Module 24 Flow-Through Entities: Basis Issues

Menu 1. Computation of a partner’s basis in a partnership interest 2. Termination of a partnership interest 3. Computation of an S corporation shareholder’s basis in S corporation stock 4. Termination of an S corporation shareholder’s interest

Computation of a Partner’s Basis in a Partnership Interest Key Learning Objectives n Acquisition of an interest in a partnership n Partnership liabilities n Changes in a partnership interest as a result of partnership operations n Impact of nonliquidating distributions on a partnership interest

Partner’s Partnership Interest Outside Basis n Intangible asset representing ownership u Similar to corporate stock n Partnership interest must have a non- negative basis n Partnership interest basis includes partner’s share of partnership liabilities n Generally considered a capital asset

Partner’s Original Partnership Interest Basis n Cash contributed n Plus: Basis of non-cash assets contributed n Plus: Any service gain recognized u Note: NO adjustment for any liabilities > basis gain recognized n Plus: Other partner’s liabilities assumed by new partner n Minus: New Partner’s liabilities assumed by other partners

Post-Formation Adjustments to Partner’s Partnership Interest Basis n Increases to basis Additional contributions by partner Partner’s share of any increase in partnership liabilities Partner’s share of partnership income items

Post-Formation Adjustments to Partner’s Partnership Interest Basis n Decreases to basis Distributions to partners Distributions to partners Partner’s share of any decrease in partnership liabilities Partner’s share of any decrease in partnership liabilities

Partnership’s Basis in Contributed Assets--Inside Basis n Carryover basis for assets transferred in u Depreciation recapture potential and holding periods also carryover to partnership n Add any investment company gain recognized by partner n No adjustment for liabilities > basis gain recognized

Categories of Distributions n Nonliquidating (current) n Liquidating

§751 “Hot Assets” n These assets produce ordinary income n They can affect both partnership distributions and sales of a partnership interest n Two kinds: (1) Unrealized receivables (1) Unrealized receivables (2) Substantially appreciated inventory (2) Substantially appreciated inventory

Unrealized Receivables n Always hot n Includes: u Accounts receivable of cash method partnership u Depreciation recapture items

Substantially Appreciated Inventory n Hot only if aggregate FMV of inventory items exceeds 120% of their aggregate basis n Broad definition: u All assets other than cash, capital assets, and §1231 assets

Current Distributions n Three tiers of property n Deemed distributed in this order Cash Unrealized receivables and inventory Other property

Effect on Partner-- Current Distribution n No gain recognized unless cash distributed exceeds partner’s predistribution partnership interest basis Exception: disproportionate distribution of hot assets (discussed later) NOTE: reduction of a partner’s share of partnership liability = deemed cash distribution n A loss is never recognized

Effect on Partner-- Current Distribution n Distributed tier two and tier three properties have a carryover basis to the partner n However, basis carried over cannot exceed partner’s remaining partnership interest basis u Allocation of bases is necessary if multiple assets are distributed within a tier n Distributions reduce a partner’s partnership interest basis, but never below zero

Effect on Partnership-- Current Distribution n No gain or loss recognized n Exception: disproportionate distributions of hot assets n Partnership may be entitled to a basis adjustment if: Gain is recognized by the partner Basis “disappears”

Termination of a Partnership Interest Key Learning Objectives n n Involuntary termination n n Voluntary termination u Sale or exchange u Abandonment u Liquidation of a partnership u Liquidation of a partnership interest u Merger/consolidation u Conversion to limited liability company

Involuntary Termination Close of Tax Year n Sale of > 50% capital within 12 months n Partnership ceases to do business n Causes loss of tax attributes n Deceased partner u Successor in interest steps into deceased’s shoes, so no close of tax year u Successor’s partnership interest basis equals FMV of interest at date of death

Voluntary Termination Close of Tax Year n Partnership year closes with respect to partner IF n Liquidation or sale of entire interest n Gift of interest

Sale of a Partnership Interest n Amount realized n - partnership interest basis n Gain or loss realized n Amount realized includes Cash FMV of property Any partnership liabilities assumed by the new partner

Sale of a Partnership Interest n Gain or loss is generally capital n Exception: hot assets generate ordinary income n New partner may be entitled to a basis adjustment u Adjustment is with respect to new partner only

Liquidating Distributions n “Liquidation” refers to the termination of a partner’s interest n Do not confuse this with the partnership liquidating, although it may be

Liquidating Distributions n Three tiers of property n Deemed distributed in this order Cash Unrealized receivables and inventory Other property

Effect on Partner-- Liquidating Distribution n No gain recognized unless cash exceeds partner’s predistribution basis u Exception: disproportionate distributions of hot assets n Partner may recognize a loss, if other property is not distributed n If tier three property is distributed, any remaining basis is assigned to it n “Substituted” rather than carry over basis

Effect on Partnership-- Liquidating Distribution n No gain or loss recognized n Exception: disproportionate distributions of “hot assets” (discussed later) n Partnership may be entitled to a basis adjustment if: Gain or loss is recognized by the partner, or Basis “disappears” or is “created”

