module 24 flow-through entities: basis issues. menu 1. computation of a partner’s basis in a...
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Module 24Flow-Through Entities:
Basis Issues
Menu
1. Computation of a partner’s basis in a partnership interest
2. Termination of a partnership interest
3. Computation of an S corporation shareholder’s basis in S corporation stock
4. Termination of an S corporation shareholder’s interest
Computation of a Partner’s Basis in a Partnership Interest
Key Learning ObjectivesKey Learning Objectives Acquisition of an interest in a partnershipAcquisition of an interest in a partnership Partnership liabilitiesPartnership liabilities Changes in a partnership interest as a result of Changes in a partnership interest as a result of
partnership operationspartnership operations Impact of nonliquidating distributions Impact of nonliquidating distributions
on a partnership intereston a partnership interest
Partner’s Partnership InterestOutside Basis
Intangible asset representing ownership Intangible asset representing ownership Similar to corporate stockSimilar to corporate stock
Partnership interest must have a non-Partnership interest must have a non-negative basisnegative basis
Partnership interest basis includes partner’s Partnership interest basis includes partner’s share of partnership liabilitiesshare of partnership liabilities
Generally considered a capital assetGenerally considered a capital asset
Partner’s Original Partnership Interest Basis
Cash contributedCash contributed Plus: Basis of non-cash assets contributedPlus: Basis of non-cash assets contributed Plus: Any service gain recognized Plus: Any service gain recognized
Note: NO adjustment for any liabilities > basis Note: NO adjustment for any liabilities > basis gain recognizedgain recognized
Plus: Other partner’s liabilities assumed by new Plus: Other partner’s liabilities assumed by new partnerpartner
Minus: New Partner’s liabilities assumed by other Minus: New Partner’s liabilities assumed by other partnerspartners
Post-Formation Adjustments to Partner’s Partnership Interest Basis Increases to basisIncreases to basis
Additional contributions by partnerAdditional contributions by partner
Partner’s share of any increase in Partner’s share of any increase in partnership liabilitiespartnership liabilities
Partner’s share ofPartner’s share ofpartnership partnership
income itemsincome items
Post-Formation Adjustments to Partner’s Partnership Interest Basis Decreases to basisDecreases to basis
Distributions to partnersDistributions to partners
Partner’s share of any Partner’s share of any decrease in partnershipdecrease in partnership
liabilitiesliabilities
Partnership’s Basis in Contributed Assets--Inside Basis Carryover basis for assets transferred inCarryover basis for assets transferred in
Depreciation recapture potential and holding Depreciation recapture potential and holding periods also carryover to partnershipperiods also carryover to partnership
Add any investment company gain Add any investment company gain recognized by partnerrecognized by partner
No adjustment for liabilities > basis gain No adjustment for liabilities > basis gain recognizedrecognized
Categories of Distributions
Nonliquidating (current)Nonliquidating (current) LiquidatingLiquidating
§751 “Hot Assets”
These assets produce ordinary incomeThese assets produce ordinary income They can affect both partnership distributions They can affect both partnership distributions
and sales of a partnership interestand sales of a partnership interest Two kinds:Two kinds:
(1) Unrealized receivables(1) Unrealized receivables
(2) Substantially appreciated inventory(2) Substantially appreciated inventory
Unrealized Receivables
Always hotAlways hot Includes:Includes:
Accounts receivable of cash method Accounts receivable of cash method partnershippartnership
Depreciation recapture itemsDepreciation recapture items
Substantially Appreciated Inventory
Hot only if aggregate FMV of inventory Hot only if aggregate FMV of inventory items exceeds 120% of their aggregate basisitems exceeds 120% of their aggregate basis
Broad definition:Broad definition: All assets other than cash, capital assets, and All assets other than cash, capital assets, and
§1231 assets§1231 assets
Current Distributions
Three tiers of property Three tiers of property Deemed distributed in this orderDeemed distributed in this order
CashCash
Unrealized receivables and inventoryUnrealized receivables and inventory
Other propertyOther property
Effect on Partner-- Current Distribution
No gain recognized unless cash distributed No gain recognized unless cash distributed exceeds partner’s predistribution partnership exceeds partner’s predistribution partnership interest basisinterest basis
Exception: disproportionate distribution of Exception: disproportionate distribution of hot assets (discussed later)hot assets (discussed later)
NOTE: reduction of a partner’s share of NOTE: reduction of a partner’s share of partnership liability = deemed cash distributionpartnership liability = deemed cash distribution
A loss is never recognizedA loss is never recognized
Effect on Partner-- Current Distribution
Distributed tier two and tier three properties Distributed tier two and tier three properties have a carryover basis to the partnerhave a carryover basis to the partner
