Module 22 Operations of Flow- Through Entities

Menu (1) 1. Definition of a flow-through entity 2. Reporting the operations of a flow-through entity 3. Accounting periods and methods 4. S corporation qualifications

Menu (2) 5. Allocations of partnership income and deductions 6. Compensation of employee-owners 7. Limitations on flow-through losses 8. Special taxes imposed on S corporations 9. Terminating the S election

Definition of a Flow-Through Entity Key Learning Objectives n n What is a flow-through entity? n n The association issue n n Relief from the association issue n n The association issue and LLC statutes

The Flow-Through Entity n n An organization separate from the owners n n Not generally subject to tax n n Entity functions as a reporting mechanism for the owners n n All income or loss is reported by the owners on their own tax returns n n The entity serves as a tax conduit

Flow-Through Entities n n There are four general categories of entities classified as flow-through entities: S corporations Partnerships Limited liability companies Limited liability partnerships

The Association Issue n n An association is an unincorporated entity with more corporate characteristics than non-corporate characteristics n n Four characteristics distinguish associations from other entities n n To avoid association status, noncorporate entities can have no more than two of these characteristics

Corporate Characteristics For Association n n Limited liability n n Centralized management n n Continuity of life n n Free transferability of interests

Reporting the Operations of a Flow-Through Entity Key Learning Objectives n n Reporting operations n n Entity tax reporting by flow-through entities n n Ordinary and separately stated items n n How a flow-through entity reports to the owners n n Example of reporting by a flow-through entity n n Entity level audit procedures

Partnership Reporting of Income n n Ordinary operating income n n Separately stated items n n See Form 1065 and Schedule K

Partner Reporting of Income n n Distributive share of income, deduction, or credit n n Based on partnership agreement n n Year partner reports income n n Rules for contributed property with built-in gain or loss n n Special allocations allowed if they have substantial economic effect

Entity Level Audit Procedures n n An audit change to the entity's income will affect all owners n n The IRS will conduct audit proceedings at the entity level n n An adjustment to the entity's income will affect all owners.

Accounting Periods and Methods Key Learning Objectives n n Choice of tax year n n Required year: partnerships n n Required year: S corporations n n Business purpose year n n §444 year n n Available accounting methods n n Restrictions on use of cash method by partnership

Partnership Required Tax Year n n Majority partners n n Principal partners n n Least aggregate deferral n n Exceptions: Natural business year §444 election

Choice of Taxable Year S Corporation n n Calendar year n n Business purpose year u 25%, 2-month, 3-year Test n §444 election

§444 Election n n No more than 3 months deferral n n Must make noninterest-bearing deposit n n As if paid tax on deferral

S Corporation Qualifications Key Learning Objectives n n S corporation qualification n n S corporations: maximum shareholder limit n n Permitted shareholders of an S corporation n n Single class of stock requirement n n Affiliated group membership restriction n n S election requirement n n S election: who must consent

Only Eligible Corporations May Elect S Status n n Domestic corporations n n No financial institutions or insurance companies n n Only one class of stock n n No more than 75 shareholders Only individuals, estates, and certain trusts Not partnership, nonresident aliens

S Election Requirement n n All shareholders must consent n n Made by March 15 u Effective January 1 n n Made after March 15 u Effective following year

Allocation of Partnership Income and Deductions Key Learning Objectives (1) n n General allocation rules n n Required partnership allocations n n §704(C) allocations: the traditional method n n §704(C) allocations: ceiling rule limitation n n §704(C) allocations: curative allocations n n §704(C) allocations: remedial allocations

Allocation of Partnership Income and Deductions Key Learning Objectives (2) n n Optional special allocations n n Partnership special allocations: economic effect n n Partnership special allocations: substantiality n n Partnership special allocations: nonrecourse n n Changes in partnership ownership n n Changes in S corporation ownership

Substantial Economic Effect n n Special allocations must be charged to partners' capital accounts n n Liquidating distributions must be in accordance with capital account balances n n Partners must have an obligation to restore negative capital accounts upon liquidation

Compensation of Employee- Owners Key Learning Objectives n n Who may be an employee? n n Compensating partners for services n n Compensating S corporation shareholder- employees for services n n Reasonable compensation in S corporations

Guaranteed Payments of Partners n n Compensation for Services performed OR Interest on invested capital n n Deductible to partnership n n Ordinary self-employment income to partner

Limitations on Flow-Through Losses Key Learning Objectives n n Limitations on utilization of flow-through losses n n Basis limitations n n At-risk basis limitations n n Passive loss limitations

Loss limitations of Partnerships n n Overall loss limit n n At-risk loss limit n n Passive activity loss limit

Partner's Share of Liabilities General Partners n n Recourse vs. nonrecourse n n Use profit sharing % u For nonrecourse loans n n Use loss sharing % u For recourse loans

Partner's Share of Liabilities Limited Partners n n Recourse vs. nonrecourse n n Use profit sharing % for nonrecourse loans n n Generally no basis adjustment for recourse loans unless partner has pledged additional contributions

S Corporation Overall Loss Limit n n Cannot deduct losses in excess of u Stock basis PLUS u Basis of loans from shareholder to corporation n n Unused losses can be carried forward indefinitely until bases restored n n At-risk and passive loss limitations also apply

Special Taxes Imposed on S Corporations Key Learning Objectives n Taxes imposed on flow-through entities n LIFO recapture tax n Tax on excess passive income n Built-in gains tax n Computation of built-in gains tax n How to avoid the built-in gains tax n Reporting the built-in gains tax

Special S Corporation Taxes n n LIFO recapture tax u Actually a C corporation tax, but triggered by an S election n n Excess net passive income tax u C corporation E&P must be present u >25% gross receipts test

Special S Corporation Taxes Built-In Gains Tax (BIG) n n Applies only to C corporations that elected to become S corporations after 1986 n n Tax is in effect for first 10 years after becoming an S n n Tax rate is highest corporate rate u Currently 35%

Special S Corporation Taxes Built-In Gains Tax (BIG) n n Big tax is applied against the net recognized built-in gain for the year u Or taxable income, if lower n n "Net" means recognized built-in gains minus recognized built-in losses

Built-In Gains Tax (BIG) n n NOLs and capital losses carried over from C years offset net recognized gain n n Net unrealized built-in gain at time of conversion to S serves as the 10-year cumulative limit n n Tax is paid by the S corporation n n Gain that flows through to shareholders is net of any tax paid

Terminating the S Election Key Learning Objectives n n Termination of S election n n Effective date of S termination n n Re-election of S status n n Partnership terminations

Termination of S Status n n Revocation n n Requires majority vote n n Filed by March 15— u Effective January 1 or prospective date n n Filed after March 15 u Effective next year or prospective date

Termination of S Status n n Inadvertent termination u Violate any S condition u Flunk 3-year passive income test F >25% Gross receipts test and F Have C corporation E&P n n Possible IRS relief

Re-Election of S Status n n 5-year rule precludes reecection for five years

Involuntary Termination Close of PartnershipTax Year n Sale of > 50% capital within 12 months n Partership ceases to do business n Loss of tax attributes