Income Tax Fundamentals 2010 Gerald E. Whittenburg Martha Altus-Buller 2010 Cengage Learning

 Tax year must be the same tax year as 50% of partners  If majority of partners’ tax years are different, must use tax year of ‘principal partners’  Principal partner defined as partner with at least 5% share in profits or capital  If principal partners have different tax years, partnership generally required to use least aggregate deferral method Note: Partnerships don’t pay tax as an entity 2010 Cengage Learning

 Partnerships/S-Corporations may elect to adopt a different fiscal tax year from the one prescribed on previous slide, but only °If entity can demonstrate that natural business cycle easily conforms to fiscal year other than calendar year  Such as golf course (natural cycle in Denver ends in October) Note: S-Corporations don’t pay tax as an entity 2010 Cengage Learning

 Even though S-Corporations and partnerships don’t pay tax, the entity must make an estimated payment if choosing to use a fiscal year-end different from calendar year-end ◦ Estimated taxes are calculated as Estimated deferral period taxable income x (Highest individual tax rate + 1%) ◦ Estimate deferral period taxable income by using average monthly income from preceding fiscal year 2010 Cengage Learning

Example San Juan River Expeditions Inc., an S-Corp, has taxable income of $360,000 for the year ended 9/30/09 with a three-month deferral period. The company made a $15,000 payment last year. What’s their current required tax payment? 2010 Cengage Learning

Example San Juan River Expeditions Inc., an S-Corp, has taxable income of $360,000 for the year ended 9/30/09 with a three-month deferral period. The company made a $15,000 payment last year. What’s their current required tax payment? Solution The required tax payment = (Estimated taxable income in deferral period x 36%) - prior year’s tax payment Deferral period is 3 months (October – December) [($360,000/12) x 3 months] = $90,000 ($90,000 x 36%) = $32,400 ($32, ,000) = $17,400 estimated tax payment due in current year 2010 Cengage Learning

 A Personal Service Corporation (PSC) is a corporation with shareholder-employee(s) whom provide a personal service, such as architects or dentists  Generally must adopt calendar year  However, can adopt a fiscal year if ◦ Can prove business purpose or ◦ Fiscal year results in a deferral period of less than 3 months and  Shareholders’ salaries for deferral period are proportionate to salaries received during rest of the period or  Corporation limits its salaries deduction 2010 Cengage Learning See next slide

 Purpose is to keep the PSC from deducting one year’s salary in first nine months  If salaries don’t remain constant, the PSC can only deduct pro rata amount ◦ Based on a required formula 2010 Cengage Learning

 If taxpayer has a short year (other than first/last year of operation), tax is calculated based on following example: °In 2009, Flo-Mex changes from a calendar year to tax year ending 9/30. For the short period 1/1/09 – 9/30/09, Flo-Mex’s taxable income = $20,000. Calculate tax for the short period Annualize TI $20,000 x 12/9 = 26,667 Tax on annualized TI $26,667 x 15%* = 4,000 Allocate tax to short period $4,000 x 9/12 = $3,000  Individual taxpayers rarely change tax years *Chapter 1, page Cengage Learning

 Partnerships must file an informational tax return ◦ Form 1065 ◦ But partnership itself does not pay tax ◦ Income/expenses ‘flow through’ to partners ◦ Partnership income taxable to partner even if he/she does not receive cash!!  Partnerships must make various elections (depreciation and inventory methods, for example) 2010 Cengage Learning

 A partnership is a syndicate, group, pool, joint venture or other unincorporated organization through which any business, financial operation or venture is carried on ◦ Simply co-owning property does not constitute a partnership  Note: many co-owners of real estate choose to operate as a limited partnership or limited liability company 2010 Cengage Learning

 Can form general partnership by simple verbal agreement ◦ However, prudent to document agreement in writing ◦ General partners usually take on risk of legal liability for certain partnership actions and debts ◦ Limited partnerships or Limited Liability Companies (LLCs) limit some of that exposure Limited partnerships or LLCs are required to register with state in which they are formed 2010 Cengage Learning

