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					       Course Notes to Accompany

                ACCT 5327




Corporations, Partnerships, Estates, & Trusts
      Hoffman, Raabe, Smith, & Maloney




                  Fall 2007




                      1
                           Chapter 2
          Corporations: Introduction, Operating Rules,
                   and Related Corporations

Various Business Forms

     Sole Prorietorships

         1. Not a separate taxable entity

         2. Income reported on owner’s Schedule C



     Partnerships

         1. Separate entity, but does not pay tax

         2. Allocates partnership income to partners
            - Partners report partnership income on personal tax returns

         3. Files information return


     S Corporation

         1. Separate entity, only pays special taxes

         2. Allocates entity income to shareholders

                 -    Shareholders report entity income on personal tax return

         4. Files information return.
     C Corporation

         1. Separate tax-paying entity

         2. Income taxed at corporate level and again at owner level when distributed
            as a dividend.
                                     Dividends




                                            2
•Tax Relief Reconciliation Act of 2003 provides partial relief from double taxation of
corporate dividends

– Generally, dividends received in taxable years beginning after 2002 are taxed at same
  marginal rate applicable to a net capital gain

•Thus, individuals otherwise subject to the 10% or 15% marginal tax rate pay 5% tax on
qualified dividends received

•Individuals subject to the 25, 28, 33, or 35 percent marginal tax rate pay a 15% tax on
qualified dividends

•Stock on which the dividend is paid must have been held for more than 60 days during
the 120-day period beginning 60 days before the ex-dividend date



                   Nontax Issues in Selecting Entity Form
    Liability
         Sole proprietors and some partners have unlimited liability for claims against the
         entity.

    Capital-raising
         Corporations and partnerships to a lesser extent can raise large amounts of capital
         for entity ventures.

    Transferability

         Corporate stock is easily sold, but partners must approve partnership interest
         transfer.

    Continuity of Life
         Corporations exist indefinitely.

    Centralized Management

                    -   Corporate actions are governed by a board of directors.

                    -   Partnership operations may be conducted by each partner without
                            approval by other partners.



                                              3
                    Limited Liability Companies (LLC)

    LLC’s have proliferated since 1988 when IRS ruled it would treat
    LLC’s as partnerships.

 Major nontax advantage

    Allows entity to avoid unlimited liability



 Major tax advantage

    Allows qualifying business to be treated as a partnership for tax purposes, thereby
    avoiding double taxation associated with C corporations.


                      Entity Classification Prior to 1997

 Sometimes difficult to determine if entity will be taxed as a
  corporation.

    If entity has a majority of corporate characteristics, it is taxed as a corporation.


   Most entities have the following characteristics:

    - Associates

    - Objective to carry on business and share profits.


   If entity has a majority of the following relevant corporate
    characteristics it is treated as a corporation.

    - Continuity of life

    - Centralized management

    - Limited liability to owners

    - Free transferability of ownership interests


                                           4
                  Entity Classification After 1996
 Check-the-box Regulations

       1. Allows the taxpayer to choose tax status of entity without regard to
          corporate or noncorporate characteristics.

    - Entities with > 1 owner can elect to be classified as partnership or corporation.

    - Entities with only 1 owner can elect to be classified as sole proprietorship or as a
      corporation.

       2. If no election is made, multi-owned entities treated as partnerships, single
          person businesses treated as sole proprietorships.

       3. Election is not available to:

               -   Entities incorporated under state law, or
               -   Entities required to be incorporated under federal law.


Comparison of Corporate and Individual Tax Treatment
   Similarities

    - Gross income of a corporation and individual are very similar.

       1. Includes compensation for services, income from trade or business, gains
          from property, interest, dividends, etc.

       2. Corp t/p’s are allowed fewer exclusions.

       3. Nontaxable exchange treatment is similar.

       4. Depreciation recapture applies to both but corp may have additional
          recapture under Sec. 291.

   Dissimilarities

    - Different tax rates apply.

    - All deductions of corp are business deductions.

       1. Corp does not calculate AGI.



                                          5
      2. Corp does not calculate standard deduction, itemized deductions, or
         personal and dependency exemptions.

      3. Corp does not reduce casualty and theft loss by $100 statutory floor or
         10% of AGI.


                Accounting Periods and Methods

 Accounting periods

  - Most C corps can use calendar year or fiscal year ending on last day of a
  calendar month.

  - S corps and Personal Service Corporations (PSC) are limited in available year
    ends.

 Accounting Methods

  Cash method can’t be used by C corp. unless:
     o In farming or timber business
     o Qualified PSC
     o Avg. annual gross receipts < = $5,000,000.



                      Capital Gains and Losses

 Individuals

  - Net capital gains subject to the following preferential treatment

        o Net short-term gains subject to regular tax rates.
        o Net long-term gains max tax rate 15%.

  - Net capital losses deductible up to $3,000 with remainder carried to future
    years.




 Corporations


                                        6
   - No special tax rates apply to capital gains

        o Entire gain is included in income subject to normal corporate tax rates.

   - Corp. cannot take a deduction for net capital losses

        o Capital losses can be used only to offset capital gains.
        o Unused capital losses are carried back 3 years and carried forward for 5
          years. Carried over losses are treated as short-term.




                               Passive Losses

 Passive loss rules apply to:

      1. Individuals and PSC’s

          - Cannot offset passive losses against active or portfolio income.

      2. S corps. and partnerships

          - Passive income and loss flows through to owners and rules applied at
          owner level.

      3. Closely held C corps.

          - May offset passive losses against active income, but not portfolio
          income.




                       Charitable Contributions
 Both corporate and non-corporate taxpayers may deduct charitable
  contributions in year paid.


   - Exception for accrual basis corporations allows deduction in year preceding
   payment if:


                                         7
                        1. Approved by board and
                        2. Paid within 21/2 months of year-end.


 Amount deductible for property contributions depends on type of
  property contributed.

    o Long-term capital gain property deduction = fair market value of property.
       - exception: Corp may only deduct basis if tangible personal property
       contributed and not used by charity in its exempt function.

    o Ordinary income property deduction = basis in property.
        - exception: Basis plus 50% of appreciation can be deducted if inventory or
          scientific property is contributed which is used by charity as required by
          Code.


   Corporate charitable contribution deduction is limited to 10% of
    taxable income before:

              -   Charitable contribution deduction,
              -   NOL or capital loss carryback, and
              -   Dividends received deduction

   Contributions in excess of 10% limit can be carried forward for 5
    years.


                             Net Operating Loss

 Net operating loss of corporations and individual may be:

              -   Carried back 2 years
              -   Unused portion carried forward 20 years.




                                        8
                        Dividends Received Deduction

    If corporation owns stock in another corporation and receives
     dividends, a portion of dividends may be deducted from income:

       % Owned                               Deduction Percent

       Less than 20%                                70%

       20% but less than 80%                        80%

        80% or more, and affiliated                100%

   1. Multiply dividends received by deduction percentage.

   2. Multiply taxable income by deduction percentage.

   3. Subtract 1. from taxable income

       - If entity has income before DRD, but DRD creates NOL, amount in 1. is DRD.

       - If DRD does not create NOL, deduction is limited to lesser of 1. or 2.

            Organizational Expenditures and Start-up Costs
•A corporation may elect to amortize organizational expenses over a period of 15 years
or more
–A special exception allows the corporation to immediately expense the first $5,000 of
these costs

•Phased out on a dollar-for-dollar basis when these expenses exceed $50,000
Organizational Expenditures

Organizational expenditures include the following:
–Legal services incident to organization
–Necessary accounting services
–Expenses of temporary directors and of organizational meetings of directors and
shareholders
–Fees paid to the state of incorporation

•Expenditures connected with issuing or selling shares of stock or other securities or with
the transfer of assets to a corporation do not qualify

– Such expenditures reduce the amount of capital raised and are not deductible at all


                                              9
Start-up Expenditures

Start-up expenditures include:
–Various investigation expenses involved in entering a new business
•e.g., Travel, market surveys, financial audits, legal fees
•
–Also includes operating expenses, such as rent and payroll, that are incurred by a
corporation before it actually begins to produce any gross income

•At the election of the taxpayer, such expenditures can be treated in the same manner as
organizational expenditures
–Up to $5,000 can be immediately expensed (subject to the dollar cap and excess-of-
$50,000 phaseout)
–
–Any remaining amounts are amortized over a period of 180 months or longer


   Start new or unrelated business – deduct first $5,000, capitalize and
   amortize remainder over 180 months. Phase-out begins at $50,000 over
   $5,000 range.

   Do not start new or unrelated business – personal expenditures – no
   deduction.

   Investigate expanding an existing business
      Whether or not business opens a current deduction is allowed since
   business purpose exists.

                            Corporate Tax Formula
Gross income

Less: Deductions (except charitable, Div. Rec’d, NOL carryback, STCL carryback)
= Taxable income for charitable limitation
Less: Charitable contributions (< = 10% of above)
= Taxable income for DRD
Less: DRD
=Taxable income for carrybacks
Less: NOL carryback and STCL carryback

= TAXABLE INCOME




                                            10
              Tax Liability of Related Corporations
 Related corps. are subject to special rules for computing income tax

    - Limits controlled group’s taxable income in tax brackets below 35% to amount
    corporations in-group would have if they were one corporation.

 Controlled groups include:
               -   Parent-subsidiary groups
               -   Brother-sister groups
               -   Combined groups

               Parent-Subsidiary Controlled Group
   Consists of one or more chains of corps. connected through stock
    ownership with a common parent

    - Ownership is established through either:
    o Voting power test: requires ownership of stock with at least 80% of total
      voting power of all classes of stock entitled to vote.

    o Value test: requires ownership of at least 80% of total value of all classes of
      stock.


                   Brother-Sister Controlled Group

 Exists if 5 or fewer persons meet two 50% tests:

    - 50% total ownership test: group owns 50% of vote or value of all classes of each
    corp’s. stock.

    - 50% identical (common) ownership test: smallest amount owned by each
    shareholder in one of the entities is determined. Amounts are summed for all
    s/h’s and must be > 50%.




