in all cases. A dividend for tax purposes is a term of art and defined in IRC. - Ordinary income (dividend distributions) – Dividends are taxed at that 15% rate (although they are ordinary income). Now we can have ordinary income taxed at a favorable rate - Distributions are not always cash (could be stock, stock rights, tangible property) - For publicly traded corporations, it is not likely for them to distribute property other than stock or stock rights (or cash). - Distribution of stock = Stock split (or right to purchase stock for each share they own). - Closely held corporations have more variety – not all distributions will be dividends and in addition to cash, there may be other types of distributions. - Timing of distributions for closely held corporations is quite different than timing for publicly held companies. Public has periodic distributions. With closely held corporations, the owners can decide when they want to make a distribution and what they want to distribute. - Last class, we looked at the capitalization of a corporation. Often, corporation is capitalized with debt as well as equity because there is a tax benefit in debt (interest deduction). Incidents of taxation of shifted to the shareholder with debt instruments. - Closely held corporations are much more sensitive to the double taxation problem than publicly held corporations. o Shying away from those distributions that will be taxed as ordinary income (dividends). o The new tax rate is better though for them. o Preferable to have interest or repayment of principal of debt. - Other ways to avoid double taxation – salaries, payment of rent for the use of property (corporate deduction), - If we cannot avoid double taxation, we have to deal with dividend taxation. §301 – Distributions in General (of property) – EFFECT ON OWNERS NOT CORPORATION - §301(a): “Except as otherwise provided in this chapter, A distribution of property made by a corporation to a shareholder with respect to its stock shall be treated in the manner provided in subsection (c).” o Distribution: can’t be a loan or leasing of property – has to be a distribution o Property: Defined §317: Money, security and any other property except for stock in the corporation making the distribution o Corporation: LLC? – If they elect to be treated as a corporation – Anything that elects to be taxed as a corporation o Shareholder: Those treated as a shareholder o With Respect to its Stock: Because the person has stock in the corporation o Except as otherwise provided (§311) – Taxability of corporation on distribution: These will effect any distribution that is governed by §301; (§302) Distributions in Redemption of Stock; (§303), (§304). - §301: Contains the plain vanilla rules (special rules contained in other sections) - §301(c): The amount of a distribution by a corporation to a shareholder with respect to the stock that is taxable – o If (a) applies then:    First treated as described in 301(c)(1): Amount distributed shall be dividend to the extent of E & P. Dividends (§316) shall be included as gross income  “DIVIDEND”: Any distribution of property made by corporation out of earnings and profits accumulated or of the taxable year (§316) - Must have distribution out of earnings and profits o Earnings & Profits: e & p is not defined in IRC - Adjustments that have to be made to arrive at them are described in §312(a): E & P will start out being taxable income. Then we make adjustments to the taxable income to arrive at the current years earnings and profits. (Adjustments are made to accumulated E & P also – but only for distributions that have been made). Initially, we have to compute current E & P.  Dividend to the extent of E & P – If amount of distribution exceeds the E & P Then treated as described in 301(c)(2): If it exceeds E & P, then it is applied against the basis and tax-free.  That portion that is not recognized, as dividend, will be applied against and reduce the adjusted basis of the stock. To the extent you are getting your capital back, you are not going to pay tax. Basis = property we put into the corporation – Capital contributions are dealt with in §118 (shareholder to corporation) from the corporations point of view (no income when it receives that). Basis will be adjusted Then treated as described in 301(c)(3): If it exceeds (1) and (2), Shall be treated as gain from the sale or exchange of property. EXAMPLE:  A $100 A formed X and gave $10 in cash and other property with an A/B of $20 for total of $30. In corporation’s E & P account it has $40. How is the $100 distribution going to be taxed to A? §301(a) tells us that it is taxed as in §301(c) - $40 is gross income because it is the amount of E & P out of the $100 - $30 is return of capital and is tax free Not E & P is applied against the A/B of the stock – A’s basis in the X stock is $30 so it uses up to basis - $30 is going to be gain from the sale of property (stock) which is almost always long-term capital gain (LTCG) X Let’s say that the basis in the stock is now zero (as in above problem). Next year, we have another distribution of $60. What happens? - First, what portion is going to be a dividend? As a result we must figure out what the E & P is. Last year, we paid out E & P. Unless we have more E & P in the next year, we will not have dividend with a distribution. Let’s assume we have $20. - §301(c)(1): $20 of dividend - §301(c)(2): $0 because basis = 0 so we can’t apply it - §301(c)(3): $40 LTCG This company is liquidating in this case. Be careful not to conclude that the type of liquidation that is taking place here is the same as liquidations that we will deal with later. Liquidation is a term of art in the IRC but ask us the question from an economic point of view. It is distributing more than it is making and can’t live very long like this. Let’s say we make the $100 distribution in Year 4 without distribution in Year 3 - $60 = dividend - $30 = return of capital (non-taxable) - $10 = LTCG Before the change in law it made a BIG difference as to the distribution but now we have same tax rate for dividend and LTCG so it doesn’t matter too much. §312 – EARNINGS & PROFITS - “A corporation’s earnings and profits for the tax year are arrived at by starting with taxable income and making adjustments set forth in §312 and the regulations thereunder.” The Problem: - Gross Receipts: Not the same as gross income – This is more accurately defined as sales minus cost of goods sold. o SALES – COST OF GOODS SOLD = GROSS RECEIPTS (if no inventory it would be gross income) - Dividend from a company they don’t own much of - < 20% - Long Term Capital Gain (amount realized – adjusted basis = gain and the gain is with respect to a capital asset and held the asset more than 1 year) - Long term capital loss - Long term capital loss carry-over = For tax purposes, we were unable to utilize that deduction in an earlier year. A corporation is not permitted to deduct capital losses in excess of capital gains. A corporation may only offset capital losses against gains. (No additional $3K like individuals) §1211 - Tax-Exempt Income - Salaries - Tax depreciation (Asset that cost $14K and we buy it this year – 5 year property. Under §167 and 168 we are permitted to use DDB method to recover the cost. Take depreciation deductions – In the year you acquire the asset under §168 we have to use the ½ year convention meaning that we are only entitled to a ½ years appreciation (all assets acquired during a year are acquired at the mid-point of the year) – We are permitted $5600 because of Double Declining Balance and ½ year convention make is $2800. - Estimated Tax Paid $1500 (estimated taxes) EARNINGS AND PROFITS - What is “earnings & profits”? What is it getting at? Something like what you would have available to really pay out to your shareholders. Distributable cash at the end of the year. TAXABLE INCOME: $100,000 Gross Receipts (Cash) $1000 Dividend Income (Cash) $2000 long-term CG is cash $3000 (reduces the cash if you have economic loss) LTCL Tax-Exempt Income $1500 Salaries $50K Tax Depreciation $2800 Estimated Tax Paid $1500 When we make our computation we want to think of things in this like - §312 requires that we start with taxable income DETERMINING THE TAXABLE INCOME – List all income items - Gross Receipts = $100K is taxable income - Dividends = $1K is taxable income - LTCG = $2K is taxable income (Tax-Exempt Income = $50K – not even in the computation) GROSS INCOME IS $103K DEDUCTIONS - §162 Salaries = $50K as business expense - § 243 Dividends received deduction = 70% deduction = $700 - §1211 Capital Losses = Permitted to take capital losses to the extent of capital gains and capital loss = We are taking LTCL deduction of $2K - § 68 Depreciation Deduction $2800 TOTAL DEDUCTIONS: $55,500 TAXABLE INCOME = $47,500 EARNINGS AND PROFITS CALCULATION UNDER §312 - TI = $47,500 Adjustments = Tax Exempt income $50K it would be added in - Add Back the Dividend Received Deduction $700 - LTCL: $1000 - Estimated Tax: $1500 - Depreciation: 5 year property with a 7 year class life (for purposes of E & P) – The class life: A LIFE THAT THE REVENUE SERVICE ASCRIBED TO PROPERTY YEARS AGO (Asset depreciation range system) – For purposes of E & P, we must use the class life under the ADR and not the life set forth in §168. As a result, the depreciation would be a seven year life – We use straight line, ½ year convention with seven year life so we have $2000 per year and ½ of that is $1000. We took $2800 depreciation and are allowed $1000. We add back $1800. - Earnings and Profits = $48,000 (those numbers will not always be similar – Taxable income and E & P) ASIDE: Accounting Principals: Retained earnings – similar to E & P - Assets = Liabilities + Capital - A = $100 - L = $70 - C has 2 components: 1) Par value; 2) “Paid-In” = Par value may be $1 and paid in would have to be $29 here. - If we make a profit at the end of the year, $10 and the $10 is expressed as cash. o Assets would increase by $10 o The other 10 is going into Retained Earnings which is under Capital as 3 rd Category. - The $10 however may already be spend for computer which would still be reflected in the equation but not equal to cash. - This does not take into account §312. EARNINGS AND PROFITS: Definition of a dividend – Distribution out of earnings and profits for the year and accumulated E & P – Each year when the corporation earns money and doesn’t pay it out the earnings and profits will go up. - Back to the problem above. - This will be a big deal for closely held corporations but not so much for large companies. - There will never be a capital loss carryover for E & P purposes. §301: When a distribution is made and exceeds the current year’s earnings and profits - What happens if there is a deficit in current year’s E & P (negative balance)? (i.e. more deductions than income) o There may be an accumulated deficit and current year positive and vice versa. Problems Alternative 1. 2. 3. 4. 