Exam 3

Apple Union (AU), a C corporation with a March 31 year-end, uses the accrual method of accounting. If AU elects to be taxed as an S corporation, what will its year-end and method of accounting be (assuming no special elections)?

AU can continue to use the accrual method of accounting, but the company's year-end will change to December 31 because S corporations must use a calendar year end unless they can establish a business purpose for an alternative year end or a natural business year end.

How do partners determine whether they are passive participants in partnerships when applying the passive activity loss limitation rules?

According to the Code, a partner is considered to be a passive participant if the activity conducted is a trade or business and the partner does not materially participate in the activity. The IRS has made it clear that those participants in rental activities and limited partners within a partnership are automatically considered to be passive participants. Further, regulations help clarify whether a partner would be considered a material participant. If the partner meets any of the conditions below, then the partner would be a material participant and the activity would not be considered a passive activity to the partner. 1. The individual participates in the activity more than 500 hours during the year. 2. The individual's activity constitutes substantially all of the participation in such activity by individuals. 3. The individual participates more than 100 hours during the year and the individual's participation is not less than any other individual's participation in the activity. 4. The activity qualifies as a "significant participation activity" (individual participates for more than 100 hours during the year) and the aggregate of all other "significant participation activities" is greater than 500 hours for the year. 5. The individual materially participated in the activity for any 5 of the preceding 10 taxable years. 6. The activity involves personal services in health, law, accounting, architecture, and so on, and the individual materially participated for any three preceding years. 7. Taking into account all the facts and circumstances, the individual participates on a regular, continuous, and substantial basis during the year.

What adjustments are made annually to a shareholder's basis in S corporate stock and in what order? What impact do these adjustments have on a subsequent sale of stock?

Adjustments to basis are made in the following order; increased for contributed capital, ordinary business income and separately stated income/gain items (including tax-exempt income); decreased for distributions made throughout the year, non-deductible expenses, and ordinary business losses and separately stated expense/loss items. These adjustments will determine the shareholder's adjusted basis in the S corporation stock, which will be subtracted from sales price to determine the gain or loss on the sale of the stock. Reg. § 1.1367-1(g) allows a shareholder to elect to decrease basis by ordinary business losses and separately stated expense/loss items before decreasing basis by nondeductible expenses by attaching a statement to the shareholder's tax return. This election is advantageous because loss/expense deductions are limited to a shareholder's basis, and this election results in a higher basis limitation for deductible loss/expense items.

In general terms, how are C corporations different from and similar to S corporations?

All corporations, both S and C Corporations, are incorporated under state law and thus have the same legal protections. S corporations are governed by the same corporate tax rules that apply in the organization, liquidation, and reorganization of C corporations. Legally speaking, S corporations are identical to C corporations. However, because an S corporation has made the election to be taxed under subchapter S of the Internal Revenue Code, S corporations are different from C corporations for tax purposes. Unlike a C corporation, an S corporation is a flow-through entity and shares many tax similarities with partnerships. For example, basis calculations for S corporation shareholders and partners are similar, the income or loss of an S corporation flows through to its owners, and distributions are generally not taxed to the extent of the owner's basis.

Why must an S corporation report separately stated items to its shareholders? How is the character of a separately stated item determined? How does the S corporation report this information to each shareholder?

An S corporation must separately state those items that are taxed differently than ordinary business income (loss) to shareholders so that the items are reported correctly and receive the appropriate tax treatment on each shareholder's tax return. The character of a separately stated item is determined at the corporate level, and the information is reported to the shareholder on his or her specific schedule K-1.

What is inside basis and outside basis, and why are they relevant for taxing partnerships and partners?

An inside basis, in relation to partnerships, is the basis the partnership takes in the assets that the partnership holds. An outside basis, in relation to partnerships, is the tax basis each partner has in the partnership. The inside basis is necessary to compute the gain/loss recognized on all property sold by the partnership. The outside basis is necessary to compute the gain/loss recognized on the partnership interest when sold. For tax purposes, the inside basis is similar to the basis the partner had in the property prior to contribution. On the other hand, the outside basis corresponds not only to the contributed property, but also to the debt and income/losses of the partnership that have been allocated to the individual partners.

What role does debt basis play in determining the taxability of operating distributions to shareholders?

Debt basis plays no role in determining the taxability of operating distributions. Only stock basis is considered to determine the taxability of operating distributions.

How do S corporations report dividends they receive? Are they entitled to a dividends received deduction? Why or why not?

Dividends that are received by the S corporation are reported as a separately stated item to each owner. The S corporation is not entitled to the dividends received deduction because the dividends flow directly through the company to the owner. Therefore, since the S corporation will not pay a tax on the dividend it would not qualify for the dividends received deduction.

What is a flow-through entity, and what effect does this designation have on how business entities and their owners are taxed?

Entity is not taxed on the entity level, rather they are taxed on the owner's level. These types conduct a regular business, but the income earned and deductions allowed are passed to the owners of these flow-through entities. The owners are then taxed on the amount allocated to them. Flow through entities provide a way for income and deductions to be taxed only once instead of twice.

How do the tax laws treat family members for purposes of limiting the number of owners an S corporation may have?

Family members and their estates count as one shareholder for the 100 shareholder limit. Family members include a common ancestor (not more than 6 generations removed) and her lineal descendants and their spouses (or former spouses). Under this broad definition, great- grandparents, grandparents, parents, children, brothers and sisters, grandchildren, great- grandchildren, aunts, uncles, cousins and the respective spouses are family members for this purpose.

How do the tax consequences of S corporation liquidating distributions differ from the tax consequences of S corporation operating distributions at both the corporate and shareholder levels?

For operating distributions, S corporations recognize gain but not loss on property distributions and neither gain nor loss on cash distributions. Operating distributions are tax free to the shareholder up to his or her stock basis. Amounts in excess of the stock basis are taxed as capital gains. In contrast, with a liquidating distribution the S corporation recognizes gains or losses on each asset that is distributed and that gain or loss increases or reduces the owner's stock basis. On the shareholder level, the owners recognize a gain or loss depending on their stock basis in relation to the value of property received.

JB Corporation is a C corporation owned 80 percent by Jacob and 20 percent by Bauer. Jacob would like JB to make an S election but Bauer is opposed to the idea. Can JB elect to be taxed as an S corporation without Bauer's consent? Explain.

JB Corporation is a C corporation owned 80 percent by Jacob and 20 percent by Bauer. Jacob would like JB to make an S election but Bauer is opposed to the idea. Can JB elect to be taxed as an S corporation without Bauer's consent? Explain.

On June 1, year 1, Jasper Corporation's S election was involuntarily terminated. What is the earliest Jasper may be taxed as an S corporation again? Are there any exceptions to the general rule? Explain.

Jan 1, year 6 would be the earliest that Jasper Corporation could reelect S corporation status. After terminating or voluntarily revoking S corporation status, the corporation must wait to reelect S corporation status until the beginning of the fifth tax year after the tax year in which it terminated the election. The IRS may consent to an earlier election under a couple of conditions: (1) if the corporation is now owned more than 50 percent by shareholders who were not owners at the time of termination, or (2) if the termination was not reasonably within the control of the corporation or shareholders with a substantial interest in the corporation and was not part of a planned termination by the corporation or shareholders.