 When forming a partnership, individuals contribute assets to partnership in exchange for a partnership interest  No gain/loss is usually recognized  Exceptions include ◦ When services are performed in exchange for partnership interest ◦ When property is contributed with liabilities in excess of basis, then Recognized Gain = Liabilities Allocable to Others – Adjusted Basis of Property Contributed 2010 Cengage Learning

 Partner’s basis in partnership interest Cash contributed plus:Basis of property transferred to partnership plus:Gain recognized (from prior screen) less:Liabilities allocable to other partners Equals:Partner’s initial basis in partnership 2010 Cengage Learning

Example Anna contributes equipment with a $100,000 fair market value (FMV) for a 50% interest in JSC Partnership. The equipment has an adjusted basis of $45,000 and a $12,000 mortgage against it, Anna also renders legal services valued at $13,000. What is Anna’s basis in the partnership interest? Does she recognize any taxable gain on this transaction?

Example Anna contributes equipment with a $100,000 FMV for a 50% interest in JSC Partnership. The equipment has an adjusted basis of $45,000 and a $12,000 mortgage against it, Anna also renders legal services valued at $13,000. What is Anna’s basis in the partnership interest? Does she recognize any taxable gain on this transaction? Solution Anna must report $13,000 of ordinary income because of services performed. The liability (mortgage) allocable to other partners ($6,000) does not exceed the basis of the property contributed, so no gain recognition. Her basis in the partnership interest equals $52,000. $45,000 + $13, ($12,000) 2010 Cengage Learning Anna’s partnership basis = adjusted basis in equipment + income recognized - liability assumed by other partner

2010 Cengage Learning Example Leisle contributes land with a FMV of $2,000,000 for 60% interest in Fuel Cell Tech LLP. The land has a basis of $450,000 and a mortgage of $1,200,000. What is Leisle’s basis in the partnership interest and does she have any taxable gain on this transaction?

Example #2 Leisle contributes land with a FMV of $2,000,000 for 60% interest in Fuel Cell Tech LLP. The land has a basis of $450,000 and a mortgage of $1,200,000. What is Leisle’s basis in the partnership interest and does she have any taxable gain on this transaction? Solution Leisle has contributed property with liabilities assumed by other partners in excess of basis, so her taxable gain is [($1,200,000 x 40%) - $450,000] = $30,000 Leisle’s basis in her partnership interest equals $0. $450,000 + $30,000 –.40($1,200,000) 2010 Cengage Learning Her adjusted basis in land + gain recognized - liability assumed by other partners

2010 Cengage Learning Changes occur to partner’s basis due to subsequent activities Beginning Basis +Additional Contributions +Share of Net Ordinary Taxable Income +Share of Capital Gains/Other Income -Distributions of Property or $ -Share of Net Loss from Operations* -Share of Capital Losses/Other Deductions +/- Increase/Decrease in Liabilities Basis in Partnership Interest *Note: Can’t take basis below 0 and must comply with at-risk limitations

2010 Cengage Learning Example Suresh and Kia enter into a partnership, sharing equally in the profits and losses. Suresh contributed land with a $70,000 basis and $150,000 FMV. Subsequent to formation, the partnership incurred liabilities = $130,000 and the partnership income for 2009 totaled $42,000. What is Suresh’s basis in the partnership interest at year-end?

Example Suresh and Kia enter into a partnership, sharing equally in the profits and losses. Suresh contributed land with a $70,000 basis and $150,000 FMV. Subsequent to formation, the partnership incurred liabilities = $130,000 and the partnership income for 2009 totaled $42,000. What is Suresh’s basis in the partnership interest at year-end? Solution $70, ($130,000) +.50($42,000) = $156,000 Beginning balance + 50% liabilities + 50% net income 2010 Cengage Learning

 Partnerships do not pay tax ◦ All information flows through to be reported by the partners ◦ Tax return is due by 15th of 4th month following close of partnership tax year  Must report each element of income and expense separately on Form 1065 (Partnership Tax Return) ◦ Schedule K-1 shows allocable partnership income/expenses for each partner based upon the individual ownership percentage  Ordinary income/loss  Special income/deduction items such as charitable deductions, interest, capital gains/losses 2010 Cengage Learning