                                        11
                   Brother-Sister Group Example

                 A         B         C       >50% test
Bob             60%       20%       20%       20%
Alice           20%       60%       20%       20%
Ted             20%       20%       60%       20%
>50% test      100%      100%      100%

1. The group, combined, owns 100% of each entity’s stock, so meets 50% test.
2. The lowest amount owned by Bob in any entity is 20%; same for Alice and Ted. Sum
the 20% amounts for 60%. This is > 50% so 2nd test met.




                               Combined Groups

    Exist if all of the following conditions are met:

      - Each corp is a member of either a parent-subsidiary or brother-sister controlled
      group,

      - At least one of the corps is parent of a parent-subsidiary controlled group,

      - Parent corp is also a member of a brother-sister controlled group.



                           Application of Sec. 482

    Sec. 482 permits IRS to reallocate income, deductions, and credits
     between two or more businesses owned or controlled by the same
     interests.

    Used to prevent avoidance of taxes or to reflect income properly.

      - Controlled groups of corps are especially vulnerable to Sec. 482.




                                           12
                         Consolidated Returns
 Members of a parent-subsidiary affiliated group may be able to file a
  consolidated income tax return.

                    Corporate Filing Requirements

 Must file Form 1120 on or before the 15th day of the 3rd month
   following close of tax year.

   - Automatic 6-month extensions are available by filing Form 7004.

 Must make estimated tax payments equal to lesser of:

   - 100% of corporation’s final tax, or

   - 100% of tax for preceding year

   - No estimated tax payments required if tax liability expected to be less than $500.


                               Schedule M-1

 Corporations must reconcile financial accounting income with taxable
   income on Sch M-1, Form 1120.

   - Common reconciling items include:

         o Federal tax liability
         o Net capital losses
         o Income reported for tax but not book income (e.g., prepaid revenue) and
           vice versa.
         o Expenses deucted for book income but not tax (e.g., excess charitable
           contributions) and vice versa.


                               Schedule M-2

 Corporations must reconcile retained earnings at beginning of year
  with retained earnings at end of year using Sch M-2 form 1120.



                                           13
                             Schedule M-3

•Corporate taxpayers with total assets of $10 million or more are now
required to report much greater detail regarding differences in financial
accounting income (loss) and taxable income (loss)
–Reported on new Schedule M–3
–Must be filed for years ending after December 31, 2004
•Schedule M–3 should
–Create greater transparency between corporate financial statements and tax
returns
–Help the IRS identify corporations that engage in aggressive tax practices




                                     14
                            CHAPTER 3
                        Special Situations

Manufacturers’ Deduction

  • The American Jobs Creation Act of 2004 created a new deduction
    based on the income from manufacturing activities


        – The manufacturers’ deduction is based on the following
          formula:
             • 3% × Lesser of
                   – Qualified production income
                   – Taxable (or adjusted gross) income

                     – The deduction cannot exceed 50% of an
                       employer’s W–2 wages


  • Qualified production income is the total of qualified production
    receipts reduced by:
       – Cost of goods sold that are attributable to such receipts
       – Other deductions, expenses, or losses that are directly allocable
          to such receipts
       – A share of other deductions, expenses, and losses that are not
          directly allocable to such receipts or another class of income


  • The term also includes receipts for certain services rendered in
    connection with construction projects in the United States

  • Domestic Production Gross Receipts include gross receipts derived
    from any lease, rental, sale, exchange or other disposition of (a)
    tangible personal property, computer software and sound recordings,
    which was manufactured, produced, grown or extracted ("MPGE") by
    the taxpayer in whole or in significant part within the U.S., (b) any
    qualified film produced by the taxpayer and (c) electricity, natural gas


                                    15
   or potable water produced by the taxpayer in the U.S. but not the
   transmission or distribution

• Qualified production receipts do not include proceeds from the sale of
  food and beverages prepared at a retail establishment
• A phase-in provision increases the applicable rate for the
  manufacturer’s deduction as follows:

         Rate                Years
         3%                 2005-2006
         6%                 2007-2009
         9%                 2010 and thereafter

• Eligible taxpayers include:

      – Individuals, partnerships, S corporations, C corporations,
        cooperatives, estates, and trusts

            • For a pass-through entity (e.g., partnerships, S
              corporations), the deduction flows through to the
              individual owners

            • For sole proprietors, a deduction for AGI results

            • For C corporations, the deduction is included with other
              expenses in computing corporate taxable income




                                  16
                                       Chapter 4
      CORPORATIONS: ORGANIZATION AND CAPITAL
                     STRUCTURE


 Corporation Formation Transaction




   Formation Example
Ron will incorporate his donut shop:
                                            Asset          Fair Mkt
                                         Tax Basis          Value
Cash                               $10,000        $ 10,000
Furniture & Fixtures                20,000          60,000
Building                            40,000         100,000
Total                              $70,000        $170,000


•Without §351: gain of $100,000.

•With §351: no gain or loss. Ron’s economic status has not changed.


   Consequences of §351
     In general, no gain or loss to transferors:
        On transfer of property to corporation

        In exchange for stock



                                           17
       IF immediately after transfer, transferors are in control of
        corporation


          If boot (property other than stock) received by
                             transferors

                       Gain recognized up to lesser of:
            Boot received or

            Realized gain

       No loss is recognized

   Issues re: Formation
     Definition of property includes:
       Cash

       Secret processes and formulas

       Unrealized accounts receivable (for cash basis taxpayer)

       Installment obligations

     Code specifically excludes services from definition of
      property

     Stock transferred

       Includes common and most preferred stock

            Does not include nonqualified preferred stock which possesses many
             attributes of debt

       Does not include stock rights or stock warrants
       Does not include corporate debt or securities (e.g., corporate
        bonds)

                                        18
        Treated as boot


     Transferors must be in control immediately after
       exchange to qualify for nontaxable treatment
                 To have control, transferors must own:
        80% of total combined voting power of all classes of stock entitled to
         vote, plus

        80% of total number of shares of all other classes of stock



 “Immediately after” the exchange
     Does not require simultaneous transfers if more than one
                             transferor

         Rights of parties must be outlined before first transfer

          Transfers should occur as close together as possible


  After control is achieved, it is not necessarily lost upon
   the sale or gift of stock received in the transfer to others
                not party to the initial exchange

          But sale might violate §351 if prearranged

              Transfers for property and services
    May result in service provider being treated as a member of
                        the 80% control group

                      Taxed on value of stock issued for services

            Not taxed on value of stock received for property contributions




                                    19
       Service provider should transfer property having more than “a
                            relatively small value”


                  Subsequent transfers to corporation
           Tax-free treatment still applies as long as transferors in
              subsequent transfer own 80% following exchange

   Assumption of Liabilities
     Assumption of liabilities by corp DOES NOT result in
      boot to the transferor shareholder for gain recognition
      purposes
       Liabilities ARE treated as boot for determining basis in
        acquired stock

       Basis of stock received is reduced by amount of liabilities
        assumed by the corp


     Liabilities are NOT treated as boot for gain recognition
      unless:
       Liabilities incurred for no business purpose or as tax
        avoidance mechanism
            Boot = Entire amount of liability

       Liabilities > basis in assets transferred

          Gain recognized = Excess amount (liabilities - basis)

   Formation with Liabilities Example
Property transferred has:
Fair market value =       $150,000
Basis              =       100,000
Realized Gain      =        50,000

                                        20
Liabilities assumed by corp. (independent facts):
                    Business Business        No Business
                    Purpose Purpose             Purpose
Liability:          $80,000 $120,000           $120,000
Boot                None        $ 20,000       $120,000
Gain
Recognized          None         $20,000       $ 50,000*
*(Gain is lesser of $50,000 realized gain or boot)


   Basis Computation for §351 Exchange
     Shareholder’s basis in stock:

       Adjusted basis of transferred assets
       + Gain recognized on exchange
       - Boot received
       - Liabilities transferred to corporation
       = Basis of stock received by shareholder


   Basis Computation for §351 Exchange
     Corporation’s basis in assets:
      Adjusted basis of transferred assets
      + Gain recognized by transferor shareholder
      = Basis of assets to corporation

   Basis in Stock in Last Example

Adjusted Basis of transferred assets:                       $100,000
Liabilities assumed by corp. (independent facts):

                      Business Business No Business
                       Purpose Purpose    Purpose
Liability:            $ 80,000 $120,000  $120,000
Basis in assets
Transferred           $100,000    $100,000       $100,000
+ Gain recognized       None        20,000         50,000


                                            21
- Liab. Transferred    (80,000) (120,000)       (120,000)
Basis in stock        $ 20,000     -0-           $ 30,000


   Corporation’s Basis in Assets Received in Last
    Example

Liabilities assumed by corp. (Independent facts):

                        Business Business No Business
                         Purpose Purpose    Purpose
Liability:             $ 80,000 $120,000    $120,000
Basis of trans-
ferred assets:         $100,000     $100,000        $100,000
Gain recognized
by shareholder            None        20,000          50,000
Basis to Corp.          $100,000    $120,000        $150,000

   Holding Period
     Holding period of stock received
        For capital assets or §1231 property, includes holding period of
           property transferred to corporation
        For other property, begins on day after exchange
     Corp’s holding period for property acquired in the
      transfer is holding period of transferor


   Capital Contributions
     No gain or loss is recognized by corp on receipt of money
      or property in exchange for its stock
        Also applies to additional voluntary pro rata contributions of
            money or property to a corp even though no additional
            shares are issued

     Capital contributions of property by nonshareholders


                                           22
       Not taxable to corporation

       Basis of property received from nonshareholder is -0-

     Capital contributions of cash by nonshareholder
       Must reduce basis of assets acquired during 12 month period
        following contribution

       Any remaining amount reduces basis of other property owned
        by the corp
            Applied in the following order to depreciable property, amortizable
             property, assets subject to depletion, and other remaining assets


                             Debt Vs. Equity
     Debt
       Corporation pays interest to debt holder which is deductible by
        corporation