5. Shareholders A B C A/B 110 90 70 Accumulated -0-0400 400 (160) Current 600 240 200 (160) 240 Determine what happens under each when there is a distribution of $300 to each shareholder - $900. Alternative #1 A $200 $100 $0 B $200 $90 $10 C $200 (E & P is distributed equally among the S/H) $70 $30 §301(c)(1): Dividend §301(c)(2): Basis §301(c)(3): LTCG Alternative #2 §301(c)(1): Dividend §301(c)(2): Basis §301(c)(3): LTCG Alternative #3 Here we have $600 §301(c)(1): Dividend §301(c)(2): Basis §301(c)(3): LTCG $80 $110 $110 $80 $90 $130 $80 $70 $150 SAME AS #1 SAME AS #1 SAME AS #1 SAME AS #1 SAME AS #1 SAME AS #1 SAME AS #1 SAME AS #1 SAME AS #1 Alternative #4 Do we net here or do we use the most current? HERE IS WHAT WE DO: A CURRENT YEAR’S DEFICIT IS PRESUMED TO HAVE ACCRUED EVENLY THROUGHOUT THE YEAR. You have the opportunity to rebut that presumption if it can be demonstrated that the deficit is attributable to one part of the year and not another then you can so allocate it. First ½ of the year might result in positive balance and individual sells shares at the beginning of the year. ASSUMING THERE IS NO SALE, ASSUME THAT DEFICIT ACCRUES EVENLY THROUGHOUT THE YEAR, AND APPLY ANY ACCUMULATED E &P ON A FIRST COME FIRST SERVE BASIS. It will be applied to the earliest distribution first RULE 1: CURRENT YEAR DEFICITS ARE SPREAD EVENLY THROUGHOUT THE YEAR. RULE 2: WE SPREAD ACCUMULATED E & P ON A FIRST COME FIRST SERVE BASIS. Assuming that all distributions were made in December. §301(c)(1): Dividend SAME AS #2 SAME AS #2 §301(c)(2): Basis §301(c)(3): LTCG SAME AS #2 SAME AS #2 SAME AS #2 SAME AS #2 SAME AS #2 SAME AS #2 SAME AS #2 Alternative #5 How do we deal with the deficit in accumulated E & P? Do you net these two? Look at language in §316 – THE E & P, no matter whether it is positive or negative, IS SPREAD EVENLY THROUGHOUT THE YEAR THIS DISTRIBUTION WAS AT THE END OF THE YEAR – IF WE WAITED UNTIL THE NEXT YEAR WE WOULD NET THE TWO, BUT NOW WE JUST TAKE THE CURRENT YEAR’S E &P WITHOUT CONSIDERATION OF THE ACCUMULATED WHERE THERE IS AN ACCUMULATED DEFICIT A DISTRIBUTION CANNOT CREDIT A DEFICIT IN EARNINGS & PROFITS. WHEN IT GIVES OUT DISTRIBUTIONS, ALL $240 IS USED UP IN THE DISTRIBUTION SO THE (160) REMAINS. §301(c)(1): Dividend §301(c)(2): Basis SAME AS #2 SAME AS #2 SAME AS #2 SAME AS #2 SAME AS #2 SAME AS #2 §301(c)(3): LTCG SAME AS #2 SAME AS #2 SAME AS #2 MAXIMS BASIS IS GOOD STUFF E & P IS BAD STUFF (if you have individual shareholders because it creates ordinary income). Be careful with computation of E & P before you give out the information. Zens case next class Corporate shareholder: Dividend distribution is tax-free so they want the company to have E & P and apply the dividends received deduction. They would rather that than reduce basis and capital gain. LIABILITIES - What effect do they have on the amount of the distribution? - Liabilities reduce the amount of the distribution §311: TAXABILITY OF CORPORATION ON DISTRIBUTION - §311(a): No gain or loss shall be recognized on the distribution with respect to stock of stock or property. - §311(b): Actually the General Rule §301(d): Tells you the basis. X  A A/B $600 FMV $1000 What happens to X? It would have to recognize $400 of gain. What happens to A? - §301(b): A gets $1000 of property. - How much will be dividend? At least $400 of E & P because it is recognized gain. - Taxes on the gain will be paid so we will have to subtract those from the gain – so not really $400 of gain… - A lot more happens than gain being recognized under §311(b) – Taxable income is created; taxes will have to be paid. A now gets that piece of property and whenever TP holds property we have to determine taxpayer’s basis. o We have had a taxable transaction – SO §301(d): Shall be the FMV of the property. All the tax is paid on that so the FMV is fair. 09/18/03 §195 and 248: Relating to the formation of a corporation or some other type of business activity - Both seem to apply to the same situation – but there is no overlap between the two. - §248: Organizational Expenditures – Relate to the actual formation of an entity whether a corporation or other – For example an OE is the cost of preparing the corporate charter and drafting the by-laws, setting up the accounting books, the costs in general that relate to the actual organization of that entity. Permits the amortization deduction of the expenditures over a period of not less than 60 months of the new entity beginning business o May at the election of the corporation: this is not a mandatory deduction. If those are allowed to be deducted at the election of the taxpayer. They will not be deducted unless an election is made. When and how do I make the election?  Often, an election is made on a tax return. Once made it is usually binding and may not be made on an amended return. Must make it on the tax return on which it is to be made.  Usually you are barred if you don’t bring it up when you are supposed to. o Made in accordance with regulations made by the secretary o Be treated as deferred expenses: o Ratably (straight line) over no less than 60 months. You have to indicate over what period you are going to amortize the expenditures (it would usually be 60 months). o Beginning with the month in which the corporation begins business  Beginning business: Must be at a latter point from issuance of stock – Best indicator is when they open the doors for business. o Defining Organizational Expenditures: Those incident to the creation of corporation, chargeable to the capital account = Cost of preparing the charter, by-laws, first meeting, setting up the books. o ID Expenditures, Elect on the Return the period (which can’t be any less than 60 months) - §195: Start up Expenditure – Relates to starting up a new trade or business but not to the organization of the entity that may be used in connection with that new business entity. Allowed to be amortized over a period of not less than 60 months (you can recapture the cost through tax deductions). o The way the § itself is organized is a little unusual but it is clearer than §248. You must first satisfy the conditions of a particular section – here §195. This has an amortization rule nearly identical to §248.  At the election of the taxpayer  Treated as deferred expenses  Prorated equally over no less than 60 months beginning when the active trade or business begins. o Same amortization rule, here though, what begins the amortization period is “when the active trade or business begins”. Active is no different than §248 o Basically, if you form a corporation incident to incurring start-up expenditures the amortization period will begin at the same time. o Starting a new trade or business does not necessarily require organizational expenses. o We start the amortization of the §248 and 195 expenditures at the same time. o Defining start-up Expenditures: Any amount paid or incurred in connection with investigating   Investigating the acquisition or investigating the creation of an active trade or business. Active is very significant.  Any activity engaged in for profit or income in anticipation of becoming a trade or business – Those kinds of expenditures - §212 expenditures – expenditures incurred for the production of income. Must be a §212 expense incurred in anticipation of commencing a new active trade or business.  (B): If it is an already existing company it is a §162 type expenditure (ordinary and necessary but it has been incurred before carrying on a trade or business). The §195 expenditure is incurred before the taxpayer begins to carry on the new trade or business. If you satisfy all other requirements of §162 except for the carrying on requirement, you may take the deduction when you do over 60 months.  What is meant when it says investigating creation or acquisition of trade or business.  What if CC investigates buying RC Cola? It cannot be in the same line of business. It has to be a new different trade of business. Is bottled water business? It is highly factual. - Major problem: The election – Treasury department promulgated regulations about making the election and what your behavior must be with respect to the expenditures. Before the regulations, there was nothing but silence. Protective §195 election used to be added to IRS form – If we are found to have made any we elect to amortize them over 60 months. The treasury department made a regulation invalidating the protective §195 election. It requires the taxpayer to ID the expenditure, the new trade or business, indicate the beginning of the business, and then it states that the taxpayer may not take a position inconsistent with those expenditures being treated as start-up expenditures – That means that taxpayer cannot currently deduct the expenditure. If you miss it, you lose it. o Tax Accounting: Business managers of companies (publicly held particularly) are very concerned with published financial statements (tax return is not published). When those statements are made, they have to make a tax provision where they set aside the money by the amount that they expect to have to pay. They prepare an income statement and say that this is gross income, expenses and we must provide this much in taxes. That provision affects the net income after tax. After tax income – If the manager took a deduction and is not entitled to the deduction, it means that the manager did not provide enough taxes. You have to be extremely careful here  The rational person would claim it as start-up if there is a question of it not being a ordinary business expense. You want to err on the side of getting some deduction. o INVESTIGATORY EXPENSES: Investigation the creating or acquisition of active trade or business  Coca Cola wants to think about acquiring Perrier instead of creating from scratch another bottled water. Business manager sits down and forms a little group and starts to investigate the acquisition. At some point they begin to investigate via surveys, research, etc., it will all fall under category of investigating acquisition. Once the investigation stops and acquisition begins, it falls under acquisition expenses (§263). Regulations introduce into tax law – “facilitation expenses” – The expenses incurred to facilitate the acquisition of the stock are being called facilitation expenses and cannot be currently deducted or amortized. The new proposed regulations say that F.E. begins when the acquirer send out a letter of intent. (Letter of intent: authorized by BOD and informs the target that the acquirer intends to solicit stock or take action to acquire the company and may contain the terms of the acquisition). The reason why that may not survive into the final regulations because many practitioners told them that the letter of intent is not always sent out, that the letter may not be labeled as such and they take all sorts of forms. They say that the threshold is crossed when the decision is made to acquire the business.  Under §263, you add those facilitating expenses to the cost of acquisition. If you acquire stock it adds to gain or loss at sale. If you acquire assets, and you add that cost to the basis in those assets acquired, if the asset is depreciable, then you can recover your cost over the life of the asset. If there is machinery and it has a 7 year life, you will then recover the acquisition expenses over 7 years instead of 60 month amortization. Divide the cost among the assets pursuant to FMV. o Bank going into mutual fund business – Bank is becoming manager of shares for individuals. In substance, it may be a new trade or business o Utility provides electricity by burning fossil fuels – Then it decides it could do this through nuclear power. Builds a nuclear power plant. This is a same product and result is the same. In connection with nuclear power, it was found to be new trade or business. The focus was on how vastly different you have to train your people. o What about lawyer who wants to become tax lawyer? Is the education considered new trade or business expense? In general, if it does not qualify you for a new trade or business, then you can currently deduct it under §162. If you get LLM while you are lawyer you can deduct as expenditure - §162 deduction. Both sections appear and are in fact quite similar with respect to the deductibility of the expenditures – Both permit the amortization. They begin when the entity begins the business. Timely election important and err on the side of the item being treated as start-up expense – Err on side of amortization as opposed to §162 expense. The risk of losing the deduction permanently is too costly.  §311: Taxability of corporation on distribution - Distribution of property other than money - We have the general rule which is actually the exception under (a) - - - General Rule is in (b): While in general, when a corporation makes a distribution it shall have no gain or loss when it distributes cash. When distributing property, and §311 applies, the corporation is most likely to have recognized gain assuming that the property distributed is an appreciated asset. We are talking about property where FMV exceeds the adjusted basis. Depreciation is annually reducing tax basis. When we are dealing with tangible property depreciation reduces basis on accelerated scale. Bringing down basis faster than FMV drops. §311(b) will cause the recognition of gain. This rule in §311(b) will cause an increase in taxable income – That increase will result in a similar increase in E & P. There will also be an increase in tax liability which will have effect of reducing E & P. §311 does not allow for recognition of losses – only gains. PROBLEM 1: HANDOUT 12 o WHAT IS DISTRIBUTION AMOUNT? §301: Distribution = FMV of property received - $10K distribution o WHAT HAPPENS TO CORPORATE TAXES? §311(b): Does not apply because the FMV does not exceed the A/B - §311(a) applies and therefore there is no gain or loss recognized to the corporation. o DETERMINE CORPORATE E & P: §312: E & P  Decreased by $15K – You can have negative E & P only where taxable income is negative – A distribution cannot create or add to a deficit in E & P. We have E & P of $12K and we adjust under §312(a) by the A/B of the property distributed but we know it cannot put it in the negative. After the distribution the E & P is zero. o WHAT IS THE SHAREHOLDER’S TAX TREATMENT? §301(c): The distribution is $10K – The portion that will be a dividend will be those greater than E & P – WE LOOK AT E & P BEFORE DISTRIBUTION. When a distribution is made, the reduction in E & P is going to be equal to the amount of the distribution. Here it does not, since the amount of the distribution is $10K o WHAT IS THE LOSS DEDUCTIBLE TO CORPORATION? None because of §311. o If you are choosing assets to distribute, wouldn’t you want to have a depreciated value item and reduce E & P by a greater amount than the amount of the distribution which is based on the value of the property. PROBLEM 2: HANDOUT 12 o AMOUNT OF DISTRIBUTION: FMV = $10K o BECAUSE FMV is greater than basis §311(b) applies. Under §311(b), we recognize gain of $5K. o WHAT IS THE E & P? It is decreased by the adjusted basis under §312(a) and (b). It should be increased by $5K because of (b)(1) and (b)(2) says that (a)(3) becomes the FMV instead of adjusted basis. So we add $5K and subtract $10K. So, E & P is $7K. (THIS IS WRONG) We add $5K because we increase taxable income by the gain which is the starting point for E & P.  ANSWER: Opening E & P of $12K + Gain $5K (taxable income adds additional E & P) and decrease E & P by adjusted basis o §301(c): Shareholder is taxed on the $10K with all being dividends. If the distribution affects Taxable Income, then we use the E & P after the effect is felt. If the distribution does not affect taxable income, then we use the E & P before application of §312. If there is recognized loss or gain in the distribution we take that into consideration in the E & P used for shareholder taxation purposes to determine their taxation under §301. Otherwise the other E & P calculations are not taken into account for distributee purposes but only for the end of the year. NO CLASS ON 10/30/03: - - §318: Constructive Ownership of Stock - Only section in the code that is exclusively devoted to Constructive Ownership of Stock rules - There are several other sections that have within them constructive ownership of stock rules, but those rules typically are drafted in such a way that they modify something contained in §318. - This is the section from which all other constructive ownership rules stem. - We need to find out who owns the stock – If we are saying that shareholder A gets a distribution. Someone may be treated as owning stock when they don’t actually own the stock. The constructively own the stock. These are of paramount importance when we consider rules about redemption of stock under §302. - They apply in determining whether §302 applies. - Another important principal is that: If you look at the language of §318(a) – “expressly made applicable” – means that this section will have absolutely no application unless the other section says that §318 applies. §302 does say that §318 applies. As with other sections, the section is kind of dormant unless it is stimulated by language in some other section. - The rules of §318 are divided into groups of rules - - - - o SET 1: Family attribution (§318(a)(1)) o SET 2: Entity attribution (§318(a)(2) – from entities; (a)(3) – to entities) o SET 3: Option rules (§318(a)(4)) FAMILY ATTRIBUTION RULES: These are intuitively understandable – o §318(a)(1)(A)(i) and (ii): Our TP will be considered as owning stock owned by the spouse, the children, the grandchildren and the parents. All of the stock owned by all of them will be treated as owned by our taxpayer. o If TP is the child, what stock does he does not own grandparents stock but only those in the code. POLICY REASON: The TP has less ability to influence to grandparent than juniors, parents and equals. o We go up one step, down two and over one. o Adopted Children: treated like natural children §318(a)(5)(B): Stock owned because of family attribution rules stops at the TP – is not imputed to wife, etc. The purposes will be in the case of redemptions. If you redeem all of their shares, you must redeem all of their constructively owned shares. ATTRIBUTION FROM ENTITIES o From Partnership Rule: §318(a)(2)(A): LLC is treated as it had chosen to be taxed if it is partnership then we apply this rule; if corporation, then we apply corporation rules here.  Owned proportionally by its partners under this rule  Partners = A, B & C in ABC Partnership and Each own 1/3 of the partnership. The partnership owns 80% of X corp. A, B and C each own 1/3 of 80% of the stock. We don’t care what percentage ownership the partnership has in the corporation. Even if it is 30% they each own 10%. o From Corporations: §318(a)(2)(C): If ABC was corporation and we had the above problem – A, B and C will not own any of the stock because none of them own more than 50% of the corporation’s stock. If A has 50% of the ABC Corp stock, then A is said to own constructively 50% of the X corp stock owned – i.e. 40% of X corp. B and C own nothing because each has less than 50% of the stock in ABC Corp. ATTRIBUTION TO ENTITIES o To Partnership Rule: §318(a)(3)(A): Considered owned by partnership  A, B and C each have 1/3 of ABC Partnership – So what ever each of them own is attributed to the partnership. A owns 40% of X corp so the X corp stock is constructively owned by ABC Partnership. o To Corporations Rule: §318(a)(3)(C): ABC Corporation – If person owns 50% or more of the corproation, then the corporation is considered to own the stock he owns.  As above, no stock is owned by ABC because A owns less than 50%. If A owns 60% of X Corp it does not get that attributed to it unless A owns more than 50% of ABC. §318(a)(5)(A): If the person actually owns the stock, the partner’s spouses stock would be attributed to the corporation/partnership under the rules above. PARTNERSHIP 10/15/03 TAXATION OF A PARTNERSHIP - Generally: Subchapter K controls partnership taxation. - LLC generally elect partnership §701: Partners, not partnership, subject to tax - Partnership shall not be subject to income tax under the section (Contrast §11 – Imposes an income tax on corporations) - Persons carrying on as partners shall be liable: Partners are going to pay tax on the income of a partnership - §301.7701-3: Check the Box Regulation o Classification of Certain Business Entities o A business entity that is not classified as a corporation (not incorporated under state law) under previous reg can elect its classification for federal tax purposes.  Either an association and thus a corporation - -  Or a partnership REQUIREMENTS  Must have 2 members – A single member LLC cannot elect partnership tax treatment.  §301.7701-3(b): Single owners can elect association (corporation) or disregarded. May receive insulation of liability and it can be disregarded as an entity for tax purposes. If you make no election, this is the default – If you are eligible entity and you do not make an election, a domestic eligible partnership if it has two members or disregarded if it has a single owner. §301.7701-2: Corporation is a business entity organized under federal or state statute as a corporation… As an LLC, when do you choose partnership, corporation or disregarded status? o If you are service provider, it is very common for individuals to elect to be Subchapter S corporations for tax purposes. You can avoid employment taxes to a certain extent by making that election. All of the profits earned are not immediately taxed to the owner.  If entity has $200K of income during the year, if it is a sole proprietorship it would be subject to some degree for employment taxes. An S corporation is not subject to employment taxes – The money you put back into the corporation. o Apart from that, it is much simpler to operate as a partnership. o 95% of all partnership will not be subject to the most complicated partnership rules. o If you have property contributed to a corporation, what happens when at some later date you liquidate that corporation? You recognize the gains and losses. This charge is not imposed if you have a partnership. There is no simple answer in all cases about election to be taxed. §701 again: Partners are liable on the tax and partners will be taxed – not the partnership. o §703: Partnership Corporations - Compute income in the same manner as an individual. - Taxable Income is defined under §63. - Adjustments must be made with partnerships as listed under §702 §702: Income and Credits of Partner - (a)(1-7): Separately stated items - (a)(8): Catch-All - Partnership will not take into account capital gains or losses, §1231 gains or losses, charitable contributions, etc. according to §702(1-8)… - In computing the taxable income, all of the so-called separately stated items are not taken into account. Instead, they are separately stated. So, the taxable income reported out to the partners excludes the items and then lists them separately. - Separately stated items receive some special treatment on the individual’s tax return. - Take Capital Gains: A has capital loss to carry forward and B has no capital loss to carry forward. There could be some special treatment. - Charitable Contributions: An individual in general has a 50% charitable