 Income and expenses flow through to individual’s tax return  On the individual partner’s tax return the deductible losses from partnership activities are limited to basis in partnership interest ◦ Cannot reduce basis below zero ◦ Carry forward any unused losses to subsequent years (when there may be basis to absorb loss!) 2010 Cengage Learning

 Partnerships may make distributions of money or other property to partners ◦ A current distribution is one that does not completely terminate a partner’s interest ◦ No gain recognized by partner, unless partner’s basis in partnership has reached zero  Then, only the portion of the current distribution that is in excess of partner’s basis is taxed 2010 Cengage Learning

 Amount that a partner receives for services rendered is called a guaranteed payment ◦ Guaranteed payments are made regardless of income/loss situation of partnership ◦ Guaranteed payments are subtracted before partnership taxable income/loss is allocated to partners ◦ Guaranteed payments are taxable ordinary income to partner and deductible by partnership 2010 Cengage Learning

 Unless it can show bona fide business purpose for adopting another fiscal year-end, the partnership must adopt the same tax year as the majority of the partners  If this is not possible, it must adopt same tax year as majority of the principal partners  If neither of these work, partnership must use the least aggregate deferral method (see major tax service for more information) 2010 Cengage Learning

 Generally, transactions between partners and the partnership are not regarded as related party transactions  However, if a partner with more than 50% direct or indirect ownership* sells assets to the partnership (or two partnerships with > 50% ownership by same partner) ◦ And a gain results: it is taxed as ordinary income ◦ And a loss results: the loss is disallowed and any gain on future sale of asset by the partnership is reduced by the deferred loss *Note: Indirect ownership means “through spouse, siblings, lineal descendants and ancestors” 2010 Cengage Learning

 Partners cannot deduct losses from activities in excess of their investment °Losses limited to amounts at risk (AAR) in those activities  Definitions ◦ A “nonrecourse liability” is a debt for which the borrower is not personally liable ◦ “Encumbered property” is the property pledged for a liability  Taxpayers are at-risk for an amount equal to Cash and property contributed to partnership + Liabilities on encumbered properties (recourse debt) + Liabilities for which taxpayer is personally liable (recourse debt) + Retained profits in activity 2010 Cengage Learning

 Taxpayer allowed a loss deduction allocable to business activity to the extent of: ◦ Income received or accrued from activity without regard to amount at risk or ◦ Taxpayer’s amount at risk at the end of the tax year 2010 Cengage Learning

 Real estate acquired before 1987 is not subject to at-risk rules  For real estate acquired after 1986, the “qualified nonrecourse financing” is considered to be the amount at risk ◦ This is defined as debt secured by real estate and borrowed from person who regularly engages in the lending of money ◦ Does not apply to financing from seller or promoter 2010 Cengage Learning

Example Jolene buys a real estate investment and gives $200,000 cash as a down payment; she also borrows $800,000 which is secured by a bank mortgage on the property. What is Jolene’s amount at risk? Would this answer change if she had obtained the mortgage from the seller? 2010 Cengage Learning

Example Jolene buys a real estate investment and gives $200,000 cash as a down payment; she also borrows $800,000 which is secured by a bank mortgage on the property. What is Jolene’s amount at risk? Would this answer change if she had obtained the mortgage from the seller? Solution Jolene has $1,000,000 at risk in this real estate investment. If the mortgage had been obtained from the seller, her amount at risk would be limited to the down payment of $200, Cengage Learning

 Limited Liability Companies (LLCs) are a cross between a partnership and a corporation ◦ Treated generally as a partnership for tax purposes ◦ Each owner has limited liability (similar to a corporation)  Advantages of LLCs are numerous ◦ Taxable income/loss passes through to owners ◦ No general partner requirement ◦ Owners can participate in management ◦ Owners have limited liability ◦ LLC ownership interest is not a security ◦ Tax attributes pass through to owners ◦ Offer greater tax flexibility than S corporations 2010 Cengage Learning

 Disadvantages ◦ Because of newness, limited amount of case law dealing with limited liability companies ◦ States are not uniform in treatment of LLCs, so potential for confusion if LLC operating in more than one state Note: Limited Liability Companies quickly becoming a major form of business organization in the U.S Cengage Learning