       Interest paid is taxable as ordinary income to individual or
        corporate recipient

       Loan repayments are not taxable to investors unless
        repayments exceed basis


     Equity:
       Corporation pays dividends which are not deductible

       Taxable as ordinary income to recipient to extent corp has
        E&P

            Corporate shareholder may receive dividends received deduction



   Reclassification of Debt As Equity

                                      23
     If corp is “thinly capitalized”, i.e., has too much debt and
      too little equity
       IRS may argue that debt is really equity and deny tax
        advantages of debt financing

       If debt has too many features of stock, principal and interest
        payments may be treated as dividends


     Debt instrument documentation

     Debt terms (e.g., reasonable rate of interest and definite
      maturity date)

     Timeliness of repayment of debt

     Whether payments are contingent on earnings

     Subordination of debt to other liabilities

     Whether debt and stock holdings are proportionate


     Use of funds (if used to finance initial operations or to
      acquire capital assets, looks like equity)

     Debt to equity ratio

   Losses on Investment in Corporation

     Stock and security losses
       If stocks and bonds are capital assets, losses              from
        worthlessness are capital losses




                                   24
 Loss is treated as occurring on last day of tax year in
  which they become worthless

 No loss for mere decline in value

 Stock and security losses

   If stocks and bonds are not capital assets, losses from
    worthlessness are ordinary losses (e.g., broker owned)

   Sometimes an ordinary loss is allowed for worthlessness of
    stock of affiliated company



 Business versus nonbusiness bad debts
   General rule: Losses on debt of corporation treated as
    business or nonbusiness bad debt

   If noncorporate person lends as investment, loss is nonbusiness
    bad debt
        Short-term capital loss

        Only deductible when fully worthless



 Business versus nonbusiness bad debts (con’t)
   If corporation is lender, loss is business bad debt
        Ordinary loss deduction

        Deduction allowed for partial worthlessness

        All bad debts of corporate lender qualify as business bad debts




                                    25
     Business versus nonbusiness bad debts (con’t)
       Noncorporate lender may qualify for business bad debt
        treatment if:

            Loan is made in some capacity that qualifies as a trade or business, or

            Shareholder is in the business of lending money or of buying,
             promoting, and selling corporations



   §1244 stock
     Treatment of §1244 stock:
       Ordinary loss treatment for loss on stock of “small business
        corporation” (as defined)

       Gain still capital gain


     §1244 stock:
       Total amount of stock at initial issuance cannot exceed
        $1,000,000 (based on basis of property contributed, less
        liabilities assumed by company)



     Annual loss limitation:
       $50,000 or

       $100,000 if married filing joint return

       Any remaining loss is a capital loss




                                        26
     Only original holder of §1244 stock qualifies for ordinary
      loss treatment
       Sale or contribution of stock results in loss of §1244 status



     If §1244 stock is issued for property with basis > fair
      market value

       For determining ordinary loss, stock basis is reduced
        to fair market value on date of exchange

   Gain From Qualified Small Business Stock
     Noncorporate shareholders may exclude 50% of gain
      from sale or exchange of such stock
       Must have held stock for > 5 years and acquired stock as part
        of original issue

       50% exclusion can be applied to the greater of:

            $10 million, or

          10 times shareholder’s aggregate adjusted basis of
           qualified stock disposed of during year


   Gain From Qualified Small Business Stock
     Qualified Small Business Corp
       C corp with gross assets not greater than $50 million on date
        stock issued

       Actively involved in a trade or business




                                    27
   At least 80% of corporate assets are used in the active conduct of one
    or more trade or businesses




                              28
                                     Chapter 5

               Corporations: Earnings & Profits
                 and Dividend Distributions

                                Taxable Dividends
•Distributions from corporate earnings and profits (E & P) to shareholders are treated as a
dividend distribution, taxed at capital gains rates or at times ordinary income.



•Distributions in excess of E & P are nontaxable to extent of shareholder’s basis (i.e., a
return of capital)


•Excess over basis is capital gain



                                Earnings & Profits

•No definition of E & P in Code


•Similar to Retained Earnings (financial reporting), but often not the same


•E & P represents:
–Upper limit on amount of dividend income recognized on corporate distributions

–Corporation's economic ability to pay dividend without impairing capital




                                            29
                       Calculating Earnings & Profits

•Calculation generally begins with taxable income, plus or minus certain adjustments

–Add previously excluded items back to taxable income including:

       •Muni bond interest

       •Excluded life insurance proceeds

       •Federal income tax refunds

       •Dividends received deduction


•Calculation generally begins with taxable income, plus or minus certain adjustments

–Subtract certain nondeductible items:

       •Related-party and excess capital losses

       •Expenses incurred to produce tax-exempt income

       •Federal income taxes paid

       •Key employee life insurance premiums

       •Fines and penalties

•Certain E & P adjustments shift effect of transaction to year of economic effect, such as:

–Charitable contribution carryovers

–NOL carryovers

–Capital loss carryovers

•Other adjustments

–Accounting methods for E & P are generally more conservative than for taxable income,
for example:




                                            30
       •Installment method is not permitted

       •Alternative depreciation system required

       •Percentage of completion must be used (no completed contract method)


       Summary of E & P Adjustments
Effect on taxable income for E & P:

Transaction                                   Add            Subtract
Tax-exempt income
Life insurance proceeds
Deferred installment gain
Excess charitable contribution
Ded. of prior excess contribution
Federal income taxes
Officer’s life insurance premium
Accelerated depreciation


                          Current vs Accumulated E & P
•Current E & P
–Taxable income as adjusted


•Accumulated E & P
–Total of all prior years’ current E & P as of first day of tax year, reduced by
distributions from E & P


•Distinction between current and accumulated E & P is important
–Taxability of corporate distributions depends on how current and accumulated E & P are
allocated to each distribution made during year


                       Allocating E & P to Distributions
•If positive balance in both current and accumulated E & P

–Distributions are deemed made first from current E & P, then accumulated E & P




                                           31
–If distributions exceed current E & P, must allocate current and accumulated E & P to
each distribution

        •Allocate current E & P pro rata to each distribution

        •Apply accumulated E & P in chronological order



•If current E & P is positive and accumulated E & P has a deficit

–Accumulated E & P IS NOT netted against current E & P

        •Distribution is deemed to be taxable dividend to extent of positive current E & P
        balance

•If accumulated E & P is positive and current E & P is a deficit, net both at date of
distribution

–If balance is zero or a deficit, distribution is a return of capital


–If balance is positive, distribution is a dividend to the extent of the balance


    Cash Distribution Example
A $20,000 cash distribution is made in each independent situation:

                                    1          2           3*
Accumulated E & P,
beginning of year               100,000 (100,000) 15,000
Current E & P                    50,000 50,000 (10,000)
Dividend:                        20,000 20,000     5,000


*Since there is a current deficit, current and accumulated
 E & P are netted before determining treatment of distribution.




                                               32
                                       Property Dividends
•Effect on shareholder:

–Amount distributed equals FMV of property

        •Taxable as dividend to extent of E & P

        •Excess is treated as return of capital to extent of basis in stock

        •Any remaining amount is capital gain

–Reduce amount distributed by liabilities assumed by shareholder


–Basis of distributed property = fair market value

•Effect on corporation:

–Corp. is treated as if it sold the property for fair market value

        •Corp. recognizes gain, but not loss

–If distributed property is subject to a liability in excess of basis

        •Fair market value is treated as not being less than the amount of the liability


•Effect on corporation’s E & P:

–Increases E & P for excess of FMV over basis of property distributed

–Reduces E & P by FMV of property distributed (or basis, if greater) less liabilities on
the property

–Distributions of cash or property cannot generate or add to a deficit in E & P

        • Deficits in E & P can arise only through corporate losses




                                               33
Property Distribution Example
Property is distributed (corporation’s basis = $20,000) in each of the following
independent situations. Assume Current and Accumulated E & P are both $100,000 in
each case:
                               1        2      3
Fair market value
of distributed property     60,000 10,000     40,000
Liability on property         -0-      -0-    15,000
Gain(loss) recognized       40,000     -0-    20,000
E&P increased by gain       40,000     -0-    20,000
E & P decrease on dist.     60,000 20,000 25,000




   Constructive Dividend
•Any economic benefit conveyed to a shareholder may be treated as dividend for tax
purposes, even though not formally declared

–Need not be pro rata

•Usually arises with closely held corporations

•Payment may be in lieu of actual dividend and is presumed to take form for tax
avoidance purposes

•Payment is re-characterized as a dividend for all tax purposes


   Examples of Constructive Dividends
•Shareholder use of corporate property (e.g., company car to non-employee shareholder)

•Bargain sale of property to shareholder (e.g., sale for $1,000 of property worth $10,000)

•Bargain rental of corporate property



                                            34
•Payments on behalf of shareholder (e.g., corporation makes estimated tax payments for
shareholders)

•Unreasonable compensation

•Below market interest rate loans to shareholders

•High rate interest on loans from shareholder to corporation


   Avoiding Unreasonable Compensation
•Documentation of the following attributes will help support payments made to an
employee-shareholder:

–Employee’s qualifications
–Comparison of salaries with dividends made in past
–Comparable salaries for similar positions in same industry
–Nature and scope of employee’s work
–Size and complexity of business
–Corporation’s salary policy for other employees


   Stock Dividends
•Excluded from income if pro rata distribution of stock, or stock rights, paid on common
stock

–Five exceptions to nontaxable treatment deal with various disproportionate distribution
situations

•Effect on E & P

–If nontaxable, E & P is not reduced

–If taxable, treat as any other taxable property distribution

•Basis of stock received
–If nontaxable

       •If shares received are identical to shares previously owned, basis = (cost of old
       shares/total number of shares)

       •If shares received are not identical, allocate basis of old stock between old and
       new shares based on relative fair market value


                                             35
        •Holding period includes holding period of formerly held stock
–If taxable, basis of new shares received is fair market value



                                     Stock Rights
•Tax treatment of stock rights is same as for stock dividends
–If stock rights are taxable

       •Income recognized = fair market value of stock rights received

       •Basis = fair market value of stock rights

       •If exercised, holding period begins on date rights are exercised

       –Basis of new stock = basis of rights plus any other consideration given


•If stock rights are nontaxable
–If value of rights received < 15% of value of old stock, basis in rights = 0


•Election is available which allows allocation of some of basis of formerly held stock to
rights

–If value of rights is 15% or more of value of old stock, and rights are exercised or sold,
must allocate some of basis in formerly held stock to rights


                        Corporate Distribution Planning
•Maintain ongoing records of E & P:

–Ensures return of capital is not taxed as dividend

–No statute of limitations on E & P, so IRS can re-determine at any time

       •Accurate records minimize this possibility

•Adjust timing of distribution to optimize tax treatment:

–If accumulated E & P deficit and current E & P loss, make distribution by end of tax
year to achieve return of capital

–If current E & P is likely, make distribution at beginning of next year to defer taxation


                                             36
                       Avoiding Constructive Dividends
•Structure transactions on “arms’ length” basis:
–Reasonable rent, compensation, interest rates, etc...