Karen is the sole shareholder of a calendar year-end C corporation she formed last year. If she elects S corporation status this year on February 20, when will the election become effective and why? What if she had made the election on March 20?

January 1, current year; since the election was made on or before the 15th day of the third month of the year the status can take effect as of the beginning of the year. If Karen had waited until March 20th, the election would not take effect until the beginning of the next year.

Joey is a 25% owner of Loopy LLC. He no longer wants to be involved in the business. What options does Joey have to exit the business?

Joey's two most common options are to sell or exchange his interest in the LLC to a third party or to have the LLC liquidate his interest. Joey may also exchange his interest for corporate stock, give the interest away, or transfer the interest upon his death

Juanita is the sole shareholder of Belize Corporation (a calendar-year S corporation). She is considering revoking the S election. It is February 1, year 1. What options does Juanita have for timing the effective date of the S election revocation?

Juanita can choose to have the election terminated as of the beginning of year 1 as long as the termination is made by March 15th (calendar year S corporation). If the election is made after March 15th the effective date would be the beginning of the following year; however, she can choose a specific termination date as long as it is on or after the election date.

What happens to partnership losses allocated to partners in excess of the tax basis in their partnership interests?

Losses that are allocated to partners that exceed the partner's tax basis cannot be used during the current taxable year. The excess loss will be suspended and carried forward indefinitely until the partner has sufficient basis to utilize the losses. A partner would be able to increase her/his tax basis by (1) making a capital contribution, (2) guaranteeing more partnership debt, or (3) helping the partnership become more profitable. Once the partner's tax basis is positive, the losses previously suspended can be used.

Describe the circumstances in which an S election may be involuntarily terminated.

A failure to meet the S corporation requirements will result in the termination of the S election. This includes exceeding the 100 shareholder limit or ownership by ineligible shareholders (such as a corporation or nonresident alien). The S election will also be terminated if the corporation has excess passive investment income (over 25 percent of gross receipts) for three consecutive years and has prior earnings and profits from previous operation as a C corporation.

When might a new partner have an upward basis adjustment following the acquisition of a partnership interest?

A new partner will have an overall upward basis adjustment when he purchases an interest in the partnership for an amount greater than his inside basis immediately following the acquisition. Although the overall basis adjustment results in an increase in asset bases, it is possible for some individual asset bases to decrease if the asset has declined in value while held by the partnership.

Under what circumstances can partners with passive losses from partnerships deduct their passive losses?

A partner may deduct the passive losses she/he has generated from a partnership under three circumstances. First, a passive loss is not deductible until the taxpayer generates current year passive income in the activity producing the loss. Second, a passive loss is not deductible until the taxpayer generates current year passive income from another passive activity the taxpayer is involved with. Last, a passive loss will not be deductible unless the taxpayer sells the activity that has produced the passive loss. In this case, the taxpayer will report a gain or loss on the sale and can use the passive loss to offset this or any other source of income (i.e., active income, portfolio income, or other passive income).

Under what circumstances can a partner recognize both gain and loss on the sale of a partnership interest?

A partner may recognize both gain and loss on the sale of a partnership interest in the situation where a partner's share of the unrealized gain in hot assets is greater than his total gain or loss on the sale of his partnership interest.

Under what circumstances will a partner recognize a loss from an operating distribution?

A partner never recognizes loss from operating distributions.

How does the amount of debt allocated to a partner affect the amount of gain a partner recognizes when contributing property secured by debt?

A partner that contributes property secured by debt is not only contributing the property to the partnership but also the debt. The partner's tax basis in his or her partnership interest would be increased by the basis of the assets contributed. Next, the property's debt is allocated to each partner according to who is ultimately responsible for it or by each partner's profit-sharing ratio. The basis of the contributed assets plus the allocation of debt would represent the partner's tax basis in the partnership immediately before the deemed distribution of cash as a result of the relief of debt attached to the contributed property. If the partner is not allocated enough debt, the partner's outside basis will become negative and a gain must be recognized. Thus, a partner can only avoid gain by being allocated enough of the partnership debt to keep her/his basis at least above zero.

How do partners measure the amount they have at risk in the partnership?

A partner will measure her/his partnership at-risk amount by looking at what items affect the partner's economic risk of loss. In most cases, items included in the at-risk amount would include cash contributed, tax basis of property contributed, recourse debt, qualified nonrecourse debt, and any other adjustments to the partner's tax basis excluding nonrecourse debt. Nonrecourse debt is considered a part of the tax basis but not a part of the at-risk basis since the partner does not have an economic risk of loss for this type of debt.

Theodore, Alvin, and Simon are equal shareholders of Timeless Corp. (an S corporation). Simon wants to terminate the S election, but Theodore and Alvin disagree. Can Simon unilaterally elect to have the S election terminated? If not, what would Simon need to do to have the S election terminated?

Simon cannot voluntarily terminate the S election because he does not own more than 50 percent of the corporation. However, Simon could have the S election "involuntarily" terminated by selling some of his stock to an ineligible shareholder (such as a corporation, partnership or nonresident alien) or by contributing his stock to a partnership.

When an S corporation shareholder has suspended losses due to the tax-basis or at- risk amount limitation, is he allowed to deduct the losses if the S corporation status is terminated? Why or why not?

Suspended losses are generally not deductible after the S corporation status is terminated. However, there is a post-termination transition period (PTTP) that allows shareholders to utilize suspended losses. The transition period starts on first day after the last day of the tax year as an S corporation and ends the latter of (1) one year after the S corporations last day or (2) the due date for filing the last return of the S corporation (including extensions). This rule allows the shareholder to create additional stock basis (by making additional capital contributions) during the PTTP and to utilize suspended losses based on her stock basis (not her debt basis) at the end of the period. Any suspended losses utilized at the end of the PTTP reduce the shareholder's basis in her stock. Any losses not utilized at the end of the period are lost forever.

What does the accumulated adjustments account represent? How is it adjusted year by year? Can it have a negative balance?

The AAA represents the cumulative income or losses for the period the corporation has been an S corporation. It is calculated as: The beginning of year AAA balance + Separately stated income/gain items (excluding tax-exempt income) + Ordinary income - Separately stated losses and deductions - Ordinary losses - Nondeductible expenses that are not capital expenditures (except deductions related to generating tax-exempt income) - Distributions out of AAA = End of year AAA balance Unlike a shareholder's stock basis, the AAA may have a negative balance. However, the reduction for distributions may not cause the AAA to go negative or to become more negative. Note that if current year income and loss items net to make a negative adjustment to the AAA, the net negative adjustment from these items is made to the AAA after any AAA reductions for distributions (that is, the reduction in AAA for distributions is made before the net negative adjustment for current year income and loss items).

Describe a situation in which a former C corporation that elected to be taxed as an S corporation may have its S election automatically terminated, but a similarly situated corporation that has always been taxed as an S corporation would not.

