Basis/Distributions for Pass-Through Entities: An IRS Hot Spot

• Chapter 1 - Tax Consequences of Formation of Partnerships, LLCs, and S Corporations
  • Learning Objectives
  • Introduction
  • Determination of Basis in the Partnership Interest
    • General
    • Effect of Entity Operations
  • Effect of Liabilities
    • General
    • Gain under Section 731 – Deemed Distributions
    • Contribution of Encumbered Property
    • Section 752(c)
  • S Corp Formation
    • Controlled Corporation
    • Receipt of “Boot”
    • Contribution of Encumbered Property
  • Receipt of an Interest in the Entity for Services
    • Sections 351 and 721 – Exchange of Property for an Interest in the Entity
    • Section 83
    • Profits vs. Capital Interest
  • Transfer of a Capital Interest
    • Effect on the Service Partner
    • Consequences for Other Partners
    • Risk of Forfeiture
  • Transfer of a Profits Interest
    • IRS “Safe Harbor”
    • Background
    • Post-Diamond Activity
  • Campbell
    • Application of Section 721
    • Relevance of Section 707
    • Employee vs. Partner
    • Importance of Valuation
  • Lessons for Tax Advisers
• Chapter 2 - Partnership Distributions
  • Learning Objectives
  • Introduction
  • Current Distributions – Proportionate
    • General
    • Timing of Cash Distributions
    • Distribution of Noncash Assets: General
    • Basis in Property Exceeds Basis in Partnership Interest
    • Distribution of Multiple Properties
  • Distributions of Encumbered Property
  • Liquidating Distributions – Proportionate
    • In General
    • Recognition of Loss
    • Series of Distributions
    • Basis in Property Received
  • Holding Period of Distributed Property
  • Sale of Distributed Property
  • Disproportionate Distributions – Distribution of “Hot” Assets
  • General
  • Section 751(b) – Disproportionate Distributions
    • Mechanics
    • Filing Requirements
  • Death or Retirement of a Partner from Professional Services Partnerships or LLCs – Application of Section 736
    • General Application of Section 736
    • Structuring the Transaction to Avoid Section 736
• Chapter 3 - At-Risk and Passive Activity Limits
  • Learning Objectives
  • Overview
    • Statutory Limitations on the Deductibility of Losses
    • Disallowed Losses are Carried Forward
  • Basis and At-Risk Limitations
    • The Concept of Tax Basis as a Limit to the Deductibility of Losses
    • Accounting for Indebtedness
    • Nonrecourse Debt
    • At-Risk Rules of Section 465
  • Passive Loss Limitations
    • General
    • Passive Activity Losses
    • Passive Activity Credits
  • Gross Income from Passive Activities
    • Gain from Sale or Disposition of Property
    • Gain from Sale of an Interest in a Partnership or LLC
    • Special Rule for Substantially Appreciated Property
  • Passive Activity Deductions
  • Who Is Subject to the Passive Loss Limitations?
  • What Are Passive Activities?
    • Material Participation
    • What Constitutes Participation?
    • Rental Activities
    • Real Estate Professionals
    • Exemption for Rental Activities in which Taxpayer “Actively” Participates
    • Modified Adjusted Gross Income
  • Activities that Are Not Passive Activities
    • Re-characterization of Passive Activities as Nonpassive
  • Rules of Application
    • Installment Sales
    • Gifts
    • Dispositions by Death
  • Grouping Activities
    • Appropriate Economic Units
    • Limitations on Grouping Certain Activities
    • Consistency Is Required
• Chapter 4 - Allocation of Partnership Liabilities Under Sec. 752
  • Learning Objectives
  • Introduction – How Liabilities Affect Partner Tax Consequences
    • Basic Concepts
    • Transactions that Change a Partner’s Share of Partnership Liabilities
    • Effect of Liabilities on Partners’ and LLC Members’ Amounts at Risk
  • Allocation of Liabilities in General
    • Recourse vs. Nonrecourse Liabilities
  • Allocation of Recourse Liabilities
    • General Rules – “Constructive Liquidation”
    • Limited Partners
    • Book vs. Tax Capital Accounts
    • Effect of Partner Guarantees
    • Special Allocations of Partnership Income and Loss
  • Allocation of Nonrecourse Debts
    • Conceptual Difficulties in Allocating Nonrecourse Liabilities
    • Nonrecourse Liabilities Allocated by Reference to Partners’ Profits Interests
    • Minimum Gain
    • Tax vs. Book Minimum Gain
    • Other Partnership Profits
  • Allocation of Deductions Attributable to Nonrecourse Debt
    • Overview
    • Nonrecourse Deduction Defined
    • General Requirements for Economic Effect
    • Consistency with Other “Significant” Items
    • Minimum Gain Chargeback
• Chapter 5 - Adjustments to the Basis of Partnership/LLC Assets
  • Learning Objectives
  • Introduction
  • Section 743 – Adjustments Following the Transfer of a Partnership Interest
  • Distributions of Partnership Property
    • Situation 1 – Gain Recognized by Distributee Partner
    • Situation 2 – Loss Recognized by Distributee Partner upon Distribution of Partnership Property
    • Situation 3 – Increase or Decrease in Basis of Assets Distributed in Complete Liquidation of a Partner’s Interest
    • Situation 4 – Decrease in Basis of Partnership Assets Distributed in Partial Liquidation of a Partner’s Interest
  • Allocating the Adjustment Amount Among Partnership Properties
    • Transfers of Partnership Interests
    • Income in Respect of a Decedent
    • Partnership Goodwill
    • Distributions of Partnership Property
    • Section 751(b) Distributions
    • Making the Section 754 Election
    • Relief When Election Not Made
• Chapter 6 - Sale of an Interest in a Partnership or LLC
  • Learning Objectives
  • General Tax Consequences Associated with Sale
    • Effect of Liabilities
    • Receipt of Property other than Cash
    • Holding Period of Partnership Interest
  • Hot Assets and Section 751(a)
    • Hot Assets under Section 751(a)
    • Rules of Application
    • Statement Must be Attached to Return
  • Collectibles and Unrecaptured Section 1250 Gain
    • Collectibles Gain
    • Unrecaptured Section 1250 Gain
  • Installment Sales
  • Potential for Termination of the Partnership
    • Technical Terminations under §708
    • Consequences
    • What Constitutes a Sale under §708?
  • Consequences to the Purchaser
• Chapter 7 - S Corp Basis and Losses
  • Learning Objectives
  • Introduction
  • Basis of Stock
    • Basis Cannot Be below Zero
    • Changes to Asset Basis Due to Business Credit and Recapture Can Affect Stock Basis
    • Income in Respect of a Decedent and Basis of Inherited Stock
    • Basis of Stock Received by Gift
    • Items Must Be Reported
    • Basis Is Reduced by Nondeductible Losses
  • When Basis Is Adjusted
    • S Corporation’s Year End
    • When Election to Use Normal Tax Accounting Rules Is Made
    • When Stock Is Disposed of during the Year
    • Carryover of Losses
  • Basis in Debt
    • Basis Reduction Applies to Debt Outstanding at Year-end
    • Restoration of Basis in Debt
    • Debt Basis Increases are Applied to Debt Held on First Day of the Year
    • Separate Corporate Debts
    • What Constitutes Basis in Debt
    • Debt Must Be to Shareholder
    • Guaranteed Loans
    • Payment on Guaranteed Note Provides Debt Basis
    • Substituting Shareholder’s Note
    • Debt Basis Arises only if Shareholder Experiences Economic Outlay
    • Pledging Stock as Collateral
    • Loan from Related Entity Generally Does Not Result in Debt Basis
  • Collections on Shareholder Loans
  • Stock Dispositions
    • Reduction of Basis of Individual Shares
    • Different Lots of Shares
  • Identity of Passthrough Losses
    • Losses That Exceed Basis
    • Order of Adjustments to Basis
    • Election to First Reduce Basis by Items of Loss or Deduction
  • Carryover after Termination of Election – The Post-Termination Transition Period
    • Basis Increases during the Post-Termination Transition Period
    • Definition of Post-Termination Transition Period
  • Worthless Stock
• Chapter 8 - S Corp Distributions
  • Learning Objectives
  • Introduction
  • Definition of Distribution
  • Self-Employment Tax
  • Reporting Distributions to Shareholders
    • Nondividend Distributions
    • Dividend Distributions
    • Property Distributions
  • Relationship of Pass-through Basis, and Distributions
  • Application of Distributions
    • Distributions If No AE&P
    • AE&P
    • Reduction of AE&P
    • Distributions If There Is AE&P
  • Accumulated Adjustments Account (AAA)
    • Changes in Asset Basis Due to Certain Business Credit and Recapture
    • AAA Is Reduced by the Full Amount of Loss or Deduction
    • AAA Can Have Negative Balance
    • Election to Reduce Basis by Loss Items First Does Not Apply to the AAA
    • Business Credit Recapture
    • LIFO Recapture
  • Order of Applying Distributions – If AE&P
    • Calculation of AAA, AE&P, and Basis Illustrated
    • Stock Basis or AAA Balance at Beginning of Year Can Be Distributed Free of Tax
    • Distributions When AAA Is Less than Zero
  • Distributions of Previously Taxed Income (PTI)
  • Property Distributions
    • Gain or Loss on Property Distributions
    • Appreciated Property
    • Non-Appreciated Property
  • Distributing AE&P to Eliminate Dividend Distributions and Avoid Passive Investment Income Problems
    • Election to Make a Deemed Dividend
    • Other Adjustments Account
  • Tracking AAA, OAA, and PTI on Form 1120S
  • AAA – Stock Redemption
  • Post-Termination Transition Period
  • Summary
• Chapter 9 - Latest Developments

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Chapter 1 - Tax Consequences of Formation of Partnerships, LLCs, and S Corporations

Learning Objectives

After completing this chapter, you should be able to

• Determine the tax basis of assets transferred to a partnership, LLC or S Corporation at formation;

• Understand the tax consequences of a transfer of liabilities to a partnership, LLC or S Corporation in connection with property transfers at formation; and

• Analyze the tax consequences of the exchange of an interest in a partnership or LLC for services.

Introduction

Over the past decade, there has been a business trend toward using pass-through entities (partnerships and S corporations) for small and medium size businesses in lieu of soleproprietorships and corporations. Between 1996 and 2006, partnership filings almost tripled, growing by 180% (Wheeler and Shumofsky, Statistics of Income Bulletin, Fall 2008: p. 129). The most recent data available for S corporation filings indicates that they grew by 36.3% from 1997-2003 (Luttrell, Statistics of Income Bulletin, Spring 2006, p. 91). The IRS reported in 2005 that income or losses reported by partners from partnerships were not accurate in approximately 15% of the cases reviewed (IRS Publication 3744, IRS Strategic Plan, Fiscal Year 2005). As a result of these factors, beginning in 2002 the IRS changed its processing procedures and began processing and matching 100% of K-1s. As a result, CPAs have since seen many more clients who had received notices from the IRS that the information on the client’s return did not match up with the information on the K-1 sent out by the partnership or S corporation.

Many of the taxpayers who receive such notices have accurately reported their income, but are the victims of glitches in the reporting and monitoring systems. For example, as of March 31, 2006, the IRS had issued 71,000 notices to taxpayers questioning whether they had properly reported their income from Schedule K-1 for tax year 2003. According to the IRS, many notices could have been avoided if taxpayers and/or their preparers had ensured that documentation was provided to show offsets they had taken against income related to Schedules K-1, and if they had ensured their entity’s Schedule K-1 information was accurate when the Schedules K-1 were originally filed. The percentage of such cases in which a notice is issued and the IRS auditor finds that no change to the taxpayer’s tax liability is required is fairly high. For example, almost 40% of 2003 audits involving reporting discrepancies related to Schedule K-1s resulted in no change in the taxpayer’s tax liability.

Some of the major causes of errors in reporting partnership and S corporation income are (1) improperly applying the passive activity rules and (2) improperly applying the basis and at-risk limitations. In fact, in News Release 2005-34 the IRS acknowledged the scope of the problem in these areas by offering the following two tips to recipients of Schedules K-1:

• Avoid netting or combining income against separately stated losses or expenses. Refer to Form 8582, Passive Activity Loss Limitation, for instructions on properly deducting passive activity losses. Ordinary business income should be reported separately from other related deductions, such as unreimbursed partnership expenses or Section 179 expenses. Refer to the Schedule E instructions for information on properly accounting for deductions related to Schedule K-1 income.

• Report deductible “At Risk” or Basis Limitation losses carried forward from prior years on a separate line from current year transactions. Do not combine (net) them with any current year amounts.

The importance of these issues in the audit of a partnership or a partner can be deduced from the priority given them in the IRS’s Partnership Audit Technique Guide, where many of these issues are covered in Chapter 2 – Capital Accounts, Basis, and Liabilities. Following are just a few of the examination techniques outlined in that chapter:

1. “Request a basis calculation, if it appears that there is insufficient basis for losses, distributions, etc.”

2. “Review the Schedule M-2 to ensure it reflects the changes in the partnership capital accounts. The Schedule M-2 would reflect the amount of cash or the net FMV of property contributed during the year. It is also increased for the allocation of partnership income, including tax-exempt income or gain. It is decreased for any cash distributed to a partner. Remember that cash distributed in excess of outside basis is a taxable gain. IRC section 731(a). It is also decreased for the net FMV of property distributed.”

3. “Reconcile the partner’s share of items on Schedule K with the partner’s Schedule K-1.”

4. “Determine if there was IRC Section 704(c) property contributed to the partnership. The book capital accounts and the tax capital accounts should reflect a different value for the contributed property.”

5. “Review subsequent transactions to determine if the pre-contribution gain or loss should be recognized.”