•Use mix of techniques to “bail out” corporate earnings such as:

–Shareholder loans to corporation
–Salaries to shareholder-employee
–Rent property to corporation
–Pay some dividends

•Overdoing any one technique may attract attention of IRS




                                             37
                             CHAPTER 6
        Corporations: Redemptions And Liquidations

   Redemptions
     Transaction: corporation purchases its stock from
      shareholder

       If qualified as a redemption, from shareholder perspective,
        same result as a sale to a third party:
           Shareholder has cash or other property instead of stock

           Shareholder has less control over (ownership of) corporation



     From other shareholders’ perspective, redemption does
      not resemble sale to third party:

       Less stock is outstanding, so other shareholders’ ownership
        percentage is increased


     From corporate view, does not resemble sale to third
      party:
       Corporation has less assets, because some of these assets have
        been transferred to the shareholder redeeming stock




                                      38
   Effect of Redemption
     If qualified as a redemption treated as sale or exchange:
       Shareholder reports gain or loss on surrender of stock
            Gain taxed at favorable capital gains rates

            Only amount in excess of adjusted basis is taxed as a capital gain.


     If transaction has appearance of a dividend, redemption
      will not be qualified:
       For example, if shareholder owns 100% and corporation buys
        ½ of stock for $X, shareholder still owns 100%


     If not qualified as a redemption:
       Shareholder reports dividend income
            Taxed at favorable capital gains rates

            However, redemption proceeds may not be offset by basis in stock
             surrendered

       Corporate shareholders may prefer dividend treatment
        because of the dividends received deduction


   Transactions Treated as Redemptions
     The following types of distributions may be treated as a
      redemption of stock rather than a dividend:

       Distributions not essentially equivalent to a dividend
        (subjective test)

       Disproportionate distributions (mechanical rules)



                                        39
     Distributions in termination of shareholder’s interest
      (mechanical rules)

     Partial liquidations of a corporation where shareholder is
      not a corporation, and either
         Distribution is not essentially equivalent to a dividend, or

         An active business is terminated

            May be subjective (1) or mechanical (2)


     Distributions to pay death taxes (limitation on amount of
      allowed distribution is mechanical test)

    –   Stock attribution rules must be applied, so distribution
        which appears to meet requirements may not qualify

   Stock Attribution

    –   Qualified stock redemption must result in substantial
        reduction in shareholder’s ownership

         Stock ownership by certain related parties is attributed
          back to shareholder whose stock is redeemed

    –   Attribution from family members

         Stock owned by spouse, children, grandchildren, or
          parents attributed back to individual




                                       40
–   Attribution from entity to owner:

      Partner: deemed owner of proportionate number of
       shares owned by partnership

      Beneficiary or heir: deemed owner of proportionate
       shares owned by entity

      50% or more shareholder:         deemed owner of
       proportionate shares owned by corporation

–   Attribution from owner to entity

      Partnership: deemed owner of total shares owned by
       partner

      Estate or trust: deemed owner of total shares owned
       by heir or beneficiary

      Corporation: deemed owner of total shares owned by
       50% or more shareholder


–   Family attribution rules do not apply to redemptions in
    complete termination of shareholder’s interest

–   Stock attribution rules do not apply to redemptions to pay
    death taxes


          Not Essentially Equivalent Redemptions
–   Redemption qualifies for sale or exchange treatment if
    “not essentially equivalent to a dividend”


                              41
         Subjective test

         Provision was added to deal specifically with redemptions of
          preferred stock

            Shareholders often have no control over when preferred shares
             redeemed

            Also applies to common stock redemptions


    –   To qualify, redemption must result in a meaningful
        reduction in shareholder’s interest in redeeming corp

         Stock attribution rules apply


    –   If redemption is treated as ordinary dividend

         Basis in stock redeemed attaches to remaining stock
          owned (directly or constructively)



   Qualifying Disproportionate Redemption
    –   Redemption qualifies as disproportionate redemption if:

         Shareholder owns less than 80% of the interest owned
          prior to redemption

         Shareholder owns less than 50% of the total combined
          voting power in the corporation




                                      42
   Qualifying Disproportionate Redemption




     Shareholder has 46 2/3% ownership represented by 35
      voting shares (60-25) of 75 (100-25) outstanding voting
      shares

    –   Redemption is qualified disproportionate redemption
        because:




   Complete Termination Redemptions
    –   Termination of entire interest generally qualifies for sale
        or exchange treatment



                                  43
          Often will not qualify as disproportionate redemption
           due to stock attribution rules

          Family attribution rules will not apply if:
            Former shareholder has no interest (other than as creditor) for at
             least 10 years

            Agree to notify IRS of any disallowed interest within 10 year
             period

   Redemptions In Partial Liquidation
    –   Noncorporate shareholder gets sale or exchange treatment
        for partial liquidation including:

          Distribution not essentially equivalent to a dividend

          Distribution pursuant to termination of an active
           business


   Redemptions In Partial Liquidation
–       To qualify, distribution must be made within taxable year
        plan is adopted or the succeeding taxable year

–       Not essentially      equivalent test looks           at effect on
        corporation

          Requires genuine contraction of the business of the
           corporation
            Difficult to apply due to lack of objective tests

            Advanced ruling from IRS should be obtained




                                       44
    –   To meet the complete termination of a business test, the
        corporation must:

         Have > one trade or business, two or more of which
          have been in existence for at least five years,

         Terminate one trade or business and continue a
          remaining trade or business

   Redemptions To Pay Death Taxes
    –   Allows sale or exchange treatment if value of stock exceeds
        35% of value of adjusted gross estate

         Stock of 2 or more corps may be treated as stock of
          single corp for 35% test if 20% or more of each corp
          was owned by decedent

         Special treatment limited to sum of:
            Death Taxes

            Funeral and administration expenses


    –   Basis of stock is stepped up to fair market value on date of
        death (or alternate valuation date)

         When redemption price equals stepped-up basis, no tax
          consequences to estate




                                    45
   Effect of Redemption on Corporation
    –   Gain or loss recognition

         If property other than cash used for redemption
            Corporation recognizes gain on distribution of appreciated
             property

            Loss is not recognized

        Corporation should sell property, recognize loss, and use proceeds
        from sale for redemption


     Effect on Earnings and Profits

         E & P is reduced in a qualified stock redemption by
          ratable share of E & P attributable to stock redeemed


   Stock Redemptions-No Sale Or Exchange Treatment
     Redemptions not qualifying under previous provisions

         Treated as dividend distribution to extent of E & P

         Attempts by taxpayers to circumvent redemption
          provisions led to rules covering:
            Preferred stock bailouts

            Sales of stock to related corporations

   Effect of Preferred Stock Bailout
     Preferred stock bailout involves:




                                        46
     Corporate distribution of nontaxable (nonvoting)
      preferred stock dividend on common stock,

     Portion of basis in common stock is allocated to
      preferred stock,

     Shareholder then sells the preferred stock to third
      party
        Effect is bailout of corporate profits as a capital gain


 To minimize abuse potential, Code requires this
  treatment:
     Shareholder has ordinary income (§306 taint) on sale of preferred stock
      to third party

     Amount of ordinary income is FMV of preferred stock on date received
      as distribution from corporation (limited by E & P of company, but does
      not reduce entity E & P)

     No loss recognized on sale of “tainted” preferred stock

     If stock is redeemed by corporation, proceeds treated as a dividend



–   §306 stock is stock which is not common stock:

     Received as a nontaxable stock dividend

     Received tax-free in a corporate reorganization (plus
      other requirements), or

     Has a basis determined by reference to other §306
      stock




                                     47
   Liquidations-In General
    –   Corporation winds up affairs, pays debts, and distributes
        remaining assets to shareholders

         Produces sale or exchange treatment to shareholder

         Liquidating corporation recognizes gains and losses
          upon distribution of its assets, with certain exceptions



   Liquidations-Effect On Corporation
    • Gain or loss is recognized by corporation on distribution
        in complete liquidation

         Loss may be disallowed or limited if:
            Property distributed to related parties, or

            Property distributed has built-in losses

         Property treated as if sold for FMV

         Result:
            Liquidating distribution subject to corporate level tax (gain),
             and shareholder level tax (receipt of proceeds)



    • Limitations on losses-Related Party Situations

         Losses are disallowed on liquidating distributions to
          related parties if:



                                       48
            Distribution is not pro rata
                 IN PRO RATA DISTRIBUTIONS, EACH SHAREHOLDER RECEIVES THEIR SHARE OF EACH
                  ASSET


            Property distributed is disqualified property
                 DISQUALIFIED PROPERTY IS PROPERTY ACQUIRED BY CORP IN A §351 TRANSACTION
                  DURING THE FIVE-YEAR PERIOD ENDING ON DATE OF DISTRIBUTION




   Liquidations-Effect On Corporation
    –   Limitations on losses-Built-in Loss Situations

         Losses are disallowed when property distributed was
          acquired in a §351 transaction and principal purpose
          was to cause recognition of loss by corp on liquidation

         Purpose is presumed if transfer occurs within two
          years of adopting liquidation plan

   Distribution of Loss Property in Liquidation




                                            49
   Liquidations-Effect On Shareholder
    –   Gain or loss recognized on receipt of property from
        liquidating corporation

         Amount = FMV of property received - basis in stock
           Generally, capital gain or loss

         Basis in assets received in liquidating distribution =
          FMV on date of distribution




   Liquidations-Effect On Shareholder
        – Special rule for installment obligations

          •   Shareholder may defer gain recognition to point of collection

          •   Corporation must recognize all gain on distribution




                                      50
                                   Chapter 12
                                 S Corporations

Subchapter S Issues
   –   S Corporation status is elective

– Failure to make the election in the manner prescribed results in the entity
  being taxed as a C Corporation

       •   However, the IRS has authority to waive the effect of an invalid
           election caused by inadvertent failure to qualify or to obtain
           required shareholder consents

       •   IRS can also treat a late election as timely where there was
           reasonable cause


   S Corporations are still corporations for legal purposes

– Owners receive the benefits of limited liability, ability to raise capital (within
   limits), etc...



   Taxation resembles partnership taxation

– Certain items (primarily business income and certain expenses) are accumulated
   and passed through to shareholders


– Other items are “separately stated” and each item is passed through to
   shareholders

   –   An S corporation is a reporting (rather than tax-paying) entity




   Tax liability may still arise at the entity level for:



                                           51
– Built-in gains tax, or
– Passive investment income penalty tax


   An S Corporation is not subject to the following taxes:

– Corporate income tax

– Accumulated earnings tax

– Personal holding company tax

– Corporate alternative minimum tax

   –   Entity is subject to Subchapter C rules for a transaction unless
       Subchapter S provides alternate rules


                       When To Elect S Corp Status
   Following factors should be considered:

– If shareholders have high marginal tax rates vs Corp rates

– If NOLs are anticipated

– If currently C corp, any NOL carryovers from prior years can’t be used during
   S corp years

       •   Still reduces 20 year carryover period


– Character of anticipated flow-through items


                  S Corp Qualification Requirements
   To elect under Subchapter S, a corporation must meet the following
   requirements:

– Must be a domestic corporation



                                       52
– Must not otherwise be “ineligible”

       •   Ineligible corporations include certain banks, insurance companies
           and foreign corporations

       •   S corps can own up to 100% of a C corp

       •   After 1996, S corps can also have wholly owned S corporation
           subsidiaries

    Corporation may have only one class of stock

– Can have stock with differences in voting rights but not in distribution or
    liquidation rights

– It is possible for debt to be reclassified as stock

       •   Results in unexpected loss of S corp status

       •   Safe harbor provisions mitigate concern over reclassification of
           debt

•   Must have 100 or less shareholders

       •After 2004, family members may elect to be treated as one
       shareholder

       •Shareholders can only include individuals, estates, certain trusts, and
       certain tax-exempt organizations

       •Partnerships, Corps, LLCs, LLPs and IRAs cannot own S corp stock,
       but S corps can be partners in a partnership or shareholders in a
       corporation

•Shareholders       cannot include any nonresident aliens

                             Making The Election
    To become an S corp, must make a valid election that is:




                                           53
– Filed timely

– All shareholders must consent to the election

    –   To be effective for current year

– Make election by 15th day of third month of current tax year, or

– File in previous year


    –   Shareholder Consent
    –Each shareholder owning stock during election year must sign consent for
    election (even if stock is no longer owned at election date)

    –May be able to obtain extension of time for filing consent from IRS

    –Available only if Form 2553 is filed on a timely basis, reasonable cause is given,
    and the interests of the government are not jeopardized.


•   Election is not effective if entity does not meet S corporation
    requirements at time election is filed



                            Termination of Election

    –   The S election is lost in any of the following ways:

    1. Shareholders owning a majority of shares revoke the election

– Revocation must be filed by 15th day of third month to be effective for entire
    year

– Otherwise, it is effective for first day of following year, or any other specified
    future date

    2. New shareholder owning > 50% of entity refuses to consent to
       election




                                          54
    3. Entity no longer qualifies as S Corp

– (e.g., the entity has > 100 shareholders or a nonresident alien shareholder, a
    second class of stock exists, etc.)

– Election is terminated on date disqualification occurs

    4. The corporation has excess “passive investment income” (PII) for
       three years in a row
-   The entity has excess PII if passive investment income (net of passive investment
    expenses) > 25% of Gross Receipts

-       This test only applies if the entity has E & P from a prior year in which the
        entity was a Subchapter C corporation

-       Election is terminated the first day of the fourth year

    –    A new election normally cannot be made within five years after
         termination of a prior election
– Five year waiting period is waived if:
     • There is a > 50% change in ownership after first year termination
         is applicable

         •   Event causing termination was not reasonably within control of the
             S corp or its majority shareholders




                        Computation Of Taxable Income
    Determined in a manner similar to partnerships except

– S corp can amortize organizational costs

– S corp must recognize gain (but not losses) on distribution of appreciated
    property to shareholders

  – S corp items are divided into:
– Nonseparately stated income or loss
     • Essentially, constitutes Subchapter S taxable income or loss



                                            55
– Separately stated income, losses, deductions and credits that could
  uniquely affect tax liability of shareholders
     • Identical to separately stated items for partnerships




                  Flow-Through of S Corporation Items




Separately Stated Items
  – Include:
– Tax-exempt income

– Gains/losses from disposal of business property and capital assets

– Charitable contributions

– Income/loss from rental of real estate



                                           56
– Interest, dividend, or royalty income

– Tax preference items




                         Allocation Of Income And Loss

    –   Each shareholder is allocated a pro rata portion of
        nonseparately stated income (loss) and all separately
        stated items

-       If stock holdings change during year, shareholder is allocated a pro rata
        share of each item for each day


-       Short-year election is available if a shareholder’s interest is completely terminated
        (through disposition or death)

        •   Allows tax year to be treated as two tax years
–   Results in interim closing of books on date of termination

–   Shareholders report their shares of S corp items as they occurred during year

                            S Corporation Distributions
    –   Amount of distribution to shareholder = cash + FMV of any other
        property distributed

    –   Taxation of distribution depends on whether the S corp has
        accumulated E&P from C corp years


    –   Where no Earnings and Profits exist

    1. Nontaxable to the extent of adjusted basis in stock




                                             57
    2. Excess treated as gain from the sale or exchange of property (capital gain
       in most cases)


         •     Where Earnings and Profits exist
    1. Tax-free to the extent of accumulated adjustments account*

    2. Any PTI from pre-1983 tax years can be distributed tax-free


    3. Remaining distribution is ordinary dividend from AEP**

    4. Tax-free to extent of Other Adjustments Account

    5. Tax-free reductions in basis of stock

    6. Excess treated as gain from the sale or exchange of stock (capital gain in most
    cases)


–   * Once stock basis reaches zero, any distribution from AAA is treated as a gain
    from sale or exchange of stock. “Basis” is the maximum tax-free distribution a
    shareholder can receive.

–   ** AAA bypass election is available


    –    Accumulated Adjustments Account (AAA)

– Represents cumulative total undistributed nonseparately and separately stated
    items

– Mechanism to ensure that earnings of an S corp are taxed to shareholders only
        Once


    • Accumulated Adjustments Account (AAA) is adjusted as follows:
         – Increased by:
•   Nonseparately computed income and Schedule K items other than tax-
    exempt income

•   Depletion in excess of basis in property




                                          58
            –   Decreased by:
•   Adjustments other than distributions (losses and deductions)

•   Portion of distribution treated as tax-free from AAA (but not below zero)

    –   Other issues regarding distributions:

– Distributions of cash during a one-year period following S election termination
    receives special treatment

        •   Treated as a tax-free recovery of stock basis to the extent it does
            not exceed AAA account

        •   Since only cash distributions receive this special treatment, the
            corp. should not distribute property during this post-election
            termination period

    –   Other issues regarding distributions:

– If E & P exists, the entity may elect to first distribute E & P before reducing
    AAA



                           Distributions Of Property
  If the entity distributes appreciated property
– Gain must be recognized

        •   Treated as if property sold to shareholder for FMV

        •   Gain is allocated to shareholders and increases shareholders’ basis
            in stock in the entity, before considering the effect of the
            distribution

        •   Basis of asset distributed = FMV




                                          59
                              Shareholder’s Basis
    • Determination of initial basis is similar to that of basis of stock in
      C corp

            –   Depends on manner stock was acquired

    •   e.g., gift, inheritance, purchase, exchange

- Basis is increased by:

•   Stock purchases

•   Capital contributions

•   Nonseparately computed income

•   Separately stated income items

•   Depletion in excess of basis


– Basis is decreased by:
    • Distributions not reported as income by shareholders (e.g., from
        AAA or PTI)

        •   Nondeductible expenses (e.g., fines, penalties)

        •   Nonseparately computed loss

        •   Separately stated loss and deduction items

– Similar to partnership basis rules

        •   First increase basis by income items

        •   Then decrease it by distributions and finally losses

•   Shareholder’s basis cannot be negative
– Once basis is reduced to zero, any additional reductions (losses or deductions,
    but not distributions) decrease (but not below zero) basis in loans made to S corp




                                          60
– Any excess losses or deductions are suspended

– Once basis of debt is reduced, it is increased by subsequent net increases from all
   positive and negative adjustments

   –   Basis rules are similar to partnership rules except:

– Partner’s basis in partnership interest includes direct investment plus a ratable
   share of partnership liabilities

– Except for loans from a shareholder to the S Corp, corporate borrowing does
   not affect shareholder’s basis

                              Treatment of Losses
       Step 1. Allocate total loss to the shareholder on a daily basis, based upon
       stock ownership

       Step 2. If shareholder’s loss exceeds stock basis, apply any excess to adjusted
       basis of indebtedness to the shareholder. Distributions do not reduce debt
       basis.

       Step 3. Where loss > debt basis, excess is suspended and carried over to
       future tax years.