The S election is terminated when an S corporation has earnings and profits from prior C corporation operations and has passive investment income in excess of 25 percent of gross receipts for three consecutive years. The S election termination for excess passive investment income does not apply to an S corporation that has never been taxed as a C corporation.

Compare and Contrast the aggregate and entity concepts for taxing partnerships and their partners.

The aggregate concept treats partnerships more like a conglomeration of individual owners. Each partnership is viewed as an aggregation of the partner's separate interests in the assets and liabilities of the partnership. For Example, each partner, rather than the partnership, pays tax on their individual share of partnership income. The entity concept treats partnerships more like a corporation. Each partnership is an entity separate from its partners. For example, the partnership decides on which tax method to use and which tax elections to make rather than the individual partners.

When a corporation's S election is terminated mid-year, what options does the corporation have for allocating the annual income between the S corporation short year and the C corporation short year?

The allocation can be made using the daily method or the specific identification method. The daily method allocates income for the full year between the S and the C corporation years, using the number of days in each short year. The specific identification method uses the corporation's normal accounting rules to allocate income to the actual period in which it was earned. Use of the specific identification method requires that all shareholders at any time during the S corporation short year and the shareholders on the first day of the C corporation short year to consent to the election using the specific identification method. However, an S corporation must use the specific identification method to allocate income between the short years (the per day allocation method is not allowed) if there is a sale or exchange of 50 percent or more of the corporation's stock during the year.

Why is a shareholder's basis in an S corporate stock adjusted annually?

The annual adjustment is required to prevent income or losses from being double-counted (i.e., double-taxed or double-deducted) by shareholders either when they sell stock or receive distributions, and to ensure that tax-exempt income and non-deductible expenses are not ultimately taxed or deducted.

Can a partnership have unrealized receivables if it has no accounts receivable?

The definition of unrealized receivables is broad enough to encompass assets other than accounts receivable. §751(a) also includes assets that are NOT capital assets or §1231 assets that would produce ordinary income if sold by the partnership. Items such as depreciation recapture are also classified as unrealized receivables. Thus, a partnership can have unrealized receivables without having accounts receivable.

If a corporation has been an S corporation since inception, describe how its operating distributions to its shareholders are taxed to the shareholders.

The distributions are tax-free as long as they do not exceed the shareholder's stock basis in the corporation. Amounts in excess of the stock basis are taxed as capital gains.

What items will DECREASE a partner's basis in her partnership interest?

The following items will decrease a partner's basis and must be adjusted for on an annual basis in the order given. These items will be adjusted after all the increases to a partner's basis have been taken into effect. 1. Actual and deemed cash distributions from the partnership 2. Partner's share of non-deductible expenses (fines, penalties, etc.) 3. Partner's share of ordinary business losses and 4. Partner's share of separately-stated expenses/loss items

What items will INCREASE a partner's basis in her partnership interest?

The following items will increase a partner's basis and must be adjusted for on an annual basis in the order given. 1. Actual and deemed cash contributions to the partnership 2. Partner's share of ordinary business income 3. Partner's share of separately-stated income/gain items and 4. Partner's share of tax-exempt income

Explain the least aggregate deferral test for determining a partnership's year end and discuss when it applies.

The least aggregate deferral test is the last resort test that a partnership must follow when figuring out the partnership year end. The first test is the majority interest test. The second test is the principal partners test. If these two tests don't apply, along with the exception to elect an alternative year end, then the least aggregate deferral test goes into effect. The least aggregate deferral test selects the tax year which provides the partner group as a whole the smallest amount of aggregate tax deferral. This is calculated by taking each partner's months of deferral under the potential tax year and weighting it with the partner's profit interest percentage. Then, each partner's weighted totals are summed up to come up with an aggregate deferral number. The potential tax year that produces the smallest aggregate deferral must be the one chosen by the partnership.

List two common situations that will cause a partner's inside and outside basis to differ.

The most common situations in which discrepancies between inside and outside bases occur are following sales of partnership interests and following distributions in which a partner receives more or less than her share of the inside basis in the partnership property.

In what order are the loss limitation rules applied to limit partner's losses from partnerships?

The order of the hurdles a partner must pass through for the loss limitation rules are (1) tax basis loss limitation, (2) at-risk loss limitation, (3) passive activity loss limitation, and excess business loss limitation. As the losses exceed the limitation in the tax basis, at-risk, and passive activity loss hurdles, the suspended losses will be carried forward indefinitely within each group until enough basis or income is generated to cover these losses. Excess business losses are treated by partners as net operating losses to be carried forward and utilized to the extent allowable in future years.

In general, what effect does an operating distribution have on the partnership?

The partnership does not generally recognize gain or loss for tax purposes when making an operating distribution. This contrasts with the tax treatment of corporate distributions in which the corporation recognizes gain or loss on distributions of property other than cash.

If a partner with a taxable year-end of December 31 is in a partnership with a March 31 taxable year-end, how many months of deferral will the partner receive? Why?

A partner with a calendar year end will receive nine months of deferral in her/his partnership interest that has a March 31 year end. A partner must report the income or loss of the partnership not at the partnership's year end but at the partner's year end. Thus, the first year of the partnership will be reported by the partner on her/his return which includes the partnership's year end. This allows the partner to defer the reporting of the first nine months of income or loss from the partnership into the succeeding tax year when the partner's income tax return is filed.

Why does a partner's tax basis in her partnership need to be adjusted annually?

A partner's tax basis needs to be adjusted annually for the following three reasons. First, a partner does not want to double count any income/gain from the partnership when she/he sells her/his partnership interest or receive a distribution from the partnership. Second, the IRS does not want partners to double count any expenses/losses from the partnership in a similar situation from above. Last, partners want to make sure they adjust for tax-exempt income and non-deductible expenses, so these items will not ultimately be taxed or deducted at the time of selling a partnership interest or receiving a distribution from the partnership.

Distinguish between a capital interest and a profits interest, and explain how partners and partnerships treat when exchanging them for services provided.

A partnership interest can be broken down into two distinct rights: (1) capital interest and (2) profits interest. To become a partner in a partnership, you will receive at least one of these rights. A capital interest is the right to receive a share of the partnership assets at liquidation. A profits interest is the right to share in the future earnings and losses of the partnership. While these rights are given to most partners that contribute cash or property, special rules exist when these rights are given to partners in exchange for services. When a partner receives a capital interest in exchange for services rendered to the partnership, the partner must treat the liquidation value of the capital interest as ordinary income. Further, the tax basis for the partner will be equivalent to the amount of ordinary income recognized. The holding period for this tax basis will begin on the date the capital interest is received. From the partnership's perspective, the partnership can deduct or capitalize the value of the capital interest depending upon the type of services rendered. This is determined on a fact and circumstance basis. Additionally, the amount deducted by the partnership is allocated to the non-service partners as consideration for effectively transferring a portion of their capital interest to the service partner. When a partner receives a profits interest in exchange for services rendered to the partnership, the partner has no immediate tax impact because the profits interest has no liquidation value at the time the interest is received. Thus, the non-service partners will not receive any deductions for adding the additional partner to the partnership. As the partnership makes future profits and losses, the service partner will be allocated her/his portion of these losses according to the profit sharing ratios. The debt allocated to non- service partners must also be redistributed with the additional service partner receiving her/his portion of debt. Therefore, the initial tax basis of a service partner with only a profits interest will either be zero or the portion of debt the partner is allocated (if any).