Cash Payments Due to Retirement or Death of a Partner n Payments for property n Payments for hot assets generate ordinary income n “Other” payments Either distributive shares or Guaranteed payments For service partnerships, “other” payments include payments for unrealized receivables and goodwill

Disproportionate Distributions n Partner receives either too many or too few hot assets n Rules apply to both liquidating and nonliquidating distributions n Gain or loss may be recognized by the partner and/or the partnership

Disproportionate Distributions Two Step Analysis n To determine gain/loss recognize n When fictional steps 1 and 2 are combined, results should reflect the actual distribution

Disproportionate Distributions Step 1 n Pretend that the partner received a proportionate liquidating distribution n This is a tax-free transaction n Partner has a carryover basis for each asset

Disproportionate Distributions Step 2 n Pretend that the partner sells back to the partnership some of the assets received in step 1 in exchange for other assets n This is a taxable transaction n Use FMV for items received n Use adjusted basis for items given up

In Class Exercise: Sale of a Partnership Interest Note: The Inventory is substantially appreciated: 30,000 > 21,000 x 120%

In Class Exercise: Sale of a Partnership Interest n Refer to the previous slide n If X sells her interest to W for $25,000 cash n What are the tax consequences u To partner X u To partner W

Solution--In Class Exercise: Sale of a Partnership Interest For X n Amount realized25,000 n Basis: 16,000 n Gain: 9,000 n 3,000 of the gain is ordinary u X’s share of built-in gain for the inventory n The remaining 6,000 of the gain is capital

Solution--In Class Exercise: Sale of a Partnership Interest For W n W’s “outside” basis in his partnership interest is $25,000 n Without special election by partnership, his “inside” basis is $16,000

In Class Exercise: Liquidation of Partnership Interest n Using the facts of the last exercise n What are the tax consequences if the partnership liquidates X’s interest for $10,000 cash and $15,000 FMV inventory? n Note that this is a disproportionate liquidation because X did not receive exactly her one-third share of the hot assets

Solution--In Class Exercise: Liquidation of Partnership Interest Step 1 n Assume equal liquidating distribution u Pretend that X received one-third of each asset n See next slide

Solution--In Class Exercise: Liquidation of Partnership Interest

Step 2 n Assume a sale between X and partnership n Pretend that X gave back the land (9,000) received in Step 1 n In exchange for more cash ($4,000) and more inventory ($5,000) n Treat Step 2 as a taxable transaction n Use FMV for items received and basis for items given up

Solution--In Class Exercise: Liquidation of Partnership Interest n Amount realized 9,000 u 4,000 cash + 5,000 inventory n Basis 3,000 u Basis of land given up n Gain realized 6,000

Solution--In Class Exercise: Liquidation of Partnership Interest n The entire gain is a §1231 gain from the “sale” of land n X holds $15,000 FMV of inventory n Basis of $12,000 u $7,000 from step 1 u $5,000 from step 2 n She will realize $3,000 of ordinary income when she sells the inventory

Computation of an S Corporation Shareholder’s Tax Basis Key Learning Objectives n Acquisition of S corporation stock n Shareholder loans to an S corporation n Changes to basis as a result of operations n Changes to basis as a result of distributions n Summary

Acquisition of S Corporation Stock n n The tax consequences of the incorporation of an S corporation follows the regular C corporation rules and were covered in Module 6 n n Purchase of stock of existing S corporation u No immediate tax consequences u Cost becomes shareholder’s basis

Shareholder Loans to S Corporation n n Third party lender u No change in the equity interest n n Shareholder creditor u The indebtedness will create basis for the purpose of deducting losses from the S corporation

Shareholder Loans to S Corporation n n Loan must be: u Made directly from shareholder to corporation u A bona fide indebtedness u Written note specifying a: F Principal sum to be repaid F A rate of interest F A term loan or a demand loan

Changes to Basis as a Result of Operations n n Each shareholder's distributive share of S corporation income is reported on his or her tax return according to the percentage of stock owned n n The adjustment to the basis in the stock is n n Made on the last day of the S corporation's taxable year

Changes to Basis As a Result of Distributions n n Cash reduces basis n n S corp uses the corporate rules when making property distributions to its shareholders n n The distribution of appreciated property to an S shareholder is deemed a sale by the corporation u Gain is reported by shareholders

Termination of an S Corporation Shareholder’s Interest Key Learning Objectives n n Termination of S corporation election n n Termination of shareholder’s ownership interest n n Termination of an S corporation

Voluntary Termination of S Corporation Election n Filing a written statement indicating the corporation's desire to revoke its election. n If made on or before the 15th day of the third month of the taxable year, n It is generally effective as of the first day of such taxable year

Involuntary Termination of S Corporation Election n n Election may be revoked because of a disqualifying event n n The corporation ceases to be a small business corporation OR n n The corporation has accumulated earnings and profits AND n n Passive investment income > 25% of gross receipts for three consecutive tax years

Termination of Shareholder’s Interest n n By sale, abandonment, or redemption n n An unused S corporation loss carryover disappears

Termination of S Corporation n By selling off its assets and distributing the proceeds to its shareholders u A liquidation n By being absorbed by another corporation u A merger or consolidation