contribution limitation under §170 – One individual may have already taken 30%. - (a)(7): Other items as prescribed by regulations. Treat an item in a special way for an individual – Investment interest is subject to a special limitation; limitation on expensing certain property. The regulations identify as many of these as possible. §703(a)(2): Deductions not allowed for partnerships – - Personal exemptions; deductions for taxes; charitable contributions - The effect is felt on the partnership level. §703(b): Elections of the partnership - Made by the partnership Example: A and B have P with Taxable income of $100K – Each partner will have $50K of individual income. - Not one penny may have been distributed to the partners. - Later, when they actually get the money, there is no tax. Distributions by a partnership are tax-free. - All of the income is taxed when earned. This is under §731. §731: Extent of recognition of gain or loss on distribution (contrast to §301 and §311 in corporations) - Gain or loss shall not be recognized to such partner - Gain or loss shall not be recognized by partnership on distribution When you try to find the tax for anyone or any entity, you have to determine the tax year. Corporation’s tax year is under §441. §706(b): Partnership’s Tax Year - GENERAL RULE: Shall be the majority interest’s tax year o The tax year of the partner who holds a majority interest. - If individuals are partners, then it will be a calendar year. - EXCEPTION: If they entity can demonstrate a business purpose for a different tax year, it may use a different tax year. TAX TREATMENT OF PARTNERSHIP ITEMS IRS Audits in Regards to Partnerships – Assessment of Taxes §6221: Tax treatment at Partnership Level - The tax treatment of any partnership item shall be determined at the partnership level - It must be decided at this level §6222: Partner’s return must be consistent with partnership return. - Cannot take a different position on his return as the partnership – The partnership treatment will control - If partnership says it is an item of ordinary income, the partner cannot call it capital gain. - They are required by law to disclose on the return that they have treated it differently. §6223: If IRS is auditing the partnership, the partners must be given notice. §6224: Each partner has right to challenge adjustments made by IRS §6225: No assessment made be made with respect to partnership item before partner receives statutory notice of deficiency. §702(a): In determining his income tax, each partners shall take into account separately his distributive share of the partnership’s… - “Distributive Share”: Every o Example 1: Provides that A will receive $30K each year and B gets $20K. That is not what is meant by above. Partnership has to maintain its capital account and the accounts for each of its owners. What those accounts have in them, or what is provided – Not what is mean either o Example 2: §704: Partner’s Distributive Share - It shall be determined by the partnership agreement o Share of income, gains, deductions, losses and credits - Defined under §761 o §761: Partnership Agreement  All we are told is what it includes: It is a term that is to be accepted on its common usage. o An agreement among or between the partners as to how the partnership is going to be conducted. o The distributive share is something determined in this agreement - Partners, therefore, can determine what they want their distributive share to be. o Example: A gives $50K to partnership and B contributes $10K. If they wish, they could say that the distributive share of A and B shall be equal. It is not tied to their contribution. o They can say whatever they want – At least initially that is what they can say. - §704(b): Qualification of General Rule under (a): A partner’s DS shall be determined in accordance with the partner’s interest in the partnership if the agreement is silent or the allocation in the agreement does not have “SUBSTANTIAL ECONOMIC EFFECT”. o If there is no substantial economic effect under the partnership agreement, then their shares will be reallocated in accordance with shares in partnership. o No effect if interest = or close to DS - Distributive Share: It is a tax fiction – bearing no relationship to how much cash they will get. o o This is for tax purposes only. Subchapter K will tell us how each partner’s distributive share will be allocated among the partners. NOTE: Some things are allocated pursuant to the IRC provisions specifically under subchapter K. There are different ways to determine the taxable income of each of the partners. (May be in accordance with agreement, interest in partnership, OR with certain items, IRC will control). As below §704(c): Contributed Property Gain that is built in to any property contributed to a partnership - Remember when we went through §351 transactions – Should both get the same amount of stock in corporation if their contributions will result in built-in gain or built-in loss? No. o These things are blended under corporations - With a partnership we have a specific statutory provision that trumps any allocation made in agreement or interest in partnership. - “Reallocate the built-in gain or built-in loss back to the partner that contributed the gain or loss property” o See the difference – It is not cut off from contributor when it goes into the entity like corporations. o Example:  A and B form partnership  A contributes property with A/B of 40 and FMV of 50; B with A/B 60 and FMV50  Agreement says they will share everything equally.  Partnership decides to sell A’s property and the amount realized is $50 and A/B is $40 so there is $10 of gain.  Normally, that gain would be reported out to the partners equally  BUT under this code section, it would be reported by A because he sent that property in – and solely to A. – All of the taxable income will be attributed to A.  The cash received will go to A and B equally - $25 each but the gain will only go to A. §702(b): Characterization Rule – GENERAL RULE - The character of any item included in a partner’s DS under separately stated items shall be determined as if the item was realized directly from the source…or as the partnership dealt with it. - If the item of gain is capital gain at the partnership level, it will be CG at the partner’s level. - If ordinary income at P Level, it will be ordinary income at partner’s level. §704(c)(1)(B)(ii): Characterization Rule - The character of such gain or loss shall be determined by reference… - Seems like the same rule as §702(b). Under some circumstances, the character of the item will be determined as what the character of the item would have been to the partners o There is a limited exception stating above. Not in this section though. §731: Extent of Recognition of Gain or Loss on Distribution - No gain or loss on distribution to partners = This rule provides an allocation despite partnership agreements provisions. MANDATORY RULE o Except to the extent that money distributed exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution o Partner could have taxable income resulting from distribution by the partnership. §737: Recognition of Pre-Contribution Gain in Case of Certain Distributions to Contributing Partner - Property is distributed to a partner and that same partner contributed property with a built in gain. - It is not saying he is getting that property back – just some property o Example: A gets B’s property in distribution. §704(c) doesn’t apply to that because partnership is not recognizing gain. In that situation, what this section suggests is that A is going to have gain and that gain he may have is the built-in gain that was in the property contributed to the partnership. - Designed to prevent A from avoiding the tax in this built-in gain. - There is a special allocation of gain to A under this section. - Same category of §704(c) and §731 income situation. §752: Treatment of Certain Liabilities - Amount realized = Cash and FMV of property and relief of liability. If someone says they will pay off debt, you have been enriched. - §752(a): Increase in partners liabilities – An increase in partner’s share of liabilities in a partnership shall be considered a contribution of money. o (Compare §357): Assumption of liability for corporations – Shall be treated as money received by the taxpayer. When they say – when as part of the consideration to the taxpayer (shareholder), the other party (corporation) assumes that liability, it shall be treated as money received by the shareholder (TP). - §752(b): Decrease in partners’ liabilities – Any decrease in partner’s share of liabilities or decrease of his own liabilities by assumption by the partnership is treated as distribution of money. o BUT a distribution has no effect generally – under §731 – Gain shall not be recognized. LOSSES TO A PARTNERSHIP - Term used very broadly - Not necessary those that arise when basis exceeds FMV – it is not that narrow here. They are talking about any other losses (net operating loss, etc.). - It could all be the result of personal services…Loss is being used very broadly. §704(d): Limitation on Allowance of Losses - GENERAL RULE: A partner’s DS of partnership losses including capital losses (but could be others) shall be allowed (deductible) only to the extent of the A/B of such partner’s interest in the partnership at the end of the partnership year. You can deduct losses to the extent of basis. o Limitation imposed on the deduction of losses o The income from a partnership could be passive income – maybe it is maybe it isn’t – If you are an investor, it might be passive income.  If there is a loss, it could be subject to the passive activity loss rule of §469 and it could be subject to the loss limitation rule of this section. - You must see if you have a §704(d) limitation. - You must then see if you can deduct it under §469. o Example  A’s A/B = 50 and FMV = 40 – Can A deduct the $10 loss?  Under §704(d), his basis in his partnership interest is supposedly $50. You are applying §358 concepts here and you should. Indeed that is where A’s basis will start out – just like under §358. If there is a $10 deduction attributed to A under §704(c), (d) will say that he can deduct it to the extent of his basis in the partnership. When we looked at these situations, we are looking at either cash distributions or distributed shares to partners – we are not taking into account whether there is a relationship between the partners and the partnership other than an investor. - What if A is performing services for the partnership? o If A is attorney and gets $25 for performing legal services.. §707: Transactions between partner and partnership - (a): Partner not acting in capacity as partner: If he engages in activity other than in his capacity…transaction is considered as occurring between partner and some other unrelated party. o Examples  Assume that the transaction with the partnership that A has is the performance of services – If A has that type of transaction with partnership, then A is treated as if A is unrelated. If A gets $25 for services, how is that treated by both A and the partnership?  