1. 17-1 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

2. 17-2 PARTNERSHIPS AND S CORPORATIONS  Types of pass-through entities  Taxation of partnerships  Taxation of S corporations  Tax planning considerations  Compliance and procedural considerations Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

3. 17-3 Types of Pass-Through Entities Partnerships and Limited Partnerships  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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

4. 17-4 Types of Pass-Through Entities S Corporations and LLCs  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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

5. 17-5 Types of Pass-Through Entities LLPs and LLLPs  Limited liability partnerships (LLPs)  Used by professional service partnerships  Not liable for negligence or misconduct of other partners  Limited liability limited partnership (LLLP)  Allowed by some states  Formed under state’s limited ptrshp laws  General partners have limited liability Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

6. 17-6 Types of Pass-Through Entities Taxation  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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

7. 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

8. 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

9. 17-9 Taxation of Partnerships (3 of 3)  Sale of a partnership interest  Optional and mandatory basis adjustments  Electing large partnerships  Partnership elections Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

10. 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 liabilities assumed by partnership Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

11. 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

12. 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

13. 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

14. 17-14 Allocation of Items to Partners Separately Stated Items (1 of 3)  Guaranteed payments to partners  Charitable contributions  Investment income and expenses  Foreign income taxes paid or accrued  Specially allocated items Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

15. 17-15 Allocation of Items to Partners Separately Stated Items (2 of 3)  §1250 gain  §1231 gain  §179 expensing  Tax credits  Tax preference items  See Table 1 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

16. 17-16 Allocation of Items to Partners Separately Stated Items (3 of 3) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

17. 17-17 Allocation of Items to Partners 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

18. 17-18 Allocation of Items to Partners Items that Decrease Basis  Partner’s share of losses  Distributions  Reduction in partnership debt Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

19. 17-19 Allocation of Items to Partners Allocating Liabilities  Recourse debt allocated based on economic risk of loss  Nonrecourse debt allocated based on profit sharing percentages Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

20. 17-20 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

21. 17-21 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

22. 17-22 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

23. 17-23 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

24. 17-24 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

25. 17-25 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

26. 17-26 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

27. 17-27 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

28. 17-28 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

29. 17-29 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

30. 17-30 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

31. 17-31 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

32. 17-32 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

33. 17-33 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

34. 17-34 Qualification Requirements (3 of 3)  Corp-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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

35. 17-35 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

36. 17-36 Termination Conditions 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

37. 17-37 Termination Conditions Involuntary S Election Termination  Occurs when corporation ceases to meet S corporation requirements  Inadvertent termination can be undone Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

38. 17-38 Termination Conditions (3 of 3)  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  New S corp election cannot be made for 5 tax years after termination  Unless inadvertent termination Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

39. 17-39 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

40. 17-40 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) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

41. 17-41 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

42. 17-42 S Corporation Losses and Limitations Basic Concepts  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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

43. 17-43 S Corporation Losses and Limitations Computation  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. 5. - Nondeductible, noncapital expenditures Basis available to absorb S corp loss Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

44. 17-44 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

45. 17-45 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

46. 17-46 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%) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

47. 17-47 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

48. 17-48 Tax Planning Considerations (2 of 2)  Optional partnership basis adjusting under §754  Increases incoming partner’s basis in partnership assets  Self-employment taxes imposed on income from partnerships and sole proprietorships Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

49. 17-49 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 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

50. 17-50 Compliance and Procedural Considerations (2 of 2)  Reporting S Corporation items on Form 1120S  Comparison of alternative forms of business organizations  (See Table 2) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

51. 17-51 Comparison of Alternate Forms of Business Organizations (1 of 3) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

52. 17-52 Comparison of Alternate Forms of Business Organizations (2 of 3) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

53. 17-53 Comparison of Alternate Forms of Business Organizations (3 of 3) Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

54. Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard.newmark@PhDuh.com 17-54 Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall