17-1 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-2 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-3 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-4 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-5 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  General partners have limited liability ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-6 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-7 Taxation of Partnerships (1 of 3)  Formation of a partnership  Partnership operations  Special allocations  Allocation of partnership income, deductions, losses, and credits to partners ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-8 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-9 Taxation of Partnerships (3 of 3)  Sale of a partnership interest  Optional and mandatory basis adjustments  Electing large partnerships ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-10 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 partnership liabilities ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-11 Formation of a Partnership (2 of 2)  Cannot have negative basis  Must recognize gain to avoid negative basis  Generally partnership assumes carryover basis of assets contributed  Generally, holding period also carries over to partnership ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-12 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 agreement ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-13 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-14 Basis Adjustments for Operating Items (1 of 2)  See summary in table I17-1  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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-15 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-16 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-17 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-18 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-19 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-20 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-21 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-22 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-23 Optional and Mandatory Basis Adjustments (3 of 3)  Mandatory basis adjustment for substantial built-in loss  Substantial if Built-in loss > $250K,  Exchange of partnership interest, AND  No §754 optional basis adjustment election in effect ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-24 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-25 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  §179 deductions combined ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-26 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 $5M during the prior three years ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-27 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-28 Qualification Requirements (1 of 3)  Shareholder requirements  No more than 100 shareholders  Family members count as one shareholder  Include common ancestor, spouses of common ancestor or lineal descendents, and estates of family members  Individuals, estates, and certain types of trusts (including QSSTs)  QSSTs may be complex trusts ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-29 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 requirements  Domestic corporation  Or unincorporated entity electing to be treated as a corp under check-the-box Regs ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-30 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-31 Election Requirements  Form 2553 must be filed no later than 15th 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-32 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-33 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-34 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-35 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 per-day basis ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-36 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) ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-37 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 stock ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-38 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-39 S Corporation Losses and Limitations (2 of 2)  Sequence for stock basis limitation 1. Beginning basis 2. + Capital contributions 3. + Share of ordinary income and separately stated items 4. - Distributions not included in s/h inc Nondeductible, noncapital expenditures Basis available to absorb S corp loss ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-40 Other S Corporation 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-41 Other S Corporation 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-42 Other S Corporation 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%) ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-43 Tax Planning Considerations (1 of 2)  Use of net operating losses from pass-through 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 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-44 Tax Planning Considerations (2 of 2)  Optional basis adjusting under §754  Increases incoming partner’s basis in partnership assets ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-45 Compliance and Procedural Considerations (1 of 2)  Partnership filing requirements and elections  Reporting partnership items on Form 1065 on or before the 15th day of the 4th month  S Corporation filing requirements and accounting method elections ©2009 Pearson Education, Inc. Publishing as Prentice Hall

17-46 Compliance and Procedural Considerations (2 of 2)  Reporting S Corporation items on Form 1120S  Comparison of alternative forms of business organizations  (See Table I17-2) ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business ©2009 Pearson Education, Inc. Publishing as Prentice Hall