1. Principles of Taxation: Advanced Strategies
Slide 6-1
Chapter 6
Income and Allocation by Passthrough Entities
McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc

2. Passthrough Entities What are they Partnerships
Slide 6-2
What are they
Partnerships
Limited Liability Companies
S Corporations
All income taxed to owner not entity
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3. Passthrough Entities
Slide 6-3
Entity must establish tax year and accounting method
Elections and characterization of income made at entity level
Information return (1065 or 1120S) filed by entity
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4. Passthrough of Income Items reported to each owner on form K-1
Slide 6-4
Items reported to each owner on form K-1
Items that may affect different taxpayers differently are reported as separately stated items
Nonseparately stated items combined and reported as one item
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5. Partnership Capital Accounts
Slide 6-5
Partnership equity account
Each partner has one
Represents partner’s contributions plus undistributed earnings
Partnership earnings are allocated to the partners and their capital accounts pursuant to the partnership agreement
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6. Partnership Allocations
Slide 6-6
Normally allocated pursuant to partnership agreement
Allocation must have substantial economic effect
McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc

7. Partnership Losses Must be allocated to partnership capital accounts
Slide 6-7
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
McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc

8. Contributed Property
Slide 6-8
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
McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc

9. Section 704(c) Adjustments
Slide 6-9
Section 704(c) Adjustments
Adjustments required because fair market value of property is different than tax basis at time of contribution
Traditional Method
Allocation subject to a ceiling i.e. allocation to partners cannot exceed actual gain, loss, income, or deduction
McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc

10. Sales of Contributed Property
Slide 6-10
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 up to the amount of built-in loss
McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc

11. Partnership Varying Interests
Slide 6-11
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
McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc

12. S Corporation Allocations
Slide 6-12
Separately stated items and nonseparately stated items computed and reported to shareholders in the same manner as a partnership
McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc

13. S Corporation Varying Interests
Slide 6-13
All items generally allocated to shareholders based upon pro-rata weighted ownership percentage regardless of when item is earned
No special allocations allowed
Built in gains on losses on contribution allocated to all shareholders
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14. S Corporation Penalty Taxes
Slide 6-14
Certain income subject to taxation at both corporate and shareholder level
Built-in gains tax (Section 1374)
Tax on excessive passive net income (Section 1375)
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15. 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
Tax does not apply to corporations that have never been C corporations
McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc

16. Built-in Gains Tax Tax imposed upon net unrealized gain
Slide 6-16
Built-in Gains Tax
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
35% rate
McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc

17. Built-in Gains Tax-Effect on Shareholders
Slide 6-17
Tax is treated as a loss incurred by corporation
Allocated to shareholders in same manner as item triggering gain
In effect, shareholders are allocated the gain item less the tax attributable to it
McGraw-Hill/Irwin Copyright (c) 2003 by the McGraw-Hill Companies Inc

18. Excess Net Passive Income Tax
Slide 6-18
Only applies to corporations that were once C corporations with accumulated earnings and profits on the last day of the year
Imposed at 35% rate on excess net passive income
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19. Excess Net Passive Income Tax
Slide 6-19
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
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20. Basis Adjustments
Slide 6-20
Basis in partnership or S corporation stock need to be adjusted by partner or shareholder to prevent double taxation
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21. Loss Limitations
Slide 6-21
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
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22. Basis Limitation
Slide 6-22
Partners and S corporation shareholders cannot deduct losses in excess of basis
Basis determined at end of year after all positive adjustments and adjustment for distributions made
Any loss limited by basis can be carryforward
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23. At-Risk Limitation
Slide 6-23
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
Any amounts limited may be carried over
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24. Passive Activity Loss Limitations
Slide 6-24
Limitation applies to partners or S corporation shareholders that do not materially participate
Passive losses deductible only against passive income
Losses limited may be carried forward
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