Module 24 Flow-Through Entities: Basis Issues

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Module 24Flow-Through Entities Basis Issues
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Menu

• 1. Computation of a partners basis in a
  partnership interest
• 2. Termination of a partnership interest
• 3. Computation of an S corporation
  shareholders basis in S corporation stock
• 4. Termination of an S corporation
  shareholders interest

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Computation of a Partners Basis in a Partnership
Interest

• Key Learning Objectives
• Acquisition of an interest in a partnership
• Partnership liabilities
• Changes in a partnership interest as a result of
  partnership operations
• Impact of nonliquidating distributions on a
  partnership interest

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Partners Partnership InterestOutside Basis

• Intangible asset representing ownership
• Similar to corporate stock
• Partnership interest must have a non-negative
  basis
• Partnership interest basis includes partners
  share of partnership liabilities
• Generally considered a capital asset

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Partners Original Partnership Interest Basis

• Cash contributed
• Plus Basis of non-cash assets contributed
• Plus Any service gain recognized
• Note NO adjustment for any liabilities gt basis
  gain recognized
• Plus Other partners liabilities assumed by new
  partner
• Minus New Partners liabilities assumed by
  other partners

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Post-Formation Adjustments to Partners
Partnership Interest Basis

• Increases to basis
• Additional contributions by partner
• Partners share of any increase in
  partnership liabilities
• Partners share of partnership income
  items

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Post-Formation Adjustments to Partners
Partnership Interest Basis

• Decreases to basis
• Distributions to partners
• Partners share of any
  decrease in partnership liabilities

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Partnerships Basis in Contributed Assets--Inside
Basis

• Carryover basis for assets transferred in
• Depreciation recapture potential and holding
  periods also carryover to partnership
• Add any investment company gain recognized by
  partner
• No adjustment for liabilities gt basis gain
  recognized

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Categories of Distributions

• Nonliquidating (current)
• Liquidating

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751 Hot Assets

• These assets produce ordinary income
• They can affect both partnership distributions
  and sales of a partnership interest
• Two kinds
• (1) Unrealized receivables
• (2) Substantially appreciated inventory

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Unrealized Receivables

• Always hot
• Includes
• Accounts receivable of cash method
  partnership
• Depreciation recapture items

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Substantially Appreciated Inventory

• Hot only if aggregate FMV of inventory items
  exceeds 120 of their aggregate basis
• Broad definition
• All assets other than cash, capital assets, and
  1231 assets

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Current Distributions

• Three tiers of property
• Deemed distributed in this order
• Cash
• Unrealized receivables and inventory
• Other property

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Effect on Partner-- Current Distribution

• No gain recognized unless cash distributed
  exceeds partners predistribution partnership
  interest basis
• Exception disproportionate distribution of
  hot assets (discussed later)
• NOTE reduction of a partners share of
  partnership liability deemed cash
  distribution
• A loss is never recognized

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Effect on Partner-- Current Distribution

• Distributed tier two and tier three properties
  have a carryover basis to the partner
• However, basis carried over cannot exceed
  partners remaining partnership interest basis
• Allocation of bases is necessary if multiple
  assets are distributed within a tier
• Distributions reduce a partners partnership
  interest basis, but never below zero

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Effect on Partnership-- Current Distribution

• No gain or loss recognized
• Exception disproportionate distributions of hot
  assets
• Partnership may be entitled to a basis adjustment
  if
• Gain is recognized by the partner
• Basis disappears

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Termination of a Partnership Interest

• Key Learning Objectives
• Involuntary termination
• Voluntary termination
• Sale or exchange
• Abandonment
• Liquidation of a partnership
• Liquidation of a partnership interest
• Merger/consolidation
• Conversion to limited liability company

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Involuntary TerminationClose of Tax Year

• Sale of gt 50 capital within 12 months
• Partnership ceases to do business
• Causes loss of tax attributes
• Deceased partner
• Successor in interest steps into deceaseds
  shoes, so no close of tax year
• Successors partnership interest basis equals FMV
  of interest at date of death

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Voluntary TerminationClose of Tax Year

• Partnership year closes with respect to partner
  IF
• Liquidation or sale of entire interest
• Gift of interest

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Sale of a Partnership Interest

• Amount realized
• - partnership interest basis
• Gain or loss realized
• Amount realized includes
• Cash
• FMV of property
• Any partnership liabilities assumed by
  the new partner

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Sale of a Partnership Interest

• Gain or loss is generally capital
• Exception hot assets generate ordinary income
• New partner may be entitled to a basis adjustment
• Adjustment is with respect to new partner only

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Liquidating Distributions

• Liquidation refers to the termination of a
  partners interest
• Do not confuse this with the partnership
  liquidating, although it may be

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Liquidating Distributions

• Three tiers of property
• Deemed distributed in this order
• Cash
• Unrealized receivables and inventory
• Other property

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Effect on Partner-- Liquidating Distribution