If payment is an ordinary and necessary business expense of the partnership, then it is deductible in arriving at PS taxable income. Not separately stated; taken into account under §702(a)(8) in the basket of items. It really will have 2 effects. o Payment for services: Taxable as gross income to A under §61 compensation - Deduction to PS: The deduction that the partnership takes will be an item that A receives some benefit for. That deduction is taken into account in arriving at the PS taxable income that will be reported out to A. (c): Guaranteed Payments: Payments to a partner for services or use of capital, but only for the purposes of §61 and subject to §263 for purposes of §162(a). o Examples  A enters into arrangement with PS where A becomes an employee.  A is now managing the PS; A now receives a guaranteed payment.  As long as those are as described, amounts paid out without regard to the income of the PS, we can treat A as if A is unrelated. A will have income and PS deduction  If they are determined by income of partnership, then they look more like distributions to a partner and those are taxed how? They are not taxed.  If you are A, you want a distribution – not a guaranteed payment.  If you are B, you want a guaranteed payment so that you get a deduction for the partnership. o §704(e): Anti-abuse rule – Family Partnerships - (1): A person shall be recognized as a partner if he owns a capital interest in a partnership in which capital is a material income-producing factor, whether or not such interest was derived by purchase or gift from any other person. o Shift income of partnership which was otherwise allocated to that relative to you o Applies only when capital is an income producing factor - (2): The distributive share of the donee shall be included his gross income – Partner gets money for services for the PS and he wants it as DS and then to pass it to child. As long as the donor is performing services, the donor must be taxed on the income equal to reasonable compensation for those services, even though it is given to the donee. The income will be attributed to the person who performs the services. Thus far: WHEN PARTNERSHIP EARNS INCOME – How the partnership and the partners in general will be taxed - Partnership pays no tax - All income will be attributed out to partners - Distributive share o How much is reported out to partners – Look to partnership agreement o Special Statutory Provisions that will re-allocate = changed by §704(c) built-in gain situation; §704(e) with family gift to avoid service oriented income; liabilities assumed by partnership. Organization §709: Treatment of Organization and Syndication Fees - (§248: Corporate: could not be currently deduction but were allowed as deferred expenses over not less than 60 months) - When a partnership organizes, there is the same rule. Limited Liability Company – Can elect if you have more than 1 member - You are going to be hard pressed to clearly understand how the terms of that agreement fit in with subchapter K. o Likely to be general language  Contribution of Property…share equally… - Many of these LLC agreements are partnership agreements that have been reworked. If you read them, you will think it is a partnership agreement. o Very little trouble understanding how that agreement will fit into subchapter K - Instead it may be a non-specific agreement as to partnership taxation. PROBLEM: Rule that we are dealing with here is §704(d) rule – A partner’s distributive share of losses shall be allowed only to the extent of the partner’s adjusted tax basis in his partnership interest at the end of the loss year. - Partner will have basis in her interest equal to the basis in the property contributed + gain recognized. o Does it change every year? No, as a general rule for corporations, but for partnerships it changes constantly. $20K $6K $1K $4K Loss for 2001 Total PS Liability (share equally) Partner’s tax basis in PS interest at 1/1/01 Partnership income for 2002 - Assume that partner has 50% interest in the partnership, for 2001, the partner would be allowed ______ of the loss Amount equal to tax basis, $1K plus ½ of partnership liability $3,000 = $4000 tax basis o If you increase your share of liabilities it is like a contribution to the PS and it would increase your basis. - Losses, under PA here, are going to be shared equally. - We are assuming that partner’s distributive share is 50%. So the loss is $10K. o That only goes to the extent he can deduct the losses. o §704(d) operates like §469 – Passive loss rule – Prevents them from deducting the loss not recognizing it. - The amount he is allowed is his tax basis + ½ of partnership liability - §752: When an individual transfers property into a partnership, and that property is subject to liability it is just like §358(d), money received. When an individual is assuming a partnership liability, it is like the individual contributed money into the partnership. THIS INCREASES HIS TAX BASIS. - HE would be allowed $4K of the loss - $4K of his $10K distributed share of the loss. - His tax basis is reduced to what? We applied against the basis $4K and now the basis is at $0 at the end of 2001 - When the cash is distributed to partner, it is non-taxable because he has already paid tax on that when the partnership earned the income and he was immediately taxed on the income. Once it is distributed he will not pay tax again on it. Ergo §731: No gain or loss when distribution is made. - If you pay tax on something, it increases you tax basis. When money is earned by the partnership, o Let’s say PS earns $50 and each A and B pays tax on $25 each so they won’t pay tax on that again. - Looking back at problem: o Basis is zero at end of 2001 and increased by ½ of partnership income in 2002 to $2000. The disallowed loss of $6000 is allowed in 2002 to the extent of his tax basis of $2K. o If this is a passive activity the loss is not deductible. The at-risk rules of §465 might say you can’t deduct the loss. You may not absolutely get the tax deduction – There may be things outside subsection K that will prevent you from deducting the loss. THE ORDER OF WORKING PROBLEM: 1. §704 2. At-Risk 3. Passive Basis in Interest in Partnership = Basis in Stock Problem will require us to look at the Regulations associated with it. - This problem deals with pre-contribution gain or loss and how it will be taxed back to the contributor. - Generally, it is taxed back to the contributor with no shifting of gain or loss to the other partner. o Situation o Property that A contributes into the partnership is not sold (piece of machinery) – What will happen for tax purposes to that machinery while it is in the partnership? It will be depreciated.  (A/B of 100) (FMV of 70): Built in loss here – a benefit has been transferred into the partnership and it could be realized if it sold by the partnership or it could be realized by depreciation deductions.  Who should reap the benefit of those depreciation deductions? A or one of A’s partners. To the extent of $30, A should reap the benefit. ONLY $30 of depreciation (just like $30 of loss if property is sold) should be attributed back to A.  Implicates depreciation rules… Go through the regulation and do the problem. 10/23/03 INTRODUCTION Here, unlike when property is contributed to corporation, we attribute the built-in gain or loss to the contributing partner. The way we account for that will depend on what happens to the property after it is contributed. - USED by partnership: Does not trigger built-in gain or loss - SOLD by partnership: Trigger built-in gain or loss Both situations occur in these problems – Eligible for depreciation allowances if used. - As you see from the regulation: §1.704-3, there are different methods permitted for accounting for the gain or loss and each deals with the allocation of income or expense. §704(b) - Normally, income and expense items are allocated in accordance with PA. If not done that way or no substantial effect then the allocation is made in accordance with each partner’s interest MANDATORY ALLOCATION RULES: - In regulations for §704, there are different methods for allocating income and expense items to ensure that any built-in gain or loss is attributed to the contributing partner. - Traditional Method - Traditional Method with Curing Allocations - Remedial Method The regulations in many respects contain the law – While they are not technically legislative regs, they operate as such. Dept of Treasury was allowed to make regs under certain code sections, but these are interpretive regulations and as a practical matter – THEY CONTAIN THE LAW. REGULATION §1.704-3 – Contributed Property - Must allocate to the contributing partner - This property must be that which has built in gain or loss - Built-in Gain: Book Value (FMV) – A/B = Built in gain or loss - Both the book value and the tax basis will change after the first year – Consequently, BIG or BIL will change. o BOOK VALUE: “Tax book value” – Here it means tax book value and not accounting book value. They do not defer to the accountants to determine the value or the adjustments to book value. o Keep in mind we have tax basis and tax book value. We will look at the capital account later. Accountants will often determine capital account. o Here we have some very detailed – specific rules contained in the 704 regulations. - §1.704-3(a)(3)(ii): Built-In Gain and Built-In Loss – Built in gain on this type of property is the excess of the property’s book value over the adjusted basis of the contributing partner. The built-in gain is reduced by decreases in the difference between the property’s book value and A/B. o Keep in mind that there will be a decrease in both and the difference between those two is what will define any built-in gain or built-in loss. PROBLEM FOR TODAY: FMV property contributed by A A/B property contributed by A Cash contributed by B The built in gain to A is $6000 = = = $10,000 $4,000 $10,000 Part I: Assume that the tax depreciation is $400 (1/10 of 4000) and book depreciation is $1000 (1/10 of $10,000). The amount of book depreciation allocated to each partner is $500. The value of their contributions is equal at $10K. If we look at the definition of built-in gain or loss, we would see that there is a difference between book value and A/B at the time of contribution resulting in built-in gain of $6K. That gain would be then (without adjustment for it) shared by A and B. What they are sharing is the tax liability if it is sold or the tax detriment that would be experienced if the property were held and used in the business. (There is only $4K of depreciation that the partnership is not being entitled to because of the low tax basis). THE RULES - The basis of the property in the hands of the contributing partner at time of contribution will carry over to the partnership. Assume that tax depreciation is $400 per year (assumes straight line depreciation and 10 year property). - 1/10th of the basis of $4K is going to produce the tax depreciation. Book depreciation is $1000 - The tax book depreciation is $1000 – same method as tax purposes but applying method and recovery period to a different value. - The book value starts out being FMV. - Book depreciation is $1K. RULE: Partner is going to take a basis in his partnership interest equal to the basis in the property he contributed to the partnership. A A/B $4000 -0$4000 Capital Account $10000 (500) BVD charge $9500 A/B $10000 $400 $9600 B Capital Account $10000 - book value of assets contrib ($500) BVD charge $9500 PARTNERSHIP A/B $4000 $400 $3600 Capital Account $10000 ($1000) BVD charge $9000 TRADITIONAL METHOD OF ALLOCATION BOOK DEPRECIATION TO BOTH PARTNERS Amount of book depreciation allocated to each partner = $500  They are equal partners and they share equally for book purposes and tax purposes. As a result, if the book depreciation is $1000, they would both get $500. They each will have charged to capital account $500 TAX DEPRECIATION TO BOTH PARTNERS - If 704 did not exist: it would be split between both partners equally BUT with 704, we must attribute the built-in gain OR the consequences of it to A. - THE NEGATIVE EFFECT ON THE PARTNERSHIP OF THAT BUILT IN GAIN o A=0 o B = $400 - We are trying to make sure B does suffer a tax consequence from that built-in gain. o Why allocate all $400 of the tax depreciation to partner B?  