2011 Pearson Education Inc Publishing as Prentice Hall
© 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -1
PARTNERSHIPS AND S CORPORATIONS ® Types of pass-through entities ® Taxation of partnerships ® Partnership elections ® Taxation of S corporations ® Tax planning considerations ® Compliance and procedural considerations © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -2
Types of Pass-Through Entities (1 of 4) ® Partnerships Unincorporated association Partners have unlimited liability for partnership debt and claims ® Limited partnership Limited partners only liable for investment Cannot participate in mgmt activities Must have at least 1 general partner © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -3
Types of Pass-Through Entities (2 of 4) ®S corporations Follow C corp rules except when Subchapter S pass-through rules apply ® Limited liability companies (LLCs) Limited liability of a corporation May be taxed as partnership or corp © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -4
Types of Pass-Through Entities (3 of 4) ® Limited liability partnerships (LLPs) Used by professional service partnerships ¬Not liable for negligence or misconduct of other partners ® Limited liability limited partnership Allowed by some states Formed under state’s limited ptrshp laws © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -5
Types of Pass-Through Entities (4 of 4) ® Taxation only at ownership level ® Single level of taxation achieved by Exempting the entity from taxation Passing income, deductions, losses, and credit through to the owners, and Adjusting the basis of the owners’ interest in the entity © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -6
Taxation of Partnerships (1 of 3) ® Formation of a partnership ® Partnership operations ® Special allocations ® Allocation of partnership income, deductions, losses, and credits to partners © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -7
Taxation of Partnerships (2 of 3) ® Basis adjustments for operating items ® Limitations on losses and restoration of basis ® Transactions between a partner and the partnership ® Partnership distributions © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -8
Taxation of Partnerships (3 of 3) ® Sale of a partnership interest ® Optional and mandatory basis adjustments ® Electing large partnerships © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -9
Formation of a Partnership (1 of 2) ® Partners receive a partnership interest in exchange for property and/or services (§ 721) Nonrecognition rules similar to § 351 for contributions to a corporation except ¬Basis decreases for contribution of liabilities ¬Partner increases basis for her share of liabilities assumed by partnership 17 -10 © 2011 Pearson Education, Inc. Publishing as Prentice Hall
Formation of a Partnership (2 of 2) ® Cannot Must have negative basis recognize gain to avoid negative basis ® Generally partnership assumes carryover basis of assets contributed ® Generally, holding period also carries over to partnership © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -11
Partnership Operations ® Certain items passed through to partners without losing their identity These should be separately stated due to each partner’s different tax situation ® Items with no special tax effect netted at partnership level Results are ordinary income or loss, then allocated to partners based on © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -12
Special Allocations ® § 704 permits partners to allocate income, deductions, losses, and credits in virtually any manner as long as allocations have substantial economic effect ¬Capital accounts affected and deficit in capital account must be restored upon liquidation © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -13
Basis Adjustments for Operating Items (1 of 2) ® See summary in table 1 ® Items that increase basis Partner’s share of partnership earnings, additional contributions, & additional assumption of partnership debt ¬Increase in basis for earnings prevents double taxation of earnings upon subsequent distribution © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -14
Basis Adjustments for Operating Items (2 of 2) ® Items that decrease basis Partner’s share of losses Distributions Reduction in partnership debt ® Allocating liabilities Recourse debt allocated based on economic risk of loss Nonrecourse debt allocated based on profit sharing percentages © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -15
Limitations on Losses and Restoration of Basis (1 of 2) ® Loss recognition limitations Partner’s basis in partnership interest Portion of partner’s basis not “at risk” ¬At risk definition: amount partner would lose should the partnership suddenly become worthless © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -16
Limitations on Losses and Restoration of Basis (2 of 2) ® Loss recognition limitations (continued) Designation of partnership interest as a “passive activity” ¬“Passive” losses can only be used to offset “passive” income. ¬Disallowed losses are suspended, and can be used to offset future passive income, or when the passive activity is sold © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -17
Transactions Between a Partner and the Partnership ® Loss sales No loss deducted on sale of property between a partnership and a > 50% owner (direct or indirect) ® Gain sales Gains on sale of property involving a >50% owner produce ordinary income unless property will be a capital asset in hands of new owner © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -18
Partnership Distributions ® Generally neither partnership nor partners recognize gain or loss on distributions of money or property ® Partner’s basis reduced by basis of property distributed Partner recognizes gain to extent distribution exceeds partner’s basis in partnership interest © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -19
Sale of a Partnership Interest ® Partnership interest is a capital asset ® Generally results in capital gain or loss ® Exception for when partnership owns § 751 hot assets Portion of gain will be ordinary income © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -20
Optional and Mandatory Basis Adjustments (1 of 3) ® New partner’s outside basis Purchase price plus new partner’s share of partnership liabilities ® New partner’s inside basis likely different than outside basis © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -21
Optional and Mandatory Basis Adjustments (2 of 3) ® § 754 adjustment allows partnership to adjust basis of partnership assets for new partner’s share of partnership assets Basis adjustment belongs only to new partner © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -22
Optional and Mandatory Basis Adjustments (3 of 3) ® Mandatory basis adjustment for substantial built-in loss Substantial if Built-in loss > $250 K, Exchange of partnership interest, AND No § 754 optional basis adjustment election in effect © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -23
Electing Large Partnerships Qualifications ® Non-service partnership ® Not engaged in commodity trading ® Have at least 100 partners ® File an election to be taxed as a large partnership © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -24