       Step 4. In future tax years, any net increase in basis adjustment restores
       debt basis first, up to its original amount.

       Step 5. Once debt basis is restored, remaining net increase is used to increase
       stock basis.

       Step 6. Suspended loss from a previous year now reduces stock basis first
       and debt basis second.

       Step 7. If S election terminates, any loss carryover remaining at the end of
       the post-termination transition period is lost forever.



                         Passive Losses And Credits
   An S corp is not directly subject to the passive loss rules




                                          61
– If the corporation is involved in rental activities or shareholders do
  not materially participate

        •   Passive losses and credits flow through to shareholders

        •   Shareholder’s stock basis is reduced even if passive losses are not
            currently deductible


                                  At-Risk Rules

    Generally apply to S corp shareholders

     At-risk amounts include:
•   Cash and adjusted basis of property contributed to corp

•   Any amount borrowed for use in the activity for which the shareholder is
    personally liable

•   Net FMV of personal assets that secure nonrecourse borrowing

            –   Losses suspended under at-risk rules are carried forward and are
                available during post-termination transition period


                               Built-in Gains Tax

    Generally applies to C corporations converting to S Corp
    status after 1986
– Corporate-level tax on built-in gain recognized in a taxable
  disposition within 10 calendar years after the effective date of the S
  corp election

    –   Tax base includes unrealized gain on assets held on date of S corp
        election
        • Highest corporate tax rates apply (currently 35%)

        •   This gain passes through to shareholders as taxable gain



                                          62
   –   Amount of built-in gain recognized in any year is further limited
       to an “as if” taxable income, computed as if the corp were a C
       corp

   –   Any gain that escapes taxation under this limit is carried forward
       and recognized in future years


   LIFO recapture tax

– Any LIFO recapture amount at time of S corp election is subject to a corporate-
   level tax

– Taxable LIFO recapture amount = excess of inventory’s
   value under FIFO over the LIFO value
– Resulting tax is payable in four annual installments

       •   First payment is due on or before due date of last C corp tax return




                    Computation of Built-in Gains Tax
       Step 1. Select the smaller of built-in gains or taxable income.*

       Step 2. Deduct unexpired NOLs and capital losses from C corporation tax
       years.

       Step 3. Multiply the tax base from step 2 by the top corporate tax rate.

       *Any net recognized built-in gain > taxable income is carried forward to the
       next year, as long as the next year is within the 10-year recognition period.

       Step 4. Deduct business credit carryforwards and AMT credit carryovers
       from a C corporation tax year from the amount obtained in step 3.

       Step 5. The corporation pays any tax resulting in step 4.




                                          63
                 Passive Investment Income Penalty Tax

   If an S corp has accumulated E&P (AEP) from C corp years

– A tax is imposed on excess net passive income (ENPI) calculated as follows:

            Passive investment income                   Net passive
   ENPI =     > 25% of gross receipts           X       investment
             Passive investment income                  income for
                for the year                            the year

   • Passive investment income includes royalties, rents, dividends, interest,
      annuities, and sales and exchanges of stocks and securities

   • Only net gain from disposition of capital assets (not stocks and securities) is
      included

   • Net passive income is passive income less directly related deductions

   • Excess net passive income cannot exceed corp taxable income before
      considering any NOL or other special deductions

   • Tax rate applied is the highest corporate tax rate for the year.




                                           64
                                      Chapter 15

                        Multistate Corporate Taxation

Overview
   •   46 states and District of Columbia impose a tax based on corp’s taxable income
           – Majority of states “piggyback” onto Federal income tax base

                   •   Essentially, they have adopted part or all of the Federal tax
                       provisions



Computing Corporate State Income Tax Liability (slide 1 of 2)
Starting point in computing taxable income**
± State modification items
  State tax base
± Total net allocable income/(loss) (nonbusiness income)
  Total apportionable income/(loss) (business income)
× State’s apportionment percentage
  Income apportioned to the state

**Most states use either line 28 or line 30 of the Federal corp tax return (Form 1120). In
other states, the corp must identify and report each element of income and deduction on
the state return.




Computing Corporate State Income Tax Liability (slide 2 of 2)
Income apportioned to the state
± Income/(loss) allocated to the state
  State taxable income/(loss)
× State tax rate
  Gross income tax liability for state
- State’s tax credits
  Net income tax liability for the state




                                             65
Common State Additions

  •   Interest income on state/municipal obligations and other interest income exempt
      from Federal income tax
          – May exclude interest income on obligations within that state to encourage
              investment in in-state bonds

  •   State income taxes deducted on Federal return
          – Includes franchise taxes based on income

  •   Federal depreciation in excess of amount allowed by state (if depreciation systems
      differ)

  •   State gain in excess of Federal gain on assets; Federal loss in excess of state loss
      on assets

  •   Adjustments to amounts under Federal elections


  •   Federal Net Operating Loss Deduction


  Common State Subtractions
  •   Interest on U.S. obligations to extent included in Federal taxable income
          – States cannot impose income tax on income from U.S. obligations, but
              may assess income-based franchise tax

  •   State depreciation in excess of Federal (if depreciation systems differ)

  •   Federal gain in excess of state gain on assets; State loss in excess of Federal loss
      of assets

  •   Adjustments to amounts under Federal elections

  •   State Net Operating Loss Deduction

  •   Dividends received from certain out-of-state corps to extent included in Federal
      return

  •   Federal income taxes paid




                                           66
UDITPA and the Multistate Tax Commission

  •   Uniform Division of Income for Tax Purposes Act (UDITPA) is a model law
      relating to assignment of income among states for multistate corps

  •   Many states have adopted UDITPA either by joining the Multistate Tax Compact
      or modeling their laws after UDITPA



Nexus for Income Tax Purposes
  •   Nexus is the degree of business activity which must be present before a state can
      impose tax on an out-of-state entity’s income

  •   Sufficient nexus typically exists if:
         – Income is derived from within state

         –   Property is owned or leased in state

         –   Persons are employed in state

         –   Physical or financial capital is located in state

  •   No nexus if only “connection” to state is solicitation for sale of tangible personal
      property, with orders sent outside state for approval and shipping to customer
      (Public Law 86-272)

  •   Sales tax can still apply



  Independent Contractors
  •   May generally engage in the following activities without establishing nexus for
      the company:

         –   Solicit sales

         –   Make sales


         –   Maintain sales office

  •   Source: Public law 86-272


                                           67
Allocation and Apportionment of Income
•   Apportionment is the means by which business income is divided among states in
    which it conducts business

       –   Corp determines net income for the company as a whole and then
           apportions some to a given state, according to an approved formula


•   Allocation is a method used to directly assign specific components of a corp’s
    income, net of related expenses, to a specific state


•   Allocable income generally includes:

               •   Income or loss from sale of nonbusiness property

               •   Income or losses from rents or royalties from nonbusiness real or
                   tangible personal property


•   Typically, allocable income (loss) is removed from corporate net income before
    the state’s apportionment formula is applied

       –   Nonapportionable income (loss) assigned to a state is then combined with
           income apportionable to the state to arrive at total income subject to tax in
           the state


•   Business income is assigned to states using an apportionment formula

       –   Business income arises from the regular course of business
              • Integral part of taxpayer’s regular business


•   Nonbusiness income is apportioned or allocated to the state in which the income-
    producing asset is located



Apportionment Factors
•   Apportionment formulas vary among states

       –   Traditionally, states use a three-factor formula that equally weights sales,
           property, and payroll


                                        68
        –   Many states use a modified formula where sales factor receives a larger
            weight

                •   Tends to pull larger amount of out-of state corporation's income
                    into the state

                •   May provide tax relief to corps domiciled in the state




Sales Factor
•   Sales factor is a fraction

        –   Numerator is corp’s sales in the state

        –   Denominator is corp’s total sales everywhere



•   Most states follow UDITPA’s “ultimate destination concept”

        –   Tangible asset sales are assumed to take place at point of delivery, not
            where shipping originates

        –   Dock sales occur when delivery is taken at seller’s shipping dock
               • Most states apply the destination test to dock sales

                        –   If purchaser has out-of-state location to which it returns
                            with the product, sale is assigned to purchaser’s state

        –   Throwback rule
               • If adopted by state, requires that out-of-state sales not subject to
                 tax in destination state be pulled back into origination state

                •   Treats such sales as in-state sales of the origination state



Payroll Factor
•   Payroll factor is a fraction

        –   Numerator is compensation paid within a state
        –   Denominator is total compensation paid by the corporation


                                          69
•   Compensation includes wages, salaries, commissions, etc

       –   Amounts paid to independent contractors are excluded

       –   Some states exclude amounts paid to corporate officers


       –   Some states require that deferred compensation amounts be included in the
           payroll factor (e.g., 401(k) plans)


•   Compensation of an employee is usually not split between states (unless
    employee is transferred or changes positions)

       –   Usually allocated to state in which services are primarily performed

               •   If more than one state, attribute to:

                       –   Employee’s base of operations, or, if none,

                       –   Place where work is directed or controlled, or, if none,

                       –   Employee’s state of residency


•   Only compensation related to production of apportionable income is included in
    payroll factor

       –   In states that distinguish between business and nonbusiness income,
           compensation related to nonbusiness income is not included

       –   Compensation related to both business and nonbusiness income is prorated
           between the two


Property Factor
•   Property factor generally includes average value of real and tangible personal
    property owned or rented

       –   Numerator is amount used in the state

       –   Denominator is all of corp’s property owned or rented




                                         70
•   Property includes:

       –   Land, buildings, machinery, inventory, etc
       –   May include construction in progress, offshore property, outer space
           property (satellites), and partnership property

•   Property in transit is included in numerator of destination state


•   Property is typically valued at average historical cost plus additions and
    improvements

       –   Some states allow net book value or adjusted basis to be used


•   Leased property, when included in the property factor, is valued at eight times its
    annual rental payments


Allocation, Apportionment Example
Total allocable income (State A)                $100,000
Apportionable income (States A and B)            800,000
Total income                                    $900,000

All sales, payroll, and property is divided equally between states A and B. Both
states use identical apportionment formulas.

Taxable income:                  State A         State B .
1/2 Apportionable income        $400,000        $400,000
Allocable income                 100,000              -0-
Total state taxable income      $500,000        $400,000



Americo, Inc. operates in three states with the following
apportionment systems:

    W’s factors: average of four factors, sales double-weighted
    X’s factors: average of three factors, equally weighted
    Y’s factors: sales factor only




                                         71
State:         W              X              Y                Total   .
Sales:     $400,000       $100,000       $500,000     $1,000,000
    Factor     40%            10%            50%
Payroll:     90,000        150,000         60,000         300,000
    Factor     30%            50%            20%
Property: 120,000          240,000         40,000         400,000
    Factor     30%             60%           10%




Taxable income for year (all states) $100,000

State                 W                 X            Y.
    Sales            40%               10%          50%
    Sales            40%               N/A          N/A
    Payroll          30%               50%          N/A
    Property         30%               60%          N/A
Total               140%              120%          50%

Average               35%              40%          50%

Taxable income
to each state         $35,00     $40,000        $50,000

Total taxed in all states: $125,000
N/A = not applicable


Example 2
Americo, Inc. moves most personnel and property to state Y.

State:        W                 X           Y            Total .
Sales:     $400,000         $100,000     $500,000     $1,000,000
    Factor     40%              10%          50%
Payroll:     30,000           30,000      240,000         300,000
    Factor     10%              10%          80%
Property:    40,000           40,000      320,000         400,000
    Factor     10%              10%          80%

   W’s factors: average of four factors, sales double-weighted
   X’s factors: average of three factors, equally weighted
   Y’s factors: sales factor only




                                        72
Taxable income for year (all states)               $100,000

State:                        W             X               Y
    Sales:                   40%           10%             50%
    Sales                    40%           N/A             N/A
    Payroll:                 10%           10%             N/A
    Property:                10%           10%             N/A
Total                       100%           30%             50%
Average                      25%           10%             50%

Taxable income
to each state               $25,000              $10,000         $50,000

Total taxed in all states: $85,000
N/A = not applicable




Unitary Taxation
•   Theory: operating divisions are interdependent so cannot be segregated into
    separate units

       –   Each unit deemed to contribute to overall profits

       –   Unitary theory ignores separate legal existence of companies: all
           combined for apportionment


•   For multistate apportionment, all divisions or entities are treated as single unitary
    base:

       –   Larger apportionment base (all companies’ activities)

       –   Smaller apportionment factors (each state’s %)




                                         73
Other Multi-Entity Considerations
•   Multinational operations: If state uses Unitary system, it may require inclusion of
    worldwide activities in determining apportionment

•   Most unitary states allow Water’s Edge election so only U.S. operations are
    included


       –   Cost of election may include:

               •   Specified number of years before revocation

               •   Additional tax for privilege of excluding foreign entities

•   Combined reporting
      – Some states allow (or require) unitary companies to file together in state to
          simplify reporting

•   Consolidated returns
       – Some states allow (or require) consolidated return if filed for Federal


Taxation of S Corps
•   Majority of states with corporate income tax have special provisions that govern S
    corporations

       –   Only a few states do not provide special treatment for S corps

               •   In non-S election states, S corps are taxed the same as C corps

       –   Must have valid S corp election at federal level to get S corp treatment in
           states


•   Multistate S corps must apportion and allocate income in same manner as regular
    corp

       –   Must file a state tax return in each state with nexus

       –   Must inform shareholders of their share of income for each state so their
           tax returns can be prepared


•   S corp may be allowed to file a single return and pay tax for all shareholders


                                         74
  Taxation of LLC’s and Partnerships
  •   Most states treat partnerships, LLCs, and LLPs in a manner that parallels Federal
      treatment

         –   Entity is a tax-reporting, not a taxpaying, entity

         –   Income, loss, and credit items are allocated and apportioned among the
             partners according to the terms of the partnership agreement



  •   Some states:

         –   Require entity make est. tax pymts. for out-of-state partners

         –   Apply an entity-level tax on operating income

         –   Allow composite returns to be filed for out-of-state partners


  •   Generally, an in-state partner computes the income tax resulting from all of the
      flow-through income from the entity

         –   Partner is allowed a credit for



Sales and Use Taxes
  •   Sales tax: Consumers’ tax on tangible personal property acquired for use or
      consumption

         –   Vendor acts as collection agent

         –   Not assessed on goods purchased for shipment out-of-state


  •   Use tax complements sales tax

         –   Consumers bringing purchased goods into state pay tax to state in which
             property is used

         –   States have difficulty enforcing use tax




                                           75
•   Solicitation by independent brokers is sufficient nexus for sales tax purposes

       –   Turns “use” tax into “sales” tax for that state

       –   Seller required to collect tax

       –   Facilitates collection by state




                                            76
                                        Chapter 10
                                        Partnerships

Partnership Definition
•An association of two or more persons to carry on a trade or business
–Contribute money, property, labor
–Expect to share in profit and losses



Entities Taxed As Partnerships

•General partnership

–Consists of at least 2 partners

–Partners are jointly and severally liable
•Creditors can collect from both partnership and partners’ personal assets

•General partner’s assets are at risk for malpractice of other partners even though not
personally involved


•Limited liability partnership (LLP)
–An LLP partner is not liable for malpractice committed by other partners

–Popular organizational form for large accounting firms


•Limited partnership
–Has at least one general partner

•One or more limited partners

–Only general partner(s) are liable to creditors

•Limited partners’ loss is limited to equity investment




                                             77
•Limited Liability Company (LLC)
–Combines the corporate benefit of limited liability with benefits of
partnership taxation

•Unlike corporations, income is subject to tax only once

•Special allocations of income, losses, and cash flow are available

–Owners are “members”, not partners, but if properly structured will receive
partnership tax treatment


“Check-The-Box” Regs
•Allows most unincorporated entities to select their federal tax status
–If 2 or more owners, can choose to be treated as:

•Partnership, or

•Corporation
–Permits some flexibility

•Not all entities have a choice

•e.g., New publicly traded partnerships must be taxed as corporations



•Some entities can be excluded from partnership treatment if
organized for:

–Investment (not active trade or business)

–Joint production, extraction, or use of property

–Underwriting, selling, or distributing a specific security

•Owners simply report their share of operations on their own tax
return



                                            78
                          Partnership Taxation
•Partnership is not a taxable entity
–Flow through entity

•Income taxed to owners, not entity

•Partners report their share of partnership income or loss on their own tax return


•Generally, the calculation of partnership income is a 2-step approach
Step 1: Net ordinary income and expenses related to the trade or business of the
partnership


Step 2: Segregate and report separately some partnership items
–If an item of income, expense, gain or loss might affect any 2 partners’ tax liabilities
differently, it is separately stated

–e.g., Charitable contributions



•Electing large partnerships can net some items that would otherwise be
separately stated
–Must have at least 100 partners and elect simplified reporting procedures

–Report no more than 16 separately stated items
•e.g., Net short-term and long-term capital gains and losses at partnership level and report
the net amount to partners


•Partnership files Form 1065
–Includes Schedule K, which accumulates the information to be reported to
partners
•Provides ordinary income and separately stated items in total

–Each partner (and the IRS) receives a Schedule K-1 for each partner
•Reports each partner’s share of income, expense, gain, and loss




                                             79
                      Partner’s Ownership Interest
•Each owner normally has a:
–Capital interest
•Measured by capital sharing ratio
–Partner’s percentage ownership of capital



-Profits(loss) interest
•Partner’s % allocation of partnership ordinary income (loss) and separately stated items

•Certain items may be “specially allocated”

–Specified in the partnership agreement




                                       Basis Issues

•Each partner has a basis in their partnership interest
–Partner’s basis is adjusted for income and losses that flow through

•This ensures that partnership income is only taxed once


•Partner’s basis is important for determining:
–Deductibility of partnership losses

–Tax treatment of partnership distributions

–Gain or loss on disposition of partnership interest




                                              80
•Partner’s basis is important (cont’d):
–Partner’s capital account balance is usually not a good measure of a
partner’s adjusted basis in a partnership interest for several reasons
•e.g., Basis includes partner’s share of partnership liabilities; Capital account does not



•Involves 2 legal concepts:
–Aggregate (or conduit) concept - Treats partnership as a channel with
income, expense, gains, etc. flowing through to partners
•Concept is reflected by the imposition of tax on the partners, not the partnership



•Involves 2 legal concepts (cont’d):
–Entity concept - Treats partners and partnership as separate and is reflected
by:
•Partnership requirement to file its own information return
•Treating partners as separate from the partnership in certain transactions between the
two




Tax Consequences of Partnership Formation
•Usually, no gain or loss is recognized by a partner or partnership on the
contribution of money or property in exchange for a partnership interest
•Gain (loss) is deferred until taxable disposition of:
–Property by partnership, or
–Partnership interest by partner


•Partner’s basis in partnership interest = basis of contributed property
–If partner contributes capital assets and §1231 assets, holding period of partnership
interest includes holding period of assets contributed

–For other assets including cash, holding period begins on date partnership interest is
acquired




                                             81
–If multiple assets are contributed, partnership interest is apportioned and separate
holding period applies to each portion




WST Partnership Formation Example

•William contributes cash
–Amount                               $20,000
•Sarah contributes land
–Basis                                        $ 6,000
–FMV                                          $20,000
•Todd contributes equipment
–Basis                                        $22,000
–FMV                                          $20,000

Gain or loss       Basis in         Partnership’s
Partner Recognized         Interest        Property Basis

William     $-0-              $20,000             $20,000
Sarah       $-0-              $ 6,000             $ 6,000
Todd        $-0-              $22,000             $22,000

Neither the partnership nor any of the partners recognizes gain or loss on the transaction



Exceptions to Tax-Free Treatment on Partnership
Formation
•Transfers of appreciated stock to investment partnership
–Gain will be recognized by contributing partner

