McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Principles of Taxation: Advanced Strategies Chapter 6 Chapter 6 Income and Allocation by Passthrough Entities Income and Allocation by Passthrough Entities Slide 6-1

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Passthrough Entities What are they What are they  Partnerships  Limited Liability Companies  S Corporations All income taxed to owner not entity All income taxed to owner not entity Slide 6-2

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Passthrough Entities Slide 6-3 Entity must establish tax year and accounting method Entity must establish tax year and accounting method Elections and characterization of income made at entity level Elections and characterization of income made at entity level Information return (1065 or 1120S) filed by entity Information return (1065 or 1120S) filed by entity

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Passthrough of Income Items reported to each owner on form K-1 Items reported to each owner on form K-1 Items that may affect different taxpayers differently are reported as separately stated items Items that may affect different taxpayers differently are reported as separately stated items Nonseparately stated items combined and reported as one item Nonseparately stated items combined and reported as one item Slide 6-4

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Partnership Capital Accounts Partnership equity account Partnership equity account Each partner has one Each partner has one Represents partner’s contributions plus undistributed earnings Represents partner’s contributions plus undistributed earnings Partnership earnings are allocated to the partners and their capital accounts pursuant to the partnership agreement Partnership earnings are allocated to the partners and their capital accounts pursuant to the partnership agreement Slide 6-5

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Partnership Allocations Normally allocated pursuant to partnership agreement Normally allocated pursuant to partnership agreement Allocation must have substantial economic effect Allocation must have substantial economic effect Slide 6-6

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc 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 Slide 6-7

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Contributed Property Special allocation must be made if property’s basis is different than its fair market value when contributed 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 Slide 6-8

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Section 704(c) Adjustments Slide 6-9 Adjustments required because fair market value of property is different than tax basis at time of contribution Adjustments required because fair market value of property is different than tax basis at time of contribution Traditional Method Traditional Method  Allocation subject to a ceiling i.e. allocation to contributing partner cannot exceed actual gain, loss, income, or deduction

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc 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 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 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 Slide 6-10

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Partnership Varying Interests Any allocation must take into account any change in a partner’s interest during the year 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 Partner may only be allocated items attributable to period when they were a partner Slide 6-11

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc S Corporation Allocations Separately stated items and nonseparately stated items computed and reported to shareholders in the same manner as a partnership Separately stated items and nonseparately stated items computed and reported to shareholders in the same manner as a partnership Slide 6-12

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc S Corporation Varying Interests All items generally allocated to shareholders based upon pro-rata weighted ownership percentage regardless of when item is earned All items generally allocated to shareholders based upon pro-rata weighted ownership percentage regardless of when item is earned No special allocations allowed No special allocations allowed Built in gains on losses on contribution allocated to all shareholders Built in gains on losses on contribution allocated to all shareholders Slide 6-13

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc S Corporation Penalty Taxes Certain income subject to taxation at both corporate and shareholder level Certain income subject to taxation at both corporate and shareholder level Built-in gains tax (Section 1374) Built-in gains tax (Section 1374) Tax on excessive passive net income (Section 1375) Tax on excessive passive net income (Section 1375) Slide 6-14

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Built-in Gains Tax Slide 6-15 Enacted to prevent a C corporation from making a S election to prevent tax on sale or distribution of appreciated assets 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 Tax does not apply to corporations that have never been C corporations

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Built-in Gains Tax Tax imposed upon net unrealized gain 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 Tax imposed upon any realized gains during 10 year period after S election 35% rate 35% rate Slide 6-16

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Built-In Gains Tax-Effect on Shareholders Tax is treated as a loss incurred by corporation Tax is treated as a loss incurred by corporation Allocated to shareholders in same manner as item triggering gain Allocated to shareholders in same manner as item triggering gain In effect shareholders are allocated the gain item less the tax attributable to it In effect shareholders are allocated the gain item less the tax attributable to it Slide 6-17

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Excess Net Passive Income Tax Only applies to corporations that were once C corporations with accumulated earnings and profits on date S election effective Only applies to corporations that were once C corporations with accumulated earnings and profits on date S election effective Imposed at 35% rate on excess net passive income Imposed at 35% rate on excess net passive income Slide 6-18

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc 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 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 Tax allocated to shareholders as a loss item Slide 6-19

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Basis Adjustments Basis in partnership or S corporation stock need to be adjusted by partner or shareholder to prevent double taxation Basis in partnership or S corporation stock need to be adjusted by partner or shareholder to prevent double taxation Slide 6-20

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Loss Limitations Partners or S corporation shareholders subject to following limitations on losses 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 Slide 6-21

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Basis Limitation Partners and S corporation shareholders cannot deduct losses in excess of basis Partners and S corporation shareholders cannot deduct losses in excess of basis Basis determined at end of year after all positive adjustments made Basis determined at end of year after all positive adjustments made Any loss limited by basis can be carryforward Any loss limited by basis can be carryforward Slide 6-22

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc At-Risk Limitation Applies to partners that have receive basis for partnership loans or debts for which they are not at risk 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 Real estate normally exempt from limitation as long as financing is from a nonrelated party Any amounts limited may be carried over Any amounts limited may be carried over Slide 6-23

McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Passive Activity Loss Limitations Limitation applies to partners or S corporation shareholders that do not materially participate Limitation applies to partners or S corporation shareholders that do not materially participate Passive losses deductible only against passive income Passive losses deductible only against passive income Losses limited may be carried forward Losses limited may be carried forward Slide 6-24