• No gain recognized unless cash exceeds partners
  predistribution basis
• Exception disproportionate distributions of hot
  assets
• Partner may recognize a loss, if other property
  is not distributed
• If tier three property is distributed, any
  remaining basis is assigned to it
• Substituted rather than carry over basis

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Effect on Partnership--Liquidating Distribution

• No gain or loss recognized
• Exception disproportionate distributions of hot
  assets (discussed later)
• Partnership may be entitled to a basis adjustment
  if
• Gain or loss is recognized by the
  partner, or
• Basis disappears or is created

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Cash Payments Due to Retirement or Death of a
Partner

• Payments for property
• Payments for hot assets generate ordinary income
• Other payments
• Either distributive shares or
• Guaranteed payments
• For service partnerships, other
  payments include payments for
  unrealized receivables and goodwill

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Disproportionate Distributions

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

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Disproportionate DistributionsTwo Step Analysis

• To determine gain/loss recognize
• When fictional steps 1 and 2 are combined,
  results should reflect the actual distribution

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Disproportionate DistributionsStep 1

• Pretend that the partner received a proportionate
  liquidating distribution
• This is a tax-free transaction
• Partner has a carryover basis for each asset

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Disproportionate DistributionsStep 2

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

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

• Refer to the previous slide
• If X sells her interest to W for 25,000 cash
• What are the tax consequences
• To partner X
• To partner W

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Solution--In Class ExerciseSale of a
Partnership Interest

• For X
• Amount realized 25,000
• Basis 16,000
• Gain 9,000
• 3,000 of the gain is ordinary
• Xs share of built-in gain for the inventory
• The remaining 6,000 of the gain is capital

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Solution--In Class ExerciseSale of a
Partnership Interest

• For W
• Ws outside basis in his partnership interest
  is 25,000
• Without special election by partnership, his
  inside basis is 16,000

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In Class Exercise Liquidation of Partnership
Interest

• Using the facts of the last exercise
• What are the tax consequences if the partnership
  liquidates Xs interest for 10,000 cash and
  15,000 FMV inventory?
• Note that this is a disproportionate liquidation
  because X did not receive exactly her one-third
  share of the hot assets

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Solution--In Class Exercise Liquidation of
Partnership Interest

• Step 1
• Assume equal liquidating distribution
• Pretend that X received one-third of each asset
• See next slide

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Solution--In Class Exercise Liquidation of
Partnership Interest
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Solution--In Class Exercise Liquidation of
Partnership Interest

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

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Solution--In Class Exercise Liquidation of
Partnership Interest

• Amount realized 9,000
• 4,000 cash 5,000 inventory
• Basis 3,000
• Basis of land given up
• Gain realized 6,000

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Solution--In Class Exercise Liquidation of
Partnership Interest

• The entire gain is a 1231 gain from the sale
  of land
• X holds 15,000 FMV of inventory
• Basis of 12,000
• 7,000 from step 1
• 5,000 from step 2
• She will realize 3,000 of ordinary income when
  she sells the inventory

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Computation of an S Corporation Shareholders Tax
Basis

• Key Learning Objectives
• Acquisition of S corporation stock
• Shareholder loans to an S corporation
• Changes to basis as a result of operations
• Changes to basis as a result of distributions
• Summary

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Acquisition of S Corporation Stock

• The tax consequences of the incorporation of an S
  corporation follows the regular C corporation
  rules and were covered in Module 6
• Purchase of stock of existing S corporation
• No immediate tax consequences
• Cost becomes shareholders basis

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Shareholder Loans to S Corporation

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

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Shareholder Loans to S Corporation

• Loan must be
• Made directly from shareholder to corporation
• A bona fide indebtedness
• Written note specifying a
• Principal sum to be repaid
• A rate of interest
• A term loan or a demand loan

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Changes to Basis as a Result of Operations

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

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Changes to Basis As a Result of Distributions

• Cash reduces basis
• S corp uses the corporate rules when making
  property distributions to its shareholders
• The distribution of appreciated property to an S
  shareholder is deemed a sale by the corporation
• Gain is reported by shareholders

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Termination of an S Corporation Shareholders
Interest

• Key Learning Objectives
• Termination of S corporation election
• Termination of shareholders ownership interest
• Termination of an S corporation

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Voluntary Termination of S Corporation Election

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

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Involuntary Termination of S Corporation Election

• Election may be revoked because of a
  disqualifying event
• The corporation ceases to be a small business
  corporation OR
• The corporation has accumulated earnings and
  profits AND
• Passive investment income gt 25 of gross receipts
  for three consecutive tax years

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Termination of Shareholders Interest

• By sale, abandonment, or redemption
• An unused S corporation loss carryover disappears

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Termination of S Corporation

• By selling off its assets and distributing the
  proceeds to its shareholders
• A liquidation
• By being absorbed by another corporation
• A merger or consolidation