What is partnership interest, and what specific economic rights or entitlements are included with it?

A partnership interest is an equity interest in a partnership. This interest is created through a transfer or sale of cash, property, or services in exchange for an equity interest in the partnership. A partnership interest gives each partner certain rights or entitlements. The two main economic rights are a capital interest and profit interest in the partnership. A capital interest is the right for a partner to receive a share of the partnership assets during liquidation. A profit interest is the right or obligation for a partner to receive a share of the future income or losses of the partnership.

Why can't large, publicly traded corporations be treated as S corporations?

A publicly traded corporation could not elect S corporation status because it would not likely satisfy the maximum 100 shareholder limit required of S corporations.

What is a tax basis capital account, and what type of tax-related information does it provide?

A tax basis capital account is an equity account that is created for each partner of the partnership. This account is measured using the tax accounting rules. The account reflects tax basis of any capital contributions (i.e., property and cash), capital distributions, and future earnings and losses allocated to that partner. Additionally, a tax basis capital account can provide more tax-related information for each partner. For instance, each partner's share of inside basis of the partnership's assets can be calculated by adding the partner's share of debt to her/his capital account.

In what situation will there be a common year-end for the principal partners when there is no majority interest taxable year?

The principal partner test states that the required tax year is the taxable year all the principal partners have in common. A principal partner is a partner that owns at least 5 percent interest in the partnership profits and capital. For the principal partner test to pass and not the majority interest test, the partnership must consists of numerous partners that (1) own less than 5 percent profit and capital interest and (2) have a variety of fiscal year ends. For example, if four partners with a calendar year end owned 10 percent each and 20 additional partners with differing fiscal year ends owned less than 5 percent, then the majority test would not pass, but the principal partners test would.

What is the rationale for requiring partners to defer most gains and all losses when they contribute property to a partnership?

The rationale for requiring partners to defer most gains and losses when contributing property to a partnership is twofold. First, the IRS desires that entrepreneurs have a way to start their own business without having to pay any taxes upfront. Second, the partners are considered as still owning the property they have contributed to the partnership. While they don't own the property outright, each partner has a small percentage of the property contributed in her/his partnership interest she/he exchanged for. This second reasoning helps further support the idea that partnerships follow the aggregate concept.

What is a partnership's ordinary business income (loss) and how is it calculated?

Through the course of business, partnerships create income or losses. Some of these items are considered to affect a specific partner or groups of partners differently. Thus, these separately-stated items must be reported on a partner-by-partner basis. Then, after adjusting the partnership's business income (loss) for these separately-stated items, the partnership reports the remaining amount of business income (loss) to ordinary business income (loss). The total amount will be allocated to each partner according to the special allocation rules agreed upon or else based upon the profit sharing ratios of the partnership.

Under what circumstances will the gain or loss on the sale of a partnership interest be characterized as ordinary rather than capital?

To the extent that a gain or loss on the sale of a partnership interest is attributable to certain ordinary income assets held by the partnership, the gain or loss is ordinary. §751(a) defines the assets for which the gain or loss will be treated as ordinary.

When are partnerships mandated to adjust the basis of their assets (inside basis) when a partner sells a partnership interest or receives a partnership distribution?

Two cases require a mandatory special basis adjustment. First, when a partnership has a substantial built-in loss at the time of a sale of a partnership interest, the adjustment is required. A substantial built-in loss occurs when the partnership's adjusted basis in its assets exceeds the fair market value of the assets by more than $250,000. The second case where a mandatory special basis adjustment must be made is for distributions where there is a substantial basis reduction. A substantial basis reduction exists if the negative adjustments from a special basis adjustment exceed $250,000. Recall that negative basis adjustments only occur in liquidating distributions.

Compare and contrast the aggregate and entity approaches for a sale of a partnership interest.

Under the aggregate approach, the disposition of a partnership interest represents a sale of the partner's share of each of the partnership assets. This approach would require complex tax rules because the partner would need to allocate the sales proceeds among the different assets and determine the character of the gain or loss from each asset. Under the entity approach, the sale of a partnership interest would be very similar to the sale of corporate stock. The partner would recognize capital gain or loss on the sale based on the difference between the sales price and the partner's tax basis in the partnership interest.

When are partnerships eligible to use the cash method of accounting?

Under the tax accounting rules, a partnership with a corporate partner must use the accrual method of accounting unless the following exception applies. A partnership with a corporate partner is eligible to use the cash method of accounting when the partnership has average gross receipts over the past three taxable years less than or equal to $25 million.

Under what conditions will a partner recognize loss in a liquidating distribution?

When a distribution includes only cash, unrealized receivables, and inventory and the partner's basis in his partnership interest is greater than the sum of the bases of the distributed assets, the partner will recognize a loss on a liquidating distribution. The partner treats the loss as a capital loss.

How do partners who purchase a partnership interest determine the tax basis and holding period of their partnership interests?

When a partner purchases a partnership interest, the initial tax basis for the partner is determined by taking the cost basis of the interest the partner purchased and adding to this basis any debt allocated to the partner's interest. The holding period for this purchased interest will begin on the date that the partner purchased the partnership interest.

Explain how a partner's debt relief affects his amount realized in a sale of partnership interest.

When a partner sells his partnership interest, often he is relieved of his partnership debt obligations. As is the case in sales of other assets, debt relief will increase the amount realized in the sale of a partnership interest. Because the partner's outside basis includes his share of the partnership debt, this negates the effect of debt on the gain or loss of the partnership interest sale.

Absent any special elections, what effect does a sale of partnership interest have on the partnership?

When one partner sells his partnership interest, the sale generally has no effect on the partnership. However, if the partnership interest that is sold is large, the sale may terminate the partnership for tax purposes.

Why would a new partner who pays more for a partnership interest than the selling partner's outside basis want the partnership to elect a special basis adjustment?

An investor who pays more for a partnership interest than the seller's outside basis essentially has already paid for his share of any appreciation in the partnership's assets. However, absent a special basis adjustment, the buyer inherits the seller's inside basis, which does not reflect the gain realized on the sale of the partnership interest. As the partnership sells the appreciated assets, the partners recognize their share of the gain from the appreciated assets as a part of their annual distributive share of the partnership income. This means that the buyer pays for the appreciation of the assets as part of the acquisition price of the partnership interest AND recognizes gain again when the partnership recognizes income from the sale of the appreciated assets. Only upon the sale of his partnership interest will the over-taxation resolve itself. The special basis adjustment under §754 eliminates the disparity between a new partner's inside and outside basis.

] When considering C corporations, the IRS checks to see whether salaries paid are too large. In S corporations, however, it usually must verify that salaries are large enough. Account for this difference.

