1. ©2008 Prentice Hall, Inc.

2. PARTNERSHIPS AND S CORPORATIONS
Types of flow-through entities
Taxation of partnerships
Partnership elections
Taxation of S corporations
Tax planning considerations
Compliance and procedural considerations
©2008 Prentice Hall, Inc.

3. Types of Flow-Through Entities (1 of 4)
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
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4. Types of Flow-Through Entities (2 of 4)
S corporations
Follow C corp rules except when Subchapter S flow-through rules apply
Limited liability companies (LLCs)
Limited liability of a corporation
May be taxed as partnership or corp
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5. Types of Flow-Through Entities (3 of 4)
Limited liability partnerships (LLPs)
Used by professional service partnerships
Not liable for negligence or misconduct of other partners
Limited liability limited partnership
Allowed by about 20 states
Formed under state’s limited ptrshp laws
General partners have limited liability
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6. Types of Flow-Through Entities (4 of 4)
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
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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
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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
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9. Taxation of Partnerships (3 of 3)
Sale of a partnership interest
Optional and mandatory basis adjustments
Electing large partnerships
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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 partnership liabilities
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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
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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
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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
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14. Basis Adjustments for Operating Items (1 of 2)
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
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15. Basis Adjustments for Operating Items (2 of 2)
Items that decrease basis
Partner’s share of losses
Distributions
Reduction in partnership debt
Allocating liabilities
Recourse debt allocated based on economic risk of loss
Nonrecourse debt allocated based on profit sharing percentages
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16. 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
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17. 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
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18. 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
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19. 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
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20. 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
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21. 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
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22. 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
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23. 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
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24. 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
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25. 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
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26. 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
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27. 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
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28. Qualification Requirements (1 of 3)
Shareholder requirements
No more than 100 shareholders
Family members counted as one s/h
May elect to include all members of a family as a single shareholder
Individuals, estates, and certain types of trusts (including QSSTs)
QSSTs may be complex trusts
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29. 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
Must not be an “ineligible” corporation
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30. Qualification Requirements (3 of 3)
Corp-related requirements (continued)
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
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31. 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
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32. Termination Conditions (1 of 3)
Voluntary S election termination
Owners of more than 50% of the corporation’s stock must agree
Revocation made w/in 1st 2-1/2 months can be retroactive to beginning of year
Otherwise, election effective for 1st day of next taxable year
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33. Termination Conditions (2 of 3)
Involuntary S election termination
Occurs when corporation ceases to meet S corporation requirements
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
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34. Termination Conditions (3 of 3)
Inadvertent termination can be undone
New S corp election cannot be made for 5 tax years after termination
Unless inadvertent termination
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35. 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
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36. Basis Adjustments to S Corporation Stock In Following Order (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)
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37. 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
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38. S Corporation Losses and Limitations (1 of 2)
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
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39. S Corporation Losses and Limitations (2 of 2)
Sequence for stock basis limitation
Beginning basis
+ Capital contributions
+ Share of ordinary income and separately stated items
- Distributions not included in s/h inc.
- Nondeductible, noncapital expenditures
Basis available to absorb S corp loss
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40. Other S Corporation 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
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41. Other S Corporation Considerations Other Restrictions (1 of 2)
S corps generally must use calendar year
>2% shareholders not eligible for most tax-free 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
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42. Other S Corporation 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%)
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43. Tax Planning Considerations
Use of net operating losses
Income shifting among family members
Optional basis adjusting under §754
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44. Compliance and Procedural Considerations (1 of 2)
Partnership filing requirements and elections
Reporting partnership items on Form 1065 on or before the fifteenth day of the fourth month
S Corporation filing requirements and accounting method elections
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45. Compliance and Procedural Considerations (2 of 2)
Reporting S Corporation items on Form 1120S
Comparison of alternative forms of business organizations
(See Table I17-2)
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46. ©2008 Prentice Hall, Inc.