McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Chapter 7 7 Income and Loss Allocation by Passthrough Entities

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-3 Passthrough Entities What are they Partnerships Limited Liability Companies S Corporations All income taxed to owner not entity

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-4 Passthrough Entities Entity must establish tax year and accounting method Elections and characterization of income made at entity level Information return (1065 or 1120S) filed by entity

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-5 Passthrough of Income Items reported to each owner on form K-1 Items that may affect different taxpayers differently are reported as separately stated items Nonseparately stated items combined and reported as one item

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-6 Partnership Capital Accounts Partnership equity account Each partner has one Represents partner’s contributions plus undistributed earnings Partnership earnings are allocated to the partners and their capital accounts pursuant to the partnership agreement

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-7 Partnership Allocations Normally allocated pursuant to partnership agreement Allocation must have substantial economic effect Capital accounts maintained Liquidating distributions based upon capital accounts Deficit restoration obligation if negative capital account

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-8 Partnership Losses Must be allocated to partnership capital accounts May result in negative capital account To have substantial economic effect, there must be an obligation to restore or eliminate negative capital accounts on dissolution

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-9 Contributed Property Special allocation must be made if property’s basis is different than its fair market value when contributed Example: Partner A contributes land with a fair market value of $800,000 and a basis of $500,000. It would be unfair to allocated any of the $300,000 unrealized gain to other partners

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-10 Section 704(c) Adjustments Adjustments required because fair market value of property is different than tax basis at time of contribution Traditional Method Allocation subject to a ceiling i.e. allocation to partners cannot exceed actual gain, loss, income, or deduction

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-11 Depreciation Allocations Depreciation allocated based upon carryover basis from contributing partner If ceiling approach elected, depreciation allocated to noncontributing partners based upon fair market at date of contribution Contributing partner receives any remaining unallocated depreciation

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-12 Sales of Contributed Property Sales of property that was inventory to the contributing partner and sold within five year of contribution result in ordinary gain or loss to the partnership Any loss on the sale of contributed property sold within five years of contribution where the basis of the property exceeded its fair market value on the date of contribution that was a capital asset to the contributor is a capital loss to the partnership up to the amount of built-in loss

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-13 Partnership Varying Interests Any allocation must take into account any change in a partner’s interest during the year Partner may only be allocated items attributable to period when they were a partner

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-14 S Corporation Allocations Separately stated items and nonseparately stated items computed and reported to shareholders in the same manner as a partnership

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-15 S Corporation Varying Interests All items generally allocated to shareholders based upon pro-rata weighted ownership percentage regardless of when item is earned No special allocations allowed Built in gains on losses on contribution allocated to all shareholders

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-16 S Corporation Penalty Taxes Certain income subject to taxation at both corporate and shareholder level Built-in gains tax (Section 1374) Tax on excessive passive net income (Section 1375)

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-17 Built-in Gains Tax Enacted to prevent a C corporation from making a S election to prevent tax on sale or distribution of appreciated assets Tax does not apply to corporations that have never been C corporations

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-18 Built-in Gains Tax Tax imposed upon net unrealized gain Excess of fair market value of assets over their basis on first day of first S corporation year Tax imposed upon any realized gains during 10 year period after S election 35% rate

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-19 Built-in Gains Tax-Effect on Shareholders Tax is treated as a loss incurred by corporation Allocated to shareholders in same manner as item triggering gain In effect, shareholders are allocated the gain item less the tax attributable to it

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-20 Excess Net Passive Income Tax Only applies to corporations that were once C corporations with accumulated earnings and profits on the last day of the year Imposed at 35% rate on excess net passive income

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-21 Excess Net Passive Income Tax Imposed only to the extent passive income items such as interest, dividends, annuities, rents and capital gains exceed 25% of gross receipts Tax allocated to shareholders as a loss item

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-22 Basis Adjustments Basis in partnership or S corporation stock need to be adjusted by partner or shareholder to prevent double taxation

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-23 Loss Limitations Partners or S corporation shareholders subject to following limitations on losses Partnership or S corporation stock basis At-risk limitation of section 465 Passive loss limitation

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-24 Basis Limitation Partners and S corporation shareholders cannot deduct losses in excess of basis Basis determined at end of year after all positive adjustments and adjustment for distributions made Any loss limited by basis can be carryforward

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-25 At-Risk Limitation Applies to partners that have receive basis for partnership loans or debts for which they are not at risk Real estate normally exempt from limitation as long as financing is from a nonrelated party Any amounts limited may be carried over

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 7-26 Passive Activity Loss Limitations Limitation applies to partners or S corporation shareholders that do not materially participate Passive losses deductible only against passive income Losses limited may be carried forward