As a taxable entity, C corporations have a tax incentive to pay a shareholder/employee tax deductible salary instead of nondeductible dividends. In contrast, S corporations are flow- through entities and face different incentives. Specifically, because salary paid by S corporations is subject to payroll taxes whereas S corporation profits are not, there is an incentive for the S corporation to pay a shareholder/employee a lower salary and report higher S corporation profits to avoid the payroll taxes on the shareholder/employee's salary.

Can a shareholder's basis in S corporation stock ever be adjusted to a negative number? Why or why not?

As with a partnership, adjustments that decrease basis cannot reduce an S corporation shareholder's tax basis below zero. This feature of the federal tax system makes sense because basis represents the shareholder's investment in the stock of a corporation. Because it is not possible to have a negative investment, it is not possible to have a negative basis

Super Corp. was organized under the laws of the state of Montana. It issued common voting stock and common nonvoting stock to its two shareholders. Is Super Corp. eligible to elect S corporation status? Why or why not?

Assuming that the voting and nonvoting stock shares have equal distribution and liquidation rights, Super Corp. may elect S corporation status. While the law specifies that S corporations can have only one class of stock, differences in voting power are permitted as long as distribution and liquidation rights are identical.

In general, how do the disproportionate distribution rules ensure that partners recognize their share of partnership ordinary income?

Basically, the tax rules require partners to treat disproportionate distributions as though three separate events occur. To illustrate, assume a partner's interest in the partnership hot assets decreases as a result of the distribution. First, the partner is treated as though a hypothetical current distribution of the hot assets occurs. The partner is treated as though she receives the fair market value of the decrease in hot assets as a current distribution. Next, the rules require the partner to act as though she has sold the hot assets received in the hypothetical distribution to the partnership for an amount equal to the amount of the cold assets that her interest increases. Finally, the last step is to treat the amount of the distribution that is proportionate as a normal distribution.

What challenges do LLCs face when deciding whether to treat their members' shares of ordinary business income as self-employment income?

Before a string of relatively recent Tax Court decisions, only Proposed Reg. §1402(a)-2 provided guidance on this matter; however, the regulation was never finalized leaving LLCs without any authoritative guidance to help resolve this issue. The proposed regulation provided that if an LLC member is involved in the operations of the LLC, the member should treat the ordinary business income as self-employment income. The regulation listed the following three criteria that would demonstrate active involvement in the LLC: (1) personal liability for the debt of the LLC as an LLC member, (2) authority to contract on behalf of the LLC, or (3) more than 500 hours participating in the LLC's trade or business during the taxable year. If any one of these requirements were met, then the LLC member would be more associated as a general partner and should account for their share ordinary business income as self-employment income.

What are guaranteed payments and how do partnerships and partners treat them for income and self-employment tax purposes?

Guaranteed payments are similar to cash salary payments for services provided. Fixed payments made to a partner in the capacity as a partner no matter the profit (loss) of the partnership for that tax year are known as guaranteed payments. Thus, on the partnership level, they are treated like a salary payment to an unrelated party. Thepartnership deducts the guaranteed payment in computing the partnership's ordinary business income (loss). On the partner level, the partner that receives a guaranteed payment must account for the guaranteed payment as a separately-stated item that is taxed as ordinary income. Further, the partner must include the amount of the guaranteed payment in computing self-employment income for tax purposes. This reporting requirement is required no matter if the partner is a general partner, limited partner, or LLC member.

What are "hot assets" and why are they important in the sale of a partnership interest?

Hot assets are assets defined in §751 that will re-characterize the portion of a gain or loss on the sale of a partnership interest as ordinary. The two categories of hot assets under §751(a) are unrealized receivables and inventory items. Unrealized receivables include rights to receive payment for goods delivered or to be delivered, rights for services rendered or to be rendered, and items treated as ordinary income if the partnership were to sell the item at its fair market value. Under §751(a) inventory items include property held for sale to customers in the ordinary course of business and assets that are not capital assets or §1231 assets that would produce ordinary income if sold by the partnership. To the extent that a seller realizes any amounts from the sale of his partnership interest that are attributable to these unrealized receivables or inventory items, the gain or loss will be classified as ordinary.

How do hot assets affect the character of gain or loss on the sale of a partnership interest?

Hot assets cause a portion of the gain or loss on the sale of a partnership interest to be classified as ordinary rather than capital.

Discuss the underlying concern to tax policy makers in distributions in which a partner receives more or less than his share of the partnership hot assets.

If a partner's share of hot assets is altered from a distribution, the primary concern is that the partner will convert capital gain or loss to an ordinary gain or loss. Thus, if a partnership has §751 property, the partnership must determine whether any distribution is proportionate or disproportionate. If the distribution is disproportionate, the tax rules require the application of a complex set of rules to ensure that the distributee partner recognizes a proportionate amount of ordinary and capital gain or loss commensurate to his interest in the partnership. Most operating distributions are proportionate and do not require the application of these rules. However, in cases where a partner is reducing his interest in the partnership (e.g., from 40% to 25%) or in liquidating distributions, the application of these rules is more commonplace.

If a partner's outside basis is less than the partnership's inside basis in distributed assets, how does the partner determine his basis of the distributed assets in an operating distribution?

If only money is distributed, the partner recognizes gain equal to the difference between the money distributed and the basis in the partnership interest. If the partnership distributes money and hot assets only, the partner defers gain recognition by reducing the basis of the hot assets distributed. The partner first allocates basis to the assets received equal to the partnership basis (allocating to money first). Then, the partner allocates the required decrease (difference between the partnership's basis in the distributed assets and the partner's outside basis) to the assets with unrealized depreciation. Finally, the partner allocates any remaining required decrease to the distributed assets in proportion to their adjusted bases. If the partnership distributes other property in addition to money and hot assets, the partner defers gain by reducing the basis in the other property distributed. The partner first assigns basis to the distributed assets equal to the partnership basis. The partner then allocates the required decrease to property other than money, inventory and unrealized receivables to the extent of the unrealized depreciation in the assets. Finally, the partner allocates any remaining required decrease to the other property in proportion to the assets' adjusted bases.

In what circumstances could a calendar-year C corporation make an election on February 1, year 1, to be taxed as an S corporation in year 1 but not have the election effective until year 2?

If the corporation did not meet all the S corporation requirements for each day of the current year before it made the S election, the election would not be effective until the subsequent year. Likewise, if one or more shareholders who held the stock in the corporation during the current year and before the S corporation election was made did not consent to the election (for example, a shareholder disposes of his stock in the corporation in the election year before the election is made and fails to consent to the S election), the election would not be effective until the following year

How does a partner determine his basis in distributed assets when the partnership distributes other property in addition to money and hot assets?

If the partner's basis in the partnership interest is greater than the basis of the distributed assets, the partner defers loss recognition by increasing the basis of the other property distributed. The required increase equals the difference between the partner's outside basis and the partnership bases in the distributed assets. The partner first assigns a basis to the distributed assets equal to the partnership's basis. The partner then allocates the requiredincrease to the other property with unrealized appreciation. Finally, the partner allocates any remaining required increase to the other property in proportion to their fair market values. When the partnership distributes other property in addition to money, inventory, and unrealized receivables and the partner's basis in the partnership interest is less than the basis of the distributed assets, the partner defers gain by reducing the basis in the other property distributed. The partner first assigns basis to the distributed assets equal to the partnership basis. The partner then allocates the required decrease to property other than money, inventory and unrealized receivables to the extent of the unrealized depreciation in the assets. Finally, the partner allocates any remaining required decrease to the other property in proportion to the assets' adjusted bases.