Following is a list of documents the agents are instructed (in Chapter 2 of the Audit Technique Guide) to request, and which the partnership should have on hand:

1. Partnership agreement and all amendments;

2. Partnership books and records (that is, working trial balance, depreciation schedules, income statements, balance sheets, general ledger, etc.);

3. Prior and subsequent year partnership tax returns;

4. Current year financial statements;

5. Partnership book capital account calculations;

6. Partner basis calculations (if the quick test reveals lack of basis);

7. Copies of all loan documents including, but not limited to, promissory notes, deeds of trust, mortgages, loan payment histories, loan guarantees, and/or loan indemnification agreements;

8. Calculations of adjusted basis in property contributed; and

9. Proof of ownership by the partnership in property contributed.

As can be seen from the above items, an audit of a partner or partnership can involve some very complicated issues and items. This first chapter of this course will help CPAs meet their client’s needs in this area by introducing them to the rules concerning (or refreshing their knowledge of) the correct computation of gain, loss, and basis in the formation of a pass-through entity. In most cases a partner or S corp shareholder will take a basis in the partnership interest or S corp stock equal to the basis of the property (including money) he or she contributed to the entity in exchange for that interest. This computation can of course be complicated if the partner does not have adequate records to substantiate the basis of the assets that were contributed. Changes to the basis of the asset before its contribution, such as depreciation or improvements, must also be taken into account and documented in order to provide support for the partner’s or shareholder’s basis in the partnership interest or stock. Any of the partner’s or shareholder’s liabilities assumed by the partnership or S corporation must be subtracted from the tax basis of the interest in the partnership or corporation, so the correct amount of those liabilities must also be recorded and substantiated. For partnerships (but not S corporations), the partners’ bases in their partnership interests include their shares of partnership debts. Thus, it is important to properly determine each partner’s share of partnership liabilities. In some cases the calculation of that share involves a fairly complicated series of hypothetical steps, and begins with the balance in the partner’s capital account.

Chapter 2 explains the treatment of distributions from partnerships. With 100% matching of K- 1’s in effect, these distributions are more and more likely to be scrutinized by the IRS. Like contributions to partnerships, distributions are often nontaxable transactions. However, distributions can present situations where the computation of the basis of distributed assets is difficult at best. Different rules sometimes apply if cash or unrealized receivables are distributed than apply if other types of assets are distributed. Taxable distributions can result if the distribution can be treated as a disguised sale or if the distribution is associated with a change in a partner’s interest. In such cases, the recognition of ordinary income might even be required.

The limitations on the deductibility of partnership losses by partners are addressed in Chapter 3. Since many partners invest in partnerships in anticipation of certain tax benefits, the limitations on the ability to deduct partnership losses are often critical, but sometimes overlooked by partners. Chapter 3 begins with an explanation of how the amount of partnership losses a partner can deduct is limited to the basis (including the partner’s share of liabilities) that he has in the partnership. Any losses not allowed under this rule are carried over indefinitely, until more basis in the partnership interest is acquired by the partner. Similarly, any losses that pass the basis limitation are only deductible to the extent that the partner is at-risk with respect to the partnership, and any suspended at-risk losses are also carried over until the partner can become more at-risk with respect to the partnership. Finally, any losses from a passive activity, including partnerships in which the partner does not materially participate, are deductible only up to the partner’s passive income from other sources.

The correct allocation of recourse and nonrecourse debt, crucial in determining the basis of a partner’s partnership interest and therefore the amount of partnership losses she can deduct, is examined in Chapter 4. The calculations associated with adjustments to the basis of partnership property when a Code Section 754 election is in effect are explained in Chapter 5. Chapter 6 covers in detail the tax consequences of the sale of a partnership interest. Frequently a partner will report only capital gain on the sale of a partnership interest, and will be surprised to learn that they also must recognize ordinary income as well.

Chapters 7 and 8 cover some of the same types of issues as the first six chapters, only they cover them as they relate to S corporations rather than partnerships. Partnerships and S corporations are both pass-through entities, but the tax treatment of various transactions for the two entities can be treated very differently, depending on the transaction involved. The basis of S corporation shares, for instance, carries over from the basis of the assets contributed by the shareholder just as in Subchapter K, but under Subchapter S, stock basis does not include the shareholder’s share of the S corporation’s liabilities. Similarly, the distribution of appreciated property from an S corporation to a shareholder is generally a fully taxable transaction, whereas most distributions from partnerships are nontaxable transactions.

This chapter begins with an overview of the consequences of formation of a pass-through entity. We begin with a discussion of the tax consequences associated with formation of a partnership. These consequences are then compared to those associated with formation of an S corporation. Finally, the chapter discusses the tax consequences arising when a partner or shareholder receives his/her interest in the entity in exchange for services.

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