However, basis carried over cannot exceed However, basis carried over cannot exceed partner’s remaining partnership interest basispartner’s remaining partnership interest basis Allocation of bases is necessary if multiple Allocation of bases is necessary if multiple
assets are distributed within a tierassets are distributed within a tier Distributions reduce a partner’s partnership Distributions reduce a partner’s partnership
interest basis, but never below zerointerest basis, but never below zero
Effect on Partnership-- Current Distribution
No gain or loss recognizedNo gain or loss recognized Exception: disproportionate distributions of Exception: disproportionate distributions of
hot assetshot assets Partnership may be entitled to a basis Partnership may be entitled to a basis
adjustment if: adjustment if:
Gain is recognized by the partnerGain is recognized by the partner
Basis “disappears”Basis “disappears”
Termination of a Partnership Interest
Key Learning Objectives Involuntary termination Voluntary termination
Sale or exchangeSale or exchange AbandonmentAbandonment Liquidation of a partnershipLiquidation of a partnership Liquidation of a partnership interestLiquidation of a partnership interest Merger/consolidationMerger/consolidation Conversion to limited liability companyConversion to limited liability company
Involuntary TerminationClose of Tax Year
Sale of Sale of >> 50% capital within 12 months 50% capital within 12 months Partnership ceases to do businessPartnership ceases to do business Causes loss of tax attributesCauses loss of tax attributes Deceased partnerDeceased partner
Successor in interest steps into deceased’s Successor in interest steps into deceased’s shoes, so no close of tax yearshoes, so no close of tax year
Successor’s partnership interest basis equals Successor’s partnership interest basis equals FMV of interest at date of deathFMV of interest at date of death
Voluntary TerminationClose of Tax Year
Partnership year closes with respect to Partnership year closes with respect to partner IFpartner IF
Liquidation or sale of entire interestLiquidation or sale of entire interest Gift of interestGift of interest
Sale of a Partnership Interest
Amount realizedAmount realized - partnership interest basis- partnership interest basis Gain or loss realizedGain or loss realized Amount realized includesAmount realized includes
CashCash
FMV of propertyFMV of property
Any partnership liabilities assumed by Any partnership liabilities assumed by the new partner the new partner
Sale of a Partnership Interest Gain or loss is generally capitalGain or loss is generally capital Exception: hot assets generate ordinary Exception: hot assets generate ordinary
incomeincome New partner may be entitled to a basis New partner may be entitled to a basis
adjustmentadjustment Adjustment is with respect Adjustment is with respect to to
new partner onlynew partner only
Liquidating Distributions
““Liquidation” refers to the termination of a Liquidation” refers to the termination of a partner’s interestpartner’s interest
Do not confuse this with the partnership Do not confuse this with the partnership liquidating, although it may beliquidating, although it may be
Liquidating Distributions
Three tiers of property Three tiers of property Deemed distributed in this orderDeemed distributed in this order
CashCash
Unrealized receivables and inventoryUnrealized receivables and inventory
Other propertyOther property
Effect on Partner-- Liquidating Distribution
No gain recognized unless cash exceeds partner’s No gain recognized unless cash exceeds partner’s predistribution basispredistribution basis Exception: disproportionate distributions of hot assetsException: disproportionate distributions of hot assets
Partner may recognize a loss, if other property is Partner may recognize a loss, if other property is not distributednot distributed
If tier three property is distributed, any remaining If tier three property is distributed, any remaining basis is assigned to itbasis is assigned to it
““Substituted” rather than carry over basisSubstituted” rather than carry over basis
Effect on Partnership--Liquidating Distribution
No gain or loss recognizedNo gain or loss recognized Exception: disproportionate distributions of Exception: disproportionate distributions of
“hot assets” (discussed later)“hot assets” (discussed later) Partnership may be entitled to a basis Partnership may be entitled to a basis
adjustment if:adjustment if:
Gain or loss is recognized by the Gain or loss is recognized by the partner, or partner, or
Basis “disappears” or is “created”Basis “disappears” or is “created”
Cash Payments Due to Retirement or Death of a Partner
Payments for propertyPayments for property Payments for hot assets generate ordinary Payments for hot assets generate ordinary
incomeincome ““Other” paymentsOther” payments
Either distributive shares orEither distributive shares or
Guaranteed paymentsGuaranteed payments
For service partnerships, “other” For service partnerships, “other” payments include payments forpayments include payments for unrealized receivables and goodwill unrealized receivables and goodwill
Disproportionate Distributions
