Chapter 17 Partnerships and S Corporations

Learning Objectives Determine the tax implications of a partnership formation Apply the operating rules for partnerships Understand the tax implications (to the partnership and its partners) of distributions to partners Understand the requirements for electing and maintaining S Corporation status Apply the operating rules for S Corporations Determine tax treatment of an S Corporation’s shareholders

Types Of Flow-through Entities Partnerships S corporations Limited liability companies(LLC) Limited liability partnerships(LLP)

Flow-through Entities: Entail taxation, only at the ownership level. This single level of taxation, is achieved by: –(1) exempting the entity from taxation –(2) passing income, deductions, losses, and credit through to the owners, and –(3) adjusting the basis of the owners’ interest in the entity

Taxation Of Partnerships Formation of a partnership Partnership operations Special allocations Allocation of partnership income, deductions, losses, and credits to partners Basis adjustments for operating items

Taxation Of Partnerships Limitations on losses and restoration of basis Transactions between a partner and the partnership –Sale or exchanges between a partner and partnership –Guaranteed payments Partnership distributions Sale of a partnership interest Optional basis adjustments Large partnership election

Formation Of A Partnership In exchange for property and/or services, partners receive an interest A partnership interest is an investment security similar to corporate stock

Formation Of A Partnership Section 721: non-recognition rules Basis of a partnership interest Section 752 adjustment Negative basis rule Holding period for a partnership interest Basis of partnership assets Financial accounting considerations Organizational & syndication fees

Operating Rules For Partnerships Certain items are passed through to partners without losing their identity –These should be separately stated due to each partner’s different tax situation Items that do not have special tax effect are netted at the partnership level and the results are ordinary income or loss, then allocated to partners based on agreement

Partnership Elections Tax year restrictions Cash method of accounting restrictions

Taxation Of S Corporations Qualification requirements Election requirements Termination conditions S Corporation operations Basis adjustments to S Corporation stock S Corporation losses and limitations Other S Corporation considerations

S Corporation Qualification Must be a domestic corporation Maximum of 100 shareholders allowed (husband/wife=1) Only individuals (citizens or resident aliens), estates, certain kinds of trusts, and certain kinds of tax- exempt can be shareholders Only one class of stock may be issued and outstanding If an S Corporation has an 80% owned subsidiary, it cannot file a consolidated tax return with that subsidiary. Certain corporation that maintain special tax statuses are ineligible

S Corporation Election Requirements All shareholders on the S Corporation election date must consent and the corporation must file Form 2553 Must be filed on or before the 15th day of the 3rd month of the election year

For voluntary revocation, consent must be obtained from shareholder’s owning > 50% of S Corporation’s stock An involuntary revocation can be forced if: –Fails to meet qualification requirements –Has excessive passive investment income in a 3-year period Corporation may not re-elect S Corp. Status for 5 years after termination S Corporation Termination Rules

Tax Treatment Of An S Corporation’s Shareholders Basis adjustments –Prevents double taxation of income or double deduction of losses Shareholder gets debt basis, separate from stock basis, for amounts lent directly to the corporation; gets no basis for corporate level liabilities Loss limitation is computed before distributions Applies losses to both stock & debt basis, in that order

Other S Corporation Considerations Distributions of cash and property to shareholders Tax year restrictions Treatment of fringe benefits Corporate tax on built-in gains Tax on excess net passive income

Tax Planning Considerations Use of net operating losses Income shifting among family members Optional basis adjusting under Sec. 754

Compliance & Procedural Considerations Partnership filing requirements and elections Reporting partnership items on Form 1065 on or before the fifteenth day of the fourth month S Corporation filing requirements and accounting method elections Reporting S Corporation items on Form 1120S Comparison of alternative forms of business organizations (See Table P 17-2)