Electing Large Partnerships Taxable Income ® Misc. itemized deductions combined & subject to a 70% deduction at partner level Remaining misc. deductions combined w/other partnership income ® Charitable contributions combined and not separately stated by partners © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -25
Partnership Elections ® Tax year restrictions Must be same as majority partner or partners with a 50% or more interest ® Cash method of accounting restrictions Partnerships cannot use cash method of accounting if gross receipts exceed $5 M during the prior three years © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -26
Taxation of S Corporations ® Qualification requirements ® Election requirements ® Termination conditions ® S corporation operations ® Basis adjustments to S corporation stock ® S corporation losses and limitations © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -27
Qualification Requirements (1 of 3) ® Shareholder No requirements more than 100 shareholders ¬Family members count as one shareholder ªInclude common ancestor, spouses of common ancestor or lineal descendents, and estates of family members Individuals, estates, and certain types of trusts (including QSSTs) © 2011 Pearson Education, Inc. Publishing astrusts Prentice Hall ¬QSSTs may be complex 17 -28
Qualification Requirements (2 of 3) ® Shareholder requirements (continued) U. S. citizens or resident aliens Tax-exempt public charity or private foundation may be a shareholder ® Corporation-related Domestic requirements corporation ¬Or unincorporated entity electing to be treated as a corp under check-the-box Regs © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -29
Qualification Requirements (3 of 3) ® Corporation-related requirements (continued) Must not be an “ineligible” corporation Only one class of stock May be a Qualified Subchapter S Subsidiary (QSSS) ¬QSSS is 100% owned by an S corp ¬Assets, liabilities, income deductions, etc. considered owned by S corp parent © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -30
Election Requirements ® Form 2553 must be filed no later than 15 th day of third month for year election is to be effective A new corporation’s tax year begins on first day it acquires assets, has shareholders or begins business ® All shareholders must consent to election © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -31
Termination Conditions (1 of 3) ® Voluntary S election termination Owners of more than 50% of the corporation’s stock must agree Revocation made w/in 1 st 2 -1/2 months can be retroactive to beginning of year ¬Otherwise, election effective for 1 st day of next taxable year © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -32
Termination Conditions (2 of 3) ® Involuntary S election termination Occurs when corporation ceases to meet S corporation requirements ® If termination occurs during tax year Portion of year prior to termination is a short S corp year and Portion of year after termination is a short C corp year © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -33
Termination Conditions (3 of 3) ® Inadvertent termination can be undone ® New S corp election cannot be made for 5 tax years after termination Unless inadvertent termination © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -34
S Corporation Operations ®S corp pass-through rules similar to partnership rules ® Tax treatment of some items similar as C corp treatment E. g. , salaries paid to shareholders deductible ® Items allocated on per-share perday basis © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -35
Basis Adjustments to S Corporation Stock (1 of 2) Initial investment + Additional contributions + Share of income/separate items - Distrib’s excluded from s/h gross inc. - Non-deductible expenses not chargeable to capital - Share of losses/distributions Ending basis (but not below zero) © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -36
Basis Adjustments to S Corporation Stock (2 of 2) ® Basis adjustments to shareholder debt After stock basis reduced to zero, basis reduction applies to indebtedness based on relative adjusted basis for each loan ® Loss/deduction not currently deductible is suspended until shareholder has basis in debt or © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -37
S Corporation Losses and Limitations (1 of 2) ® Ordinary & separately stated loss amounts “passed” through to shareholders ® Shareholder’s deduction limited to adjusted basis in stock plus adjusted basis of debt owed directly by corp to shareholder © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -38
S Corporation Losses and Limitations (2 of 2) ® Sequence for stock basis limitation Beginning basis Capital contributions Share of ordinary income and separately stated items 4. - Distributions not included in s/h inc. 5. - Nondeductible, noncapital expenditures Basis available to absorb S corp loss 1. 2. + 3. + © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -39
Other S Corp. Considerations Distributions of Cash and Property ® Money distributions tax-free and reduce shareholder basis, but not < $0 ® When shareholder has a zero basis, distributions received treated as gain from sale of stock ® Corporation recognizes gain on distribution of appreciated property ¬No loss reported when corp distributes property that has declined in value 17 -40 © 2011 Pearson Education, Inc. Publishing as Prentice Hall
Other S Corp. Considerations Other Restrictions (1 of 2) ®S corps generally must use calendar year ® >2% s/hs not eligible for most tax-free treatment of qualified fringe benefits ® Built-in gains tax applies to C corps that make S election Applies to assets that appreciated in value while operating as a C corp © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -41
Other S Corp. Considerations Other Restrictions (2 of 2) ® Built-in gains tax (continued) Tax is 35% (top corp rate) on net built-in gains recognized during tax year ® Tax on excess net passive income Passive income in excess of 25% of S corp gross receipts and has C corp E&P Excess net passive income taxed at highest corporate tax rate (35%) © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -42
Tax Planning Considerations (1 of 2) ® Use of net operating losses from passthrough entities to offset other income ® Income shifting among family members Gift non-voting S corp stock or partnership interest to low tax-rate kids ¬May be taxed at parents’ highest tax rate if kids subject to kiddie tax Family members may be employees © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -43
Tax Planning Considerations (2 of 2) ® Optional partnership basis adjusting under § 754 Increases incoming partner’s basis in partnership assets © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -44
Compliance and Procedural Considerations (1 of 2) ® Partnership filing requirements and elections ® Reporting partnership items on Form 1065 on or before 15 th day of 4 th mo. Extension reduced to 5 months after 2008 ®S Corporation filing requirements and accounting method elections © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -45
Compliance and Procedural Considerations (2 of 2) ® Reporting S Corporation items on Form 1120 S ® Comparison of alternative forms of business organizations (See Table 2) © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -46
Comments or questions about Power. Point Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard. newmark@Ph. Duh. com © 2011 Pearson Education, Inc. Publishing as Prentice Hall 17 -47
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