B is being short-changed on the property that he gets in the partnership agreement. - If it were not for 704(c), the numbers would have been $200 deductions each under the scenario. So B would really have been screwed. “CEILING RULE”: You cannot allocate more tax depreciation than you have actual tax depreciation. - Book depreciation may not exceed tax depreciation where allocated. - The reason = You only have as much depreciation to give to B as actually exists – the tax depreciation. - “However, the total income, gain, loss…cannot exceed the total partnership income, gain, loss or deduction with respect to that property for the taxable year” – p. 1329 Next step – Book value ($10,000) – A/B ($4000) = $6000  Built in Gain to A With the ceiling they can only get deduction for the amount equal to depreciation under the A/B - $400 each, and only B can get it under (b)(1). So B gets $400 and A gets $0 Part II: Tax gain from sale – Property is sold for $10K beginning in Yr-2. A/B = $3600 Sale = $10K (although this does not take into account the book depreciation for Yr-1) Subtract the $1000 deduction on book value allowed Gain would be $6400 but the $1000 deduction would apply differently. As a result of (b)(1), the entire gain must go be reported by A since A put the property in except for the $1000 of depreciation deduction taken the prior year which is allocated between A and B. Sells property instead of holding it and depreciating it – sold in year 2 BASIS HAS BEEN REDUCED BY THE $400 of depreciation that was taken in Yr-1. New A/B = $3600. New Book value = $9000 Tax gain from the sale = Amount realized ($10K) – A/B ($3600) = $6400 How much allocated to A to account for the adjusted amount of pre-contribution gain? - §1.704(a)(3): The built-in gain is thereafter reduced by decreases in the difference between book value and A/B. Now, the book value decreased to $9000 and A/B is $3600 = So built-in gain (hereinafter “BIG”) equals $5400 Originally $6000 was built-in gain. Is it reasonable to be reducing this? Well, he missed out on depreciation that year. WE COMPUTE THIS YEARLY! How much gain do they have to be charged with? - $5400 to A in its entirety They are equal partners so they share the rest of the gain equally. - $500 more to A - $500 to B Traditional Method (above) is the Default Method - You would allocate BIG or BIL this way unless you chose to use some other method. PART III Curative allocation of $100 would be appropriate (the difference between the book value depreciation deduction and what was allowed by the ceiling rule). A gets this in profits. SEE THIS EXPLAINED BELOW under the curative allocation Partner A Capital Tax Basis Contribution $10,000 $4000 Depreciation $500 Partner B Capital $10,000 $500 Tax Basis $10,000 $400 Income $350 $9850 $450 $4450 $350 $9850 $250 $9850 $10,000 Partner B Capital Account - $10,000 tax basis $500 Partner A Capital Account - $0 tax basis TRADITIONAL METHOD WITH CURATIVE ALLOCATION Go back to basic facts…After allocating all of the depreciation, B still lost $100 of depreciation for him – he got shortchanged. There wasn’t enough depreciation for B to get the full amount – depreciation equal to book depreciation. §1.704-3(c) There is this traditional method with curative allocations described in the regulations - This method is designed to correct distortions created by the ceiling rule. - A partnership using traditional method may make reasonable curative allocations to reduce or eliminate disparities between book and tax items. - This is an allocation that differs from the partnership’s allocation of the corresponding book item. If there were another asset that was owned by the partnership: Let’s say that B’s cash was used to purchase another asset. - If that other asset generated $1K of depreciation under the PA that would be allocated equally. - WE are permitted to change that equal allocation to correct the distortion caused by the ceiling rule. How does this work? We are told to assume the basic facts and that they agree to a curative allocation in the Partnership Agreement or in its amendments. Assume that B’s cash was used to purchase inventory which was sold at the end of Yr-1 for a gain. - Normally it would be split equally - $350 each. - If we choose curative allocation, A will pay tax on $450 of gain instead of $350 and therefore relieve B of tax on $100 of gain that the partnership recognized. - This will have no effect on the capital accounts of the partners and no effects on the distributions. - A is going to be required by the IRS to pay tax on $450 and B $250. How much cash is B eventually going to get with respect to the gain. B will get $350 of cash for gain but only going to have to pay tax on $250. - The relief is equivalent of allocating more depreciation…You can choose different ways to correct this distortion. In this fact pattern, we see how an additional allocation away from B corrects the distortion. We also could have given me an additional amount of depreciation. - B: If we use the curative method – the capital account will go up by the amount of gain he gets - $350 so his capital account will now be $9850. B’s capital account and tax basis are now in line. We have corrected the distortion by making a curative allocation. - A: Will work the same way. What is the tax effect on A and B with what we have done? - Prevent A’s built-in tax liability to B: The detriment associated with the low basis §704(c) IS A MANDATORY REQUIREMENT We are not going to deal with this necessarily REMEDIAL ALLOCATION: Dealing in make-believe in this case - Under the basic facts of above and we are still in Yr-1 and we see the distortion. - §704(c): Remedial allocation income – let’s call it. A will be charged with $100 of income and B will get $100 of deduction. You cannot simply say that we are going to put another $100 of deduction over here without another offsetting income. If there is no remedial item like another asset depreciable or piece of property that produces - gain…You can always make sure that B does not get screwed. You will not be happy with the default method because he is left short-changed. DON’T FORGET TO MAKE SURE THAT THE ADJUSTMENT MADE TO B’S BASIS AND CAPITAL ACCOUNT ARE EQUAL. A will suffer the consequences. Both have to agree. Examples in the little book DONE WITH §704(c) Allocations for tax liability of the partners and this contains mandatory allocation rules Character of the Allocation we make as to one partner, must have the same tax effect on the other partner. NOT necessarily the depreciation being different from ordinary income deficiency. If we used FMV of $10K A/B = $6000 / 1/10 = $600 $4000 of BIG A/B for A = $6000 - $100 = $5900 A/B for B = $10K - $500 = $9500 Capital Accounts for both = $9500 Special Allocations – later tonight – in the absence of one of those special allocations, this is the default allocation. CAPITAL ACCOUNTS - This is a tax concept. - Tax determined capital account - Extremely important – You need it in order to determine whether allocation (other than 704(c)) has substantial economic effect. §1.704(b)(2)(iv): p. 1293 & 1294 – Maintenance of Capital Accounts - These are like adjustments made to tax basis under §358, but goes beyond that. - (b): Basic Rules: The adjustments to capital accounts o Increased by  money contributed  Fair market value of property contributed  Allocations to him of partnership income and gain o Decreased by  amount of money distributed  FMV of property distributed  Allocations of expenditures  Allocations of partnership loss and deductions - As he mentioned, a special allocation between the partners will not have economic effect unless the partners maintain the capital accounts in accordance with the regulation §1.704(b)(2): Substantial Economic Effect - Two part analysis: o Does the allocation have economic effect?  Economic Effect and three requirements (the big three) – For an allocation to have economic effect – THE BIG THREE ARE AS FOLLOWS  The PA must provide for determination and maintenance of capital accounts as above.  Upon liquidation, liquidating distributions must be made in accordance with the positive capital account balances: Liquidating = Real distributions made by the partnership in liquidation and made in accordance with the positive capital account balances. (Will effect the economic impact on the partner) o If the partner has a deficit balance in the capital account, he is unconditionally obligated to eliminate that deficit balance by the end of taxable year. (The effect will have economic impact on the partner)  You can allocate as long as the allocation has economic effect that is substantial  The third requirement – deficit balance – usually cannot be satisfied in a limited partnership. They do not want to be unconditionally obligated to restore deficit in their capital accounts. General partners are usually willing to do that. This leads us to an alternate test for economic effect – THE ALTERNATE TEST  Satisfy the first two of the big three  In lieu of requirement 3, if the partnership agreement contains a qualified income offset, then you meet the requirements for economic effect. There is an obligation for the partnership to make that offset which works as follows: o QUALIFIED INCOME OFFSET: If there is a distribution for example in a year, the distribution will trigger gain sufficient to restore the deficit balance in our partner’s capital account. Partnership must allocate gain where there is a deficit in another partner’s account when there is a distribution for example to eliminate the deficit as soon as possible. (i.e. the partner would get the income first to make a contribution to the partnership to cover the deficit – nothing out of pocket but the gain is decreased by the deficit.) o See (b)(2)(ii)(6): Partnership sells a piece of property and a distribution occurs – The partner with a deficit balance will have it eliminated as quickly as possibly by having gain allocated to his partner. Is the economic effect substantial?  We are going to assume that to have substantial economic effect there cannot be another allocation in the same year or a subsequent year that tends to offset the allocation.  We are not going to focus right now on it.  Designed to get out – Where one partner benefits and the other does not.  