Describe how a partner determines his basis in distributed assets in cases in which a partnership distributes only money, inventory, and/or unrealized receivables in a liquidating distribution.

If the partner's basis in the partnership interest is greater than the basis of the distributed assets, the partner is unable to defer loss without changing the character of the loss. Therefore, the partner assigns a basis to the money, inventory, and unrealized receivables equal to the partnership's basis in the distributed assets. The partner recognizes a capital loss equal to the remaining outside basis after the distributed assets have been assigned a carryover basis. If the partner's basis in the partnership interest is less than the basis of the distributed assets, the partner defers gain recognition by reducing the basis of the hot assets distributed. The required decrease is equal to the difference between the partnership's basis in the distributed assets and the partner's outside basis. The partner allocates the required decrease to assets with unrealized depreciation first to eliminate existing losses in the distributed assets. Then the partner allocates any remaining required decrease to the distributed assets in proportion to their adjusted bases.

How do general and limited partners treat their share of ordinary business income for self-employment tax purposes?

In determining how different partners treat their share of ordinary business income, the IRS assesses the involvement the partner has in the partnership. General partners are considered to be actively involved in the management of the partnership. Thus, the general partner's share of ordinary business income is treated as trade or business income and is subject to self-employment tax. Conversely, limited partners are generally not actively involved with managing the partnership. The limited partner's share of ordinary business income is treated as investment income and not subject to self- employment tax. Both types of partners must treat guaranteed payments as income relating to self-employment; however, the treatment of ordinary business income for purposes of self-employment tax depends on the type of partner.

Under what circumstances will a partner recognize a gain from an operating distribution?

In general, partners do not recognize gain or loss from operating distributions. However, when the partnership distributes money that exceeds a partner's basis in her partnership interest, she will recognize a gain equal to the excess. In this situation, the partner is unable to adjust the basis in property distributed in order to defer the gain.

Is the character of partnership income/gains and expenses/losses determined at the partnership or partner level? Why?

In keeping with the entity concept, the character of all income/gains and expenses/losses is determined at the partnership level. Despite the chance that specific items would change character depending upon the partner who holds them, Congress has decided to unify the character of all items by looking at the character from the partnership's perspective. Thus, partnerships are required to file a form 1065 return along with all partners' K-1s to help properly report the amounts and character of various items that show up on the individual partner's return.

Generally, a selling partner's capital account carries over to the purchaser of the partnership interest. Under what circumstances will this not be the case?

In the case where the selling partner contributed built-in loss property to the partnership, the buyer's capital account will be reduced by the amount of the inherent loss at the partnership interest sale date. This treatment ensures that only the partner that contributed the built-in loss property to the partnership benefits from the inherent loss.

Under what conditions will a partner recognize gain in a liquidating distribution?

In the situation in which a partnership distributes only money and the amount exceeds the partner's basis in her partnership interest, she will recognize a gain equal to the excess. In this situation, the partner is unable to adjust the basis in property distributed in order to defer the gain.

For an accrual-method partnership, are accounts receivable considered unrealized receivables? Explain.

No. For accrual-method taxpayers, accounts receivable are not considered unrealized receivables because these amounts have already been realized and recognized as ordinary income.

Explain why a partnership might not want to make a §754 election to allow special basis adjustments.

Once the partnership makes a §754 election, the election is binding for all future sales and distributions. The election may only be revoked with the consent of the IRS. The election may not always be advantageous and limits the partnership's and partners' ability to tax plan. For example, if partnership assets decrease in value, an incoming partner will have a downward basis adjustment.

What are the limitations on the number and type of shareholders an S corporation may have? How are these limitations different from restrictions on the number and type of shareholders C corporations or partnerships may have?

Only U.S. citizens or residents, certain trusts, and certain tax-exempt organizations may be shareholders, no corporations or partnerships. In addition, S corporations may have no more than 100 shareholders; family members and their estates count as one shareholder for purposes of the shareholder limit test. Family members include a common ancestor (not more than 6 generations removed) and her lineal descendants and their spouses (or former spouses). C corporations and partnerships do not have a limit on the amount or type of shareholders or partners.

What distinguishes operating from liquidating distributions?

Operating or current distributions are made to partners whose interests in the partnership continue after the distribution. Liquidating distributions terminate a partner's interest in the partnership.

Under what circumstances is it possible for partners to recognize gain when contributing property to partnerships?

Partners have the potential of recognizing gain on the contribution of property when the property contributed is secured by debt. In determining whether gain must be recognized, the partner must assess the cash deemed to have received from the partnership distribution compared with the tax basis of the partner's partnership interest prior to the deemed distribution. This happens if the assumption of the partner's liabilities is in excess of the partner's basis of the contributed property. If the cash deemed to have received exceeds the tax basis immediately before the deemed distribution, then a gain must be recognized. This circumstance occurs due to the negative basis created for the partner, which is not allowed under partnership tax law.

In what situations do partners need to know the tax basis in their partnership interests?

Partners should always keep track of the tax basis in their partnership interest because certain situations require partners to actually know their tax basis. These situations occur when a partner sells her/his partnership interest or when a partner receives a distribution from the partnership. Tracking the tax basis in the partnership interest helps the partner determine the amount of gain or loss that must be reported on the partner's tax return.

What restrictions might prevent a partner from selling his partnership interest to a third party?

Partnership agreements may specify whether a partner may voluntarily leave the partnership. If the agreement does not allow for a voluntary withdrawal, the partnership may need to be dissolved to effect the termination. A partnership agreement may also specify whether a partner may assign his interest to a third party. This will determine if the partner is free to sell his interest to someone other than the existing partners.

How much flexibility do partnerships have in allocating partnership items to partners?

Partnerships have a great deal of flexibility in determining how to allocate partnership items to partners, both separately-stated and non-separately stated items. The determining factors must be (1) the partners agree upon the allocations and (2) the allocations either have substantial economic effect or are in accordance with the partners' interests in the partnership. The second factor is put into place to make sure the allocations are being accomplished for a business objective and not just to reduce or avoid taxes. While both of these items need to be met for a special allocation of a partnership item, certain items have mandatory allocations to specific partners. For example, contributed property built-in gain (loss) must be allocated to the partner who contributed the property when the property is sold. Any additional gain (loss) will be allocated according to the partnership agreement. Overall, if the partnership has no mandatory allocations or does not specify and meet the requirements for special allocations, the partnership will allocate partnership income and losses according to the capital or profit and/or loss interests of each partner.

What is recourse and nonrecourse debt, and how is each generally allocated to partners?