–Prevents multiple investors from diversifying their portfolios tax-free

•If transaction is essentially a taxable exchange of properties, gain
will be recognized
–e.g., Individual A contributes land and Individual B contributes equipment
to a new partnership; shortly thereafter, the partnership distributes the land
to B and the equipment to A; Partnership liquidates

                                             82
–IRS will disregard transfer to partnership and treat as taxable exchange
between A & B

•Disguised Sale
–e.g., Partner contributes property to a partnership; Shortly thereafter,
partner receives a distribution from the partnership

•Payment may be viewed as a purchase of the property by the partnership



•Receipt of partnership interest in exchange for services rendered
to partnership
–Services are not treated as “property”

–Partner recognizes ordinary compensation income = FMV of partnership
interest received



Tax Issues Relative To Contributed Property

•Partnership’s basis in property contributed to the partnership
equals contributing partner’s basis (i.e., a carryover basis)

•Partner’s basis in partnership interest received equals basis in
contributed property (i.e., a substituted basis)


•Contributions of depreciable property and intangible assets
–Partnership “steps into shoes” of contributing partner
•Continues the same cost recovery (amortization) calculations

•Cannot expense contributed depreciable property under §179




                                           83
•Gain or loss is ordinary when partnership disposes of:
–Contributed unrealized receivables

–Contributed property that was inventory in contributor’s hands, if disposed
of within 5 years of contribution

•Inventory includes all tangible property except capital assets and real or depreciable
business assets




                 Elections Made by Partnership
•Inventory method
•Accounting method
–Cash, accrual or hybrid

•Depreciation method

•Tax year

•Organizational cost amortization

•Start-up expense amortization

•Optional basis adjustment (§754)

•§179 deduction




                                            84
•Nonrecognition treatment for involuntary conversions

•Election out of partnership rules



                     Initial Costs of Partnership
•Sec.    Type of cost                                         Treatment
•
•709                Organization expense                ≥ 60 mo. Amort
•709                Syndication costs                   Capitalized
•195                Pre-operating expense               ≥ 60 mo. Amort.
•162                Ordinary/Necessary Exp.             Deduction
•167                Acquisition of property             Depreciated
•197                §197 Intangible                     15 yr. Amort.



•New partnership may adopt cash, accrual or hybrid method
–Cash method cannot be adopted if partnership:
•Has one or more C corporation partners

•Is a tax shelter


•New partnership may adopt cash, accrual or hybrid method
(cont’d)
–C Corp partner does not preclude use of cash method if:
•Partnership has average annual gross receipts of $5 million or less for preceding 3 year
period

•C corp partner(s) is a qualified personal service corp, or

•Partnership is engaged in farming business

•Partnership must adopt tax year under earliest of following tests
met:
–Majority partner’s tax year (partners with same tax year owning >50%)
–Principal partners’ tax year (all partners owning 5% or more)
–Least aggregate deferral rule


                                              85
•Other alternatives may be available if:
–Establish to IRS’s satisfaction that a business purpose exists for another tax
year
•e.g., Natural business year at end of peak season

•Obtain IRS approval to use natural business year

–Choose tax year with no more than 3 month deferral
•Partnership must maintain with IRS a prepaid, non-interest-bearing deposit of estimated
deferred taxes based on highest individual tax rate + 1%




              Measuring Income of Partnership
•Calculation of partnership income is a 2-step approach
Step 1: Net ordinary income and expenses related to the trade or business of
        the partnership

Step 2: Segregate and report separately state some partnership items

If an item of income, expense, gain or loss might affect any 2
partners’ tax liabilities differently, it is separately stated


•Separately stated items fall under the “aggregate” concept
–Each partner owns a specific share of each item of partnership income,
gain, loss or deduction
•Character is determined at partnership level

•Taxation is determined at partner level


•Short and long-term capital gains and losses
•§1231 gains and losses
•Charitable contributions
•Interest income and other portfolio income
•Personalty expensed under §179


                                            86
•Special allocations of income or expense
•AMT preference and adjustment items
•Passive activity items
•Self-employment income
•Foreign taxes paid

Partnership Taxable Income Example
Sales revenue                                       100,000
Salaries                                             35,000
Rent                                                 15,000
Utilities                                             6,000
Interest income                                       1,500
Charitable contribution                               2,000
AMT adjustment for depreciation                       3,600
Payment of partner’s medical expenses                 4,000

•Partnership ordinary taxable income:
Sales revenue                                            $100,000
Salaries                                                   35,000
Rent                                                       15,000
Utilities                                                   6,000
Partnership Ordinary Income                              $ 44,000



•Separately stated items:
–Interest income                                $1,500
–Charitable contribution                         2,000
–AMT adjustment for depreciation                 3,600
•Distribution to partner:
–Payment of partner’s medical exp.              $4,000



                       Partnership Allocations
•Partnership agreement can provide that partners share capital, profits, and
losses in different ratios
–e.g., Partnership agreement may provide that a partner has a 30% capital sharing ratio,
yet be allocated 40% of the profits and 20% of the losses




                                           87
–Such special allocations are permissible if certain rules are followed
•i.e., Economic effect test




•The economic effect test requires that:
–An allocation must be reflected in a partner’s capital account

–When partner’s interest is liquidated, partner must receive assets with FMV
 = the positive balance in the capital account

–A partner with a negative capital account must restore that account upon
liquidation


•Pre-contribution gain or loss
–Must be allocated to partners taking into account the difference between
basis and FMV on date of contribution
•For non-depreciable property this means any built-in gain or loss must be allocated to
the contributing partner when disposed of by partnership in taxable transaction




                        Basis of Partnership Interest
•For new partnerships, partner’s basis usually equals:
–Adjusted basis of property contributed, plus

–FMV of any services performed by partner in exchange for partnership
interest


•For existing partnerships, basis depends on how interest was
acquired
–If purchased from another partner, basis = amount paid for the interest

–If acquired by gift, basis = donor’s basis plus, in certain cases, a portion of
the gift tax paid on the transfer

–If acquired through inheritance, basis = FMV on date of death (or alternate
valuation date)


                                            88
•A partner’s basis in partnership interest is adjusted to reflect
partnership activity
–This prevents double taxation of partnership income




                                     Basis Example

•Pam is a 30% partner in the PDQ partnership
•Pam’s beginning basis is $20,000
•PDQ reports current income of $50,000
•Pam sells her interest for $35,000 at the end of the year
                                 With Basis            Without Basis
                                 Adjustment             Adjustment
Selling Price(A)                  $ 35,000              $ 35,000
Less: Basis in interest
Beginning basis                 20,000          20,000
Share of current income         15,000            - 0-
Ending basis (B)                35,000          20,000
Taxable gain (A)-(B)          $     -0-       $ 15,000
-If no basis adjustment, Pam's $15,000 share of partnership income is taxed twice: as
ordinary income and as gain on sale of interest



Adjustments to Basis
•Initial Basis
+ Partner’s subsequent contributions to partnership
+ Partner’s share of partnership:
•Debt increase
•Taxable income items
•Exempt income items
•Depletion adjustment
- Distributions and withdrawals from partnership
- Partner’s share of partnership:
•Debt decreases
•Nondeductible expenses
•Losses



•A partner’s basis in the partnership interest can never be negative


                                                      89
                         Partnership Liabilities
•Affect partner’s adjusted basis
–Increase in partner’s share of liabilities
•Treated as a cash contribution to the partnership
•Increases partner’s adjusted basis


–Decrease in partner’s share of liabilities
•Treated as a cash distribution to the partner
•Decreases partner’s adjusted basis


•Two types of partnership debt
–Recourse debt - At least one partner is personally liable
•Allocate to partners using a “Constructive Liquidation Scenario”


–Nonrecourse debt - No partner is personally liable
•Allocate to partners using a three-tiered allocation




Constructive Liquidation Scenario
1.Partnership assets deemed to be worthless
2.Assets deemed sold at $0; losses determined
3.Losses allocated to partners under partnership agreement
4.Partners with negative capital accounts deemed to contribute cash
5.Deemed contributed cash would repay partnership debt
6.Partnership deemed to liquidate
- Partner’s share of recourse debt = Cash contribution
        used to repay debt (Step 5)




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•Partnership losses flow through to partners for use on their tax
returns
–Amount and nature of losses that may be used by partners may be limited

–Three different loss limitations apply
•Only losses that make it through all three limits are deductible by a partner


Section        Description704(d)       Basis in partnership interest
465            At-risk limitation
469            Passive loss limitation

•Limitations are applied successively to amounts which are
deductible at all prior levels



Loss Limitation Example
Meg's basis in interest                        $50,000
At-risk amount                                 $35,000
Passive income, other sources                  $25,000
Share of partnership losses(passive)           $60,000


Provisions Deductible loss            Suspended loss
 704(d)     $ 50,000                    $ 10,000
 465          35,000                      15,000
 469          25,000*                     10,000

*Amount deducted on tax return: $25,000
    -passes all three loss limitations




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•Payment to partner for use of capital or for services provided to
partnership
–May not be determined by reference to partnership income
–Usually expressed as a fixed dollar amount or as a % of capital


Treatment of Guaranteed Payments
•May be deducted or capitalized by partnership depending on the
nature of the payment

–Deductible by partnership if meets “ordinary and necessary business
expense” test

–May create partnership loss



•Included in income of partner
–Treated as if received on last day of partnership tax year

–Character is ordinary income to recipient partner

Other Transactions Between Partner and
Partnership

•May be treated as if partner were an outsider, for example:
–Loan transactions
–Rental payments
–Sales of property

•Timing of deduction for payment by an accrual basis partnership
to a cash basis partner depends on whether payment is:

–Guaranteed payment
•Included in partner’s income on last day of partnership year when accrued (even if not
paid until the next year)


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–Payment to partner treated as an outsider
–Deduction cannot be claimed until partner includes the amount in income




Sales of Property

•No loss is recognized on the sale of property between a
partnership and a partner who owns > 50% of partnership capital
or profits

–If property is subsequently sold at a gain, the disallowed loss reduces gain
recognized




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DOCUMENT INFO
Description: Legal Malpractice Taxable Income document sample