PROBLEM 13 1. General Rule: ALLOCATIONS OF DISTRIBUTIVE SHARES MUST HAVE SUBSTANTIAL ECONOMIC EFFECT. Example 1: A  $40K B  $40K $20K is allocated to partner A for cost recovery deductions on purchased property. Otherwise, they share equally - Meets requirement 1 about capital account - Distributions shall be made equally – not necessarily for positive account balances - No partner is required to fix deficit – This does not work under the regulation - And as a result, the $20K will not be allocated to A - it instead will be allocated equally between the 2 partners. Example 2: Assume preceeding… This works. - All depreciation to one partner is OK. TONIGHT First we talked about required allocation when there is built in gain or loss. Then we looked at the allocations that you are free to make in the PA and noted that none of those allocations will be respected unless the partners maintain capital accounts in accordance with the regulations (which we saw how to maintain). Additionally, there must be substantial economic effect – liquidating distributions and deficit account balances. FORMATION OF PARTNERSHIP §721: Non-Recognition of Gain or Loss on Contribution - This rule speaks to exception in §1001(c) – Except as otherwise provided realized gain will be recognized. - (a): No gain or loss shall be recognized to partnership or any of its partners in the case of a contribution of property for an interest in the partnership. o As in corporations, there is no control requirement. The transferor does not have to be in control of the partnership immediately afterward. o There is not partial non-recognition in this section either. §722: Basis of the Contributing Partner’s Interest - Basis of the property that the contributing partner transferred to the partnership. §723: Basis of the Property contributed to the Partnership - Basis of property is the transferred basis – §357(a): Transfer of liabilities into the Corporation – not considered as boot under that section for corporations. COMPARE TO §752: Treatment of Certain Liabilities - Doesn’t deal just with when there is property contributed to the partnership: wherever there is assumption of liabilities – Those that arise or are extinguished throughout the life of the partnership - (a): Any increase of partner’s share of liabilities in the partnership will be treated as contribution of money. - (b): Any decrease of a partner’s share of liabilities is going to be considered a distribution of money. o Kind of like §358(d) with respect to corporate shareholders. - (d): When an interest is sold or exchanged, liabilities will be treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships. §707: Receipt of Partnership Interest for Services - (Corporations: Not non-recognized) - It may be a taxable event, triggering income. NEXT CLASS: Treatment of Liabilities - Read very carefully §752, etc. 11/06/03 Handed out problems Problem #4 in the handout ALLOCATION OF LIABILITIES: Effect of liability on partner’s tax basis - Any liabilities allocated to a partner increase the partner’s outside basis but they do not adjust the partner’s capital account. - The debtor-creditor relationship is unchanged. What effect the allocation of liabilities would have on a partner’s tax basis; keep in mind that whatever we say about the allocation of liability to a partner has no effect on the creditor. - The capital account: Established at the time the partnership is formed by ascribing to each partner the FMV of what they have contributed to the partnership; it is not a tax basis concept. - There will be adjustments during the life of the partnership that will change tax basis and change capital account. One adjustment may change both equally. o For example, if there is a distribution, it may change both tax basis and capital account; same for contribution. - Here, however, the allocation will have no effect on the capital account. - “Outside Basis”: The basis the partner has in the partnership interest. (Outside is partner’s basis; Inside is partnership basis) - What share of the liability will be treated as a partner’s basis? - - - §751 and 752: When you assume a liability it is treated as a contribution.  When you are relieved of a liability and now the other partners share in the liability it is as if you received a distribution. o Contributions increase basis and Distribution decreases basis. When we allocate a liability to a partner, it will act to increase basis. How they are allocated depends upon whether the liability is treated as recourse or non-recourse. o Recourse: A recourse liability, for this narrow purpose of allocating the liability (not same as creditor law), is defined under Economic Risk of Loss Analysis (below). (Personal liability under creditor law) o Non-Recourse: (Only liable for collateral under creditor law). Economic Risk of Loss Analysis is used first to determine whether a liability is recourse or non-recourse and second to determine how a recourse liability will be allocated. o If this leads us to conclude the liability is non recourse then we don’t use the analysis any further. o We then allocate the non-recourse liability under some other rules. DEFINING RECOURSE AND NON-RECOURSE: Reg §1.752-1(a)(2) o A recourse liability, for tax purposes, is one for which any partner bears an economic risk of loss. (Limited partners are not generally allocated recourse liability). o A non-recourse liability, for tax purposes, is a liability for which no partner bears an economic risk of loss. o ALLOCATION OF LIABILITIES - The steps to determine economic risk of loss with respect to liability that are actually recourse liabilities are as follows: o FIRST: Determine whether a liability is actually recourse or non-recourse. (We first must ask whether it is a recourse or non-recourse under creditor law)  If a liability is actually non-recourse, then it is treated as the amount realized when determining whether there is a loss. The loss is the excess of liability over the tax basis.  Amount realized = Non-recourse liability  You make an assumption that all of the partnership assets are sold for nothing, all debt is immediately due and paid and capital accounts are then adjusted  If one debt is non-recourse, then when we go through the hypothetical liquidation of the PS o N/R: When the liability exceeds the basis, it is treated as gain because you actually get the money – “TUFTS GAIN”. Gave rise to the tax shelter industry – They then looked at the transaction after it was completed and now you sell and your liability is way above basis – In that case, you have gain. The excess of the liability over your basis. To determine whether we have economic risk of loss, we make the assumption that the o Example: For non-recourse = Liability = $1 million and Basis is $800K  Liability equals amount realized. Loss is the excess of Amount Realized over tax basis = $200K  If a liability is actually recourse, then it is ignored when determining whether there is a loss. The loss equals the tax basis.  Example: For recourse – No amount realized and loss = tax basis. If tax basis was $800K then loss is $800K. This is not a real loss. This is a fictional exercise to determine how much of our liability and our liability is recourse of $1 million. Who will get the benefit of the liability? o SECOND: Determine the amount of the loss that is allocated among partners in accordance with the partnership agreement.  To which partner will we allocate the loss? – This is based on the partnership agreement (could say that losses shall be allocated equally between the 2 partners).  A and B: Each get $400K of loss under above problem.  Now we must go to actual capital account: A’s account is $600K and B’s is $200K. A loss will reduce the capital accounts. After the allocation, partner A still has a positive capital account balance - $200K. Partner B has $200K negative balance. That negative balance is the extent to which partner B bears an economic risk of loss. o o o o THIRD: Make hypothetical adjustment in capital accounts by reducing the account by the hypothetical loss FOURTH: Determine the restoration obligation (the excess of the loss over the balance in the capital account) and whether there is any right to reimbursement for any part of the contribution that results from the restoration payment  Restoration Obligation: Remember there was an obligation to restore the negative balance in the capital account if it is real loss and B would be required to pay into the partnership the $200K.  The full $1 million debt is not a recourse liability – it is only recourse up to $200K – There is only $200K that will be treated as recourse for tax purposes because only to $200 is there economic risk of loss. FIFTH: The economic risk of loss (basis adjustment) is the amount that is attributable to the payment obligation.  The share of the liability allocated among the partner is equal to the partner’s payment obligation. SIXTH: The share of the liability that is allocated among the partners is equal to the partner’s payment obligation.  This is a recourse debt and the bank is not limited therefore to the property.  The bank will get paid because there is $800K of capital in the partnership and that will be seized first by the bank and Partner B has to kick in the balance of $200K and this would pay the entire debt amount of $1 million. This does make sense.  Basis in B’s account will be increased because it is assumption of a liability.  This computation is made every year for tax purposes because the numbers are going to change every year. BASIS IN PARTNERSHIP Two important roles of basis - Deductibility of Losses (Deduct partnership losses to the extent of basis) - Cash distribution will be non-taxable to the extent of basis. - The basis will be increased by the allocation of liability to each partner. ALLOCATION OF LIABILITIES: That portion of the liability that is not recourse is treated as non-recourse for tax purposes NON-RECOURSE TAX LIABILITIES - In general, non-recourse liabilities (determined under the economic risk of loss analysis) are allocated (to both general and limited partners) based on each partner’s share of profits using a three prong rule: o First to the extent of the partner’s share of any §704(b) partnership minimum gain (liability over adjusted book value) o Second to the extent of the partner’s share of any §704(c) minimum gain (liability over tax basis of contributed property); o Third to the extent of the partner’s share of excess non-recourse liabilities (remainder). - (PRONG TWO) §704(c) Gain from that property with BIG or BIL (Deal with this here if the liability comes in through contributed property) o To the extent of the partner’s share of minimum gain…: It is equal to the tax liability over tax basis of contributed property. This is not simply where property is contributed, but is subject to a liability.  There would be no minimum gain if there were no liability associated with that property. - We are allocating recourse liabilities. o Allocate to a partner a portion of a recourse liability equal to the parnter’s share of §704(c) minimum gain.  The liability on that property exceeds basis.  (In corporations, if the liability exceeds basis then the excess is treated as gain.)  