Recourse debt is debt for which partners are considered to have an economic risk of loss. Partners are legally liable for recourse debt and must satisfy this type of debt personally if the partnership cannot. An example of recourse debt is accounts payable owed by a general partnership. Nonrecourse debt is debt for which no partners are considered to have an economic risk of loss because nonrecourse debt is typically secured by real property. An example of nonrecourse debt is a mortgage on a building. In regards to a partnership's debt, recourse debt is allocated to those partners that have the ultimate responsibility of paying the debt. The debt is allocated to the partners that have an economic risk of loss. On the other hand, nonrecourse debt is generally allocated to the partners according to their profit sharing ratios. Despite the partners not being legally liable for some debt, all debt is allocated to adjust the outside basis of the partners.

If an S corporation with accumulated E&P makes a distribution, from what accounts (and in what order) is the distribution deemed to be paid from?

S corporation distributions are deemed to be paid from the following sources in the order listed: (1) The AAA account (to the extent it has a positive balance). (2) Existing accumulated earnings and profits from years when the corporation operated as a C corporation. (3) The shareholder's stock basis.

Is a shareholder allowed to increase her basis in her S corporation stock by her share of the corporation's liabilities, as partners are able to increase the basis of their ownership interest by their share of partnership liabilities? Explain.

S corporation shareholders are not allowed to include any S corporation debt in their stock basis. This difference between S corporations and partnerships is attributable to the fundamental difference in liability exposure of S corporation shareholders versus partners. In particular, S corporation shareholders have limited liability with respect to S corporation debts whereas partners, in general, are liable for the debts of the partnership.

How does the tax treatment of employee fringe benefits reflect the hybrid nature of the S corporation?

S corporations are treated in part like C corporations and in part like partnerships with respect to tax deductions for qualifying employee fringe benefits. For shareholder- employees who own 2 percent or less of the entity, the S corporation receives C corporation tax treatment. That is, it gets a tax deduction for qualifying fringe benefits, and the benefits are nontaxable to all employees. For shareholder-employees who own more than 2 percent of the S corporation, it receives partnership treatment. That is, the S corporation receives a tax deduction, but the otherwise qualifying fringe benefits are taxable to the more-than-2- percent shareholder-employees. Fringe benefits taxable to this group include employer-provided health insurance (§106), group-term life insurance (§79), meals and lodging provided for the convenience of the employer (§119), and benefits provided under a cafeteria plan (§125). Examples of benefits that are nontaxable to more-than-2-percent shareholder-employees (and partners in a partnership) include employee achievement awards (§74), qualified group legal services plans (§120), educational assistance programs (§127), dependent care assistance programs (§129), no-additional-cost services (§132), qualified employee discounts (§132), working condition fringe benefits (§132), de minimis fringe benefits (§132), on-premises athletic facilities (§132), and medical savings accounts (§220).The tax treatment allows a certain fringe benefits to be nontaxable to the receiver who owns 2 percent or less of the S corporation, similar to C corporations, while withholding that nontaxable feature from owners of more than 2 percent of the company, similar to partnerships

How are the tax consequences of a cash distribution different from those of a non- cash property distribution to both the corporation and the shareholders?

S corporations do not recognize a gain on cash distributions and the distributions are tax free to the shareholder up to his or her stock basis. Amounts in excess of the stock basis are taxed as capital gains. For non-cash property distributions, S corporations recognize gain as though they had sold the appreciated property for its fair market value just prior to the distribution. Shareholders who receive (and don't receive) the distributed property recognize their distributive share of the deemed gain and increase their stock basis accordingly. On the other hand, S corporations do not recognize losses on distributions of property whose value has depreciated. For the shareholder, the amount of a property distribution is the fair market value of the property received (minus any liabilities the shareholder assumes on the distribution). The distribution is tax free to the shareholder up to his or her stock basis. Amounts in excess of the stock basis are taxed as capital gains.

Compare and contrast the method of allocating income or loss to owners for partnerships and for S corporations.

S corporations, like partnerships, are flow-through entities, and thus their profits and losses flow through to their shareholders annually for tax purposes. Partnerships have considerable flexibility in making special profit and loss allocations to their partners. In contrast, S corporations must allocate profits and losses pro rata, based on the number of outstanding shares each shareholder owns on each day of the tax year.

SBT Partnership distributes $5,000 cash and a parcel of land with a fair market value of $40,000 and a $25,000 basis to the partnership to Sam (30 percent partner). What factors must Sam and SBT consider in determining the tax treatment of this distribution?

SBT and Sam must determine if the distribution is an operating or a liquidating distribution. Sam may not recognize a loss if the distribution is an operating distribution. Sam must also consider whether the distributed cash exceeds her basis in SBT. If so, she will recognize a gain on the distribution. SBT and Sam must also consider whether the distribution is a disproportionate distribution. To the extent that SBT has any hot assets, this distribution to Sam will represent a disproportionate distribution that can cause both Sam and SBT to recognize gain or loss on the distribution. Finally, Sam must determine her basis in the distributed land. Her determination of basis will depend on whether the distribution is an operating or a liquidating distribution.

What are some common separately stated items, and why must they be separately stated to the partners?

Separately-stated items must be taken out of ordinary income (loss) because these items either (1) relate only to a specific partner in the partnership or (2) the item is taxed differently for each partner depending upon the entity of the partner and the partner's current tax situation. The following is a partial list of items that are separately stated on a partnership return. 1. Short-term capital gains (losses) 2. Long-term capital gains (losses) 3. Section 1231 gains (losses) 4. Charitable contributions 5. Dividends 6. Interest income 7. Guaranteed payments 8. Net earnings (losses) from self-employment 9. Tax-exempt income 10. Net rental real estate income (loss) 11. Investment interest expense 12. Section 179 deductions

Why do you think partnerships, rather than the individual partners, are responsible for making most of the tax elections related to the operation of the partnership?

The responsibility for the partnership, not the partners, to make the majority of tax elections regarding the operation of the partnership is twofold. First, partnerships can consist of many different types and amounts of partners ranging from two to hundreds. The hassle to obtain every partner's approval on what elections to make would be very time consuming. The costs would more than likely outweigh the benefits in performing this function. Second, in many partnerships only a few partners are actively involved in the management of the partnership. The limited partners have little to no working knowledge of the operations of the partnership and would be ill-equipped to make such decisions. Thus, the entity concept would appear more reasonable when dealing with the actual operations of the partnership.

How does a shareholder create debt basis in an S corporation? How is debt basis similar and dissimilar to stock basis?

The shareholder is able to create debt basis by lending money directly to the S corporation. Debt basis is similar to stock basis in the sense that a shareholder may deduct S corporation losses to the extent of both stock basis and debt basis. Debt basis is dissimilar to stock basis in that distributions are only nontaxable to the extent of stock basis. Thus, distributions received by a shareholder with debt basis but no stock basis are taxable.

Shawn receives stock in an S corporation when it is formed in a tax-deferred transaction by contributing land with a tax basis of $50,000 and encumbered by a $20,000 mortgage. What is Shawn's initial basis in his S corporation stock?

The shareholder's basis in stock received in forming an S corporation equals the tax basis of the property transferred, less any liabilities assumed by the corporation on the property contributed ("substituted basis"). Thus, Shawn's initial basis in the S corporation would equal $30,000, which is the $50,000 carryover tax basis of the land minus the $20,000 mortgage assumed.

