1. Module 24 Flow-Through Entities: Basis Issues

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. Categories of Distributions n Nonliquidating (current) n Liquidating

10. §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

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

12. 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

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

14. 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

15. 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

16. 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”

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

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

24. 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

25. 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”

26. 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

27. 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

28. 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

29. 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

30. 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

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

32. 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

33. 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

34. 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

35. 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

36. 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

37. Solution--In Class Exercise: Liquidation of Partnership Interest

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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

46. 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

47. 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

48. 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

49. 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

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

51. 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