When your liability is transferred into the partnership it is treated as a distribution. If a distribution exceeds your basis, you have gain. THAT IS WHAT WE ARE TALKING ABOUT HERE. That is §704(c) minimum gain. That is not going to be taxed under the partnership rules because this very computation increases basis and eliminates the specter of tax on that gain. - - You will not pay tax on that because they make the gain go away by giving you some additional basis. o Under this allocation there is a preference given to those partners who have transferred in property where the liability exceeds basis. The preference is to not have them recognize gain on that (PRONG ONE) §704(b): Partnership minimum gain – This ensures that there is going to be a special allocation before the general allocation based on his share of profits. Both (b) and (c) are to protect partners from gain or recognition – to ensure partner can deduct all losses. o Scenario: A partner contributes property subject to a non-recourse liability and the property is depreciable. We want to make sure that our partner who contributed that property can get depreciation deductions. What this provision does, is ensure that we will make a special allocation first to the partner in order to allow the partner to deduct depreciation with respect to the property – NON-RECOURSE DEDUCTIONS. o Liability over adjusted book value = Both change each year - If liability is self-amortizing, meaning that it is paid off in periodic installments, the liability will reduce, Book value starts out being something akin to market value and reduce value by any book depreciation each year.  Book value is not going to be tax basis. (PRONG THREE) Remainder…Allocate non-recourse liabilities by each partner’s share of profits. The loss above - $800K loss  That was allocated equally to A and B. It is not unusual for a provision in a PA allocating losses differently than profits. Don’t be led into thinking that they will be the same. - - Liabilities for purposes of these rules include: o Liabilities from normal borrowings (first or second mortgages, PMSI). o Accrued deductible expenses of accrual method partnership AND o Accrued non-deductible items described in §705(a)(2)(B) Does not include: Things on balance sheet that are trade payables  leases, utility bills incurred prior to entering into the partnership. GUARANTY AND INDEMNIFICATION - In a limited partnership, the limited partner is not liable under debtor creditor law for a recourse debt in the absence of a guaranty. NEXT POWER POINT EXHIBIT §752: Liabilities Transferred to Partnership - Transfer of recourse liability results in general partnership assuming the entire liability and each partner indirectly simultaneously assuming a portion of the liability (decrease in personal liability and increase in a partnership liability) - Example: A B AB RE with $600K mortgage into general partnership $600K What happens is under GP agreement each will be liable for ½ $300K $300K Net Relief to A is $300K (distribution to A) Net increase is $300K (contribution) - An increase in a partners’ share of partnership liabilities is treated as a contribution of money. The partner’s outside tax basis is increased but it does not affect the partner’s capital account. (§752, 722 and §1.752-1(c)) o Liabilities will normally not be made adjustments to both tax basis and capital account. - A decrease in partner’s share of partnership liabilities is treated as distribution of money by partnership to partner. The partner’s outside basis is decreased. - §731(a), 733, 752(b) and Reg. §1.752-3: If net decrease in liabilities exceeds the partner’s outside basis, capital gain is recognized. o It is not likely that there will be excess. - §752: When property secured by a non-recourse liability is transferred to a partnership, a basis adjustment( (increase) under the non-recourse liability allocation rules has the effect of eliminating the §731 gain. - Mandatory allocation of deductions from accounts payment to contributing partner. They are not partnership liabilities. PROBLEM 4 How much, if any, are we going to increase the outside basis as a result of the recourse liability of $20K? Step 1: Are we going to allocate the liability as recourse or non-recourse? To determine whether we have recourse or non-recourse, we go through the constructive liquidation. Assume -0- for assets. What do we actually have? We actually have a recourse liability. Amount realized therefore would be zero and A/B is $30K. So there is a $30K loss. That loss is allocated to the partners to figure out economic risk of loss. We can make any allocation under §704(a) as long as it has substantial economic effect. 90% loss A $5000 $27K -$22K 10% loss B $5000 $3K $2K Capital Account Balance Loss Capital Account now As a result, A has economic risk of loss up to $22K. There is debt of $20K so A gets all $20K allocated to him. A would be responsible for making contribution sufficient to eliminate his loss and that would cover the entire debt. Amount classified as recourse liability under these rules is $20K. Partner’s share of recourse liability is computed through economic risk of loss analysis = A gets all of it. A’s tax basis now goes up by $20K. PROBLEM 5 Assuming that they share equally  When we allocate non-recourse, we look at how they share profits. Step One: How do we allocate? - We still have to go through the calculation for economic risk of loss analysis. - Here we are going to assume that this is non-recourse. Each partner’s share of profits Capital Accounts Allocated amount Basis The §704(b) gain: Allocation Excess non-recourse liability A ½ $150K $50K $200K B ½ $150K $50K $200K AB $300K $ $ $5K $155K $45K $200K $5K $155K $45K $200K Depreciation in Year One  §704(b): Partnership minimum gain = Liability over Adjusted Book Value Liability = $100K Adjusted Book Value = $90K  Original book value = FMV at acquisition ($100K) - $10K of depreciation taken. The $10K = Partnership minimum gain Partnership minimum gain is allocated based on their interests in the partnership. (See the chart above for the amount). PARTNERSHIP FORMATION §721 - Non-recognition rule defers taxation (§721) - Recapture rules are overridden (§1245(b)(3) and 1250(d)(3)) – No need to recapture depreciation when property that is depreciated is transferred. Depreciation recapture income is taxed. - Transfer of installment notes is not a taxable “disposition”. Reg §1.453-9(c)(2) and §1.721-1(a) o You can sell property under installment sale method of accounting with respect to that property allows you to defer the recognition of gain on that property. You spread the gain out over the life of the installment notes. - No control or immediately after requirements – unlike corporation - Partial recognition has no effect on validity of non-recognition treatment. o In partnership, you can receive boot without recognition as there was in corporations. - An interest (capital or profits) for services may be taxable income to partner. §1.724-1(b); Rev. Proc. 93-27 o Capital interest: If they have interest in the capital of the partnership – True owners of the entity. o Profits interest: If they have interest in the profits and not in the capital – Their ownership interest is limited. o You can get an interest in a partner because you have contributed property or because you have performed services for that partnership. Similarly for a corporation. If the interest you receive is for services, you will be taxed on that as compensation for services. o The Revenue Procedure may allow for deferring income until you actually receive something other than the interest in the partnership. - Special rules provide for allocation of pre-contribution gain. §704(c); Reg. §1.704-3; §724; §737 o Pre-Contribution gain will never be shifted to any of the other owners, nor will any pre-contribution loss (Built in gain or loss will always be attributed back to the contributing partner – not so in corporations) - Special rules provide for gain from liabilities transferred. §752; §731 o Liabilities transferred will affect basis in partnership and not corporations. Very different rule. o Similarities between §357(c) and §752 – But §357(c) is a likely gain creating provision. It is likely, that if you are not careful you will have gain. BE EXTREMELY CAREFUL WHEN BUILDINGS AND LAND ARE TRANSFERRED INTO CORPORATION. o It is highly unlikely that there will ever be gain recognition when you transfer it in. That is because of the rules we just went through that allocate liability to partners with the effect of increasing their basis. The increased basis will eliminate that gain. - Accounts receivable transferred by cash method partner will not cause immediate recognition. §721 o This is a rule identical with the corporation rule – People owe you money and you choose to form partnership and you transfer those receivables into the partnership. Under no circumstances will you be immediately taxed on the receivables. o Corporation will be taxed on them upon receipt. o Partnership collects them, you will get them all if you put them in. - Character of partnership income from contributed accounts receivable and inventory will usually be ordinary income to contributing partner. §704(c); §724(a) and (b) o Whether you have capital gain or ordinary income, a corporation will pay the same rate of tax on that. o But a partnership will attribute to its partners and there is a significant capital gains preferential rate. o Character of income is very important – If the property is accts receivable or inventory, it will be ordinary income. - Capital loss property will retain its character after contribution and be allocated to the contributing partner. §724(c) o It will be allocated to the contributing partner - Contributions may be recharacterized as taxable sales by the IRS. Reg. §1.707-3 o They may be recast as sales of property. o The transaction will be scrutinized. o The transactions under §707 – A partner is permitted to deal with a partnership at an arm’s length basis even though he is a part-owner. He could be treated as employee, lessor, seller of property, creditor, but of course, the opportunities could be there for tax avoidance. So the IRS closely scrutinizes transactions between a partner and the partnership in which he has an interest. TRANSFEROR’S TAX BASIS AND HOLDING PERIOD §722, §1223 - General rule prescribes a substituted basis in partnership interest received, increased by gain (not decreased by loss) recognized (unlikely) under §721(b). §722 - - - - Holding period includes period property was held by transferor. §1223 o General holding period rule – Tells us when there will be a “Tacked Holding Period” which is a holding period in an assets that includes another holding period… o When you transfer property, the interest has a holding period that includes the holding period of the transferred property. Tax basis is reduced by the amount of the net decrease in a partner’s liability and increased by the amount of the net increase in partnership liabilities. Tax basis is adjusted annually for various items including: distributive share of income, loss, tax-exempt income, non-deductible items, distributions by the partnership and changes in the amount of the partnership’s liabilities for which the partner is liable. o Unlike corporations Special adjustements to tax basis are also made, including adjustment for certain recognition of pre-contribution gain and optional adjustment under §754 in the case of either a sale or exchange or as a result of the death of a partner. §704(c); §737, Reg. §1.737-3; §743; Reg. §1.743-1 Tax basis is reduced for capital losses, even though the loss may be limited by §1211. PARTNERSHIP’S TAX BASIS AND HOLDING PERIOD §723, §734, §743, §1223 - General rule prescribes for a transferred basis in the property received increased by gain recognized (unlikely) to contributing partner under §721(b). §723 - Holding period includes period property was held by partner - Partnership’s tax basis in “eligible property” is increased by gain recognized by a distribute partner under §737(c) (precontribution gain property). For next class PROBLEM 8, PROBLEM 9, PROBLEM 10, 11, 12