Describe the three hurdles a taxpayer must pass if he wants to deduct a loss from his share in an S corporation. What other loss limitation rule may impact the deductibility of losses from an S corporation?

The three hurdles are tax basis, at-risk amount, and the passive activity loss rules. The tax basis hurdle disallows allocated losses to the extent that they exceed the shareholder's stock and debt basis. While S corporation debt is not included in the stockholder's stock basis, shareholders can create debt basis in an S corporation by loaning money directly to the S corporation. When a stockholder has stock and debt basis in an S corporation, the losses are first applied to the stock basis and second to the debt basis. The non-utilized losses are not necessarily lost but are suspended until the shareholder generates additional basis. The carryover period for the suspended loss is indefinite. However, if the shareholder sells the stock before creating additional basis, the suspended losses disappear unused. Losses are also limited to the" at-risk" amount. With one notable exception, an S corporation shareholder's at-risk amount is the sum of her stock and debt basis. The primary exception relates to nonrecourse loans and is designed to ensure that shareholders only are deemed at risk when they have an actual risk of loss. Specifically, an S corporation shareholder taking out a nonrecourse loan to make a capital contribution (either cash or other property) to the S corporation generally creates stock basis in the S corporation but only increases her amount at risk by the net fair market value of her property, if any, used as collateral to secure the nonrecourse loan. IRC Sec. 465(b)(2)(B). The collateral's net fair market value is determined at the loan date. Likewise, if the shareholder takes out a nonrecourse loan to make a direct loan to the S corporation, the loan creates debt basis, but only increases her amount at risk by the net fair market value of her property, if any, used as collateral to secure the nonrecourse loan. When the stock basis plus debt basis is different from the at-risk amount, S corporation shareholders apply the tax basis loss limitation first, and then the at-risk limitation. Losses limited under the at-risk rules are carried forward indefinitely until the shareholder generates additional at-risk amounts to utilize them or sells the S corporation stock. S corporation shareholders, just like partners, are subject to the passive-activity loss rules. There are no differences in the application of these rules for S corporations; the definition of a passive activity, the tests for material participation, the income and loss baskets, and the passive activity loss carryover rules are exactly the same. Thus, as in partnerships, the passive activity loss rules limit the ability of S corporation shareholders to deduct losses unless they are involved in actively managing the business. In addition, for losses that clear each of the three separate hurdles, S corporation shareholders are not allowed to deduct excess business losses. An excess business loss for the year is the excess of aggregate business deductions for the year over the sum of aggregate business gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a tax year is $500,000 for married taxpayers filing jointly and $250,000 for other taxpayers. In the case of S corporation business losses, the provision applies at the shareholder level.

What types of business entities are taxed as flow-through entities?

The two main business entities that are taxed as flow through entities are partnerships and S corporations. Partnerships are taxed under Subchapter K and consist of general partnerships, limited partnerships, and LLCs. S corporations are taxed under Subchapter S. Both types of business entities are treated as flow-through entities and are taxed accordingly.

What hurdles (or limitations) must partners overcome before they can ultimately deduct partnership losses on their tax returns?

While a partnership can create an ordinary business loss, the individual partners potentially will not be able to deduct the entire amount in the year of the loss. The partner must potentially overcome four loss limitation rules before the deduction is available. If the loss does not pass any of the limitations, then the loss is suspended indefinitely under that specific hurdle. The four loss limitations are (1) the tax basis limitation, (2) the at-risk loss limitation, (3) the passive activity loss limitation, and (4) the excess business loss limitation. First, a partner is not able to take any losses that exceed the tax basis of the partner, the partner's outside basis. This limitation prevents partners from taking losses beyond their investment or basis in their partnership interests. Second, a partner cannot take any losses that exceed the at-risk amount for the partner. The at-risk amount is generally the same as the partner's tax basis, except that it excludes the partner's share of nonrecourse debt. This limit still includes recourse debt and qualified nonrecourse debt. In the case of a passive participant in a partnership, losses cannot be taken if the loss exceeds the amount of passive income reported by the partner. Passive losses such as losses from rental activities or losses allocated to a limited partner can only be offset with passive income and gains. Finally, losses remaining after overcoming the prior three hurdles are limited to the sum of the partner's aggregate business gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a tax year is $500,000 for married taxpayers filing jointly and $250,000 for other taxpayers.

What are the basic tax-filing requirements imposed on partnerships?

While a partnership does not pay taxes, the IRS still requires all partnerships to file an information return to the IRS - Form 1065 (U.S. Return of Partnership Income). This form must be filed by the 15th day of the 3rd month of the partnership's year end. For calendar year end partnerships, the form must be filed by March 15th. An extension is available to file by the due date of the original return and provides the partnership an additional six months to file Form 1065. The extension must be filed on Form 7004. The tax return that must be filed by all partnerships consists of a detailed calculation of the partnerships ordinary business income (loss) on page 1 of Form 1065. On page 3 of Form 1065, Schedule K must be filled out which lists the ordinary business income (loss) along with any separately-stated items. This schedule is an aggregate of each partner'sshare of items both separately-stated and non-separately stated. In addition, each partner's proportion of the above items is reported on a Schedule K-1. A Schedule K-1 for every partner must be filed with Form 1065, and each individual partner will receive her/his own Schedule K-1 from the partnership.

In what sense is the at-risk loss limitation rule more restrictive than the tax basis loss limitation rule?

While the at-risk loss limitation and tax basis loss limitation are basically the same, one difference exists between the two different hurdles a partner must overcome when faced with losses. The at-risk loss limitation only accounts for those items that the partner is at risk for. The major item that is not included under the at-risk calculation but is included in the tax basis is nonrecourse debt. As a note, qualified nonrecourse debt is still considered to be part of the partner's at-risk calculation.

Under what circumstances could a corporation with earnings and profits make a tax- free distribution to its shareholders after the S election termination?

§1371(e) provides for special treatment of any S corporation distribution in cash after an S election termination and during the post-termination transition period (PTTP): Such cash distributions are tax-free to the extent they do not exceed the corporation's AAA balance and the individual shareholder's basis in the stock. The PTTP for post-termination distributions is generally the same as the PTTP for deducting suspended losses. For determining the taxability of distributions, the PTTP generally begins on the day after the last day of the corporation's last taxable year as an S corporation; it ends on the later of (a) one year after the last S corporation day or (b) the due date for filing the return for the last year as an S corporation (including extensions). In addition to the general rules that apply to PTTP distributions, there is a special rule that apply to distributions from an "eligible terminated S corporation" that occur after the PTTP. Specifically, distributions from an eligible terminated S corporation that occur after the PTTP are treated as paid pro rata from its accumulated adjustments account and from its earnings and profits. An eligible terminated S corporation is any C corporation which (i) was an S corporation on December 21, 2017, (ii) revoked its S corporation election during the two-year period beginning on December 22, 2017, and (iii) had the same owners on December 22, 2017 and on the revocation date (in identical proportions). Under these rules, distributions out of the corporation's AAA balance would be nontaxable to the extent they do not exceed the shareholder's basis in the stock.