Partner receives either too many or too few Partner receives either too many or too few hot assetshot assets
Rules apply to both liquidating and Rules apply to both liquidating and nonliquidating distributionsnonliquidating distributions
Gain or loss may be recognized by the Gain or loss may be recognized by the partner and/or the partnershippartner and/or the partnership
Disproportionate DistributionsTwo Step Analysis
To determine gain/loss recognizeTo determine gain/loss recognize When fictional steps 1 and 2 areWhen fictional steps 1 and 2 are
combined, results should reflect the actual combined, results should reflect the actual distributiondistribution
Disproportionate DistributionsStep 1
Pretend that the partner received a Pretend that the partner received a proportionate liquidating distributionproportionate liquidating distribution
This is a tax-free transactionThis is a tax-free transaction Partner has a carryover basis for Partner has a carryover basis for each each
assetasset
Disproportionate DistributionsStep 2
Pretend that the partner sells back to the Pretend that the partner sells back to the partnership some of the assets received in partnership some of the assets received in step 1 in exchange for other assetsstep 1 in exchange for other assets
This is a taxable transactionThis is a taxable transaction Use FMV for items received Use FMV for items received Use adjusted basis for items given upUse adjusted basis for items given up
In Class Exercise: Sale of a Partnership Interest
Basis FMV Basis FMV
Cash 18,000 18,000 Capital-X 16,000 25,000
Inventory 21,000 30,000 Capital-Y 16,000 25,000
Land 9,000 27,000 Capital-Z 16,000 25,000
48,000 75,000 48,000 75,000
Note: The Inventory is substantially appreciated: 30,000 > 21,000 x 120%
In Class Exercise:Sale of a Partnership Interest
Refer to the previous slideRefer to the previous slide If X sells her interest to W for $25,000 cashIf X sells her interest to W for $25,000 cash What are the tax consequencesWhat are the tax consequences
To partner XTo partner X To partner WTo partner W
Solution--In Class Exercise:Sale of a Partnership Interest
For XFor X Amount realizedAmount realized 25,00025,000 Basis:Basis: 16,00016,000 Gain:Gain: 9,000 9,000 3,000 of the gain is ordinary 3,000 of the gain is ordinary
X’s share of built-in gain for the inventoryX’s share of built-in gain for the inventory The remaining 6,000 of the gain is capitalThe remaining 6,000 of the gain is capital
Solution--In Class Exercise:Sale of a Partnership Interest
For WFor W W’s “outside” basis in his partnership W’s “outside” basis in his partnership
interest is $25,000interest is $25,000 Without special election by partnership, his Without special election by partnership, his
“inside” basis is $16,000“inside” basis is $16,000
In Class Exercise: Liquidation of Partnership Interest Using the facts of the last exerciseUsing the facts of the last exercise What are the tax consequences if the What are the tax consequences if the
partnership liquidates X’s interest for partnership liquidates X’s interest for $10,000 cash and $15,000 FMV inventory?$10,000 cash and $15,000 FMV inventory?
Note that this is a disproportionate Note that this is a disproportionate liquidation because X did not receive liquidation because X did not receive exactly her one-third share of the hot assetsexactly her one-third share of the hot assets
Solution--In Class Exercise: Liquidation of Partnership Interest
Step 1Step 1 Assume equal liquidating distribution Assume equal liquidating distribution
Pretend that X received one-third of each assetPretend that X received one-third of each asset See next slideSee next slide
Solution--In Class Exercise: Liquidation of Partnership Interest
Basis FMV ChangePartnershipinterest 16,000 25,000 9,000
Cash 6,000 6,000 -0-Inventory 7,000 10,000 3,000Land 3,000 9,000 6,000
16,000 25,000 9,000
Solution--In Class Exercise: Liquidation of Partnership Interest
Step 2 Step 2 Assume a sale between X and partnershipAssume a sale between X and partnership Pretend that X gave back the land (9,000) Pretend that X gave back the land (9,000)
received in Step 1 received in Step 1 In exchange for more cash ($4,000) and more In exchange for more cash ($4,000) and more
inventory ($5,000)inventory ($5,000) Treat Step 2 as a taxable transactionTreat Step 2 as a taxable transaction Use FMV for items received and basis for Use FMV for items received and basis for
items given upitems given up
Solution--In Class Exercise: Liquidation of Partnership Interest Amount realized Amount realized 9,000 9,000
4,000 cash + 5,000 inventory4,000 cash + 5,000 inventory Basis Basis 3,000 3,000
Basis of land given upBasis of land given up Gain realizedGain realized 6,0006,000
Solution--In Class Exercise: Liquidation of Partnership Interest The entire gain is a §1231 gain from the The entire gain is a §1231 gain from the
“sale” of land“sale” of land X holds $15,000 FMV of inventory X holds $15,000 FMV of inventory Basis of $12,000 Basis of $12,000
$7,000 from step 1$7,000 from step 1 $5,000 from step 2$5,000 from step 2
She will realize $3,000 of ordinary income She will realize $3,000 of ordinary income when she sells the inventorywhen she sells the inventory
Computation of an S Corporation Shareholder’s Tax Basis
Key Learning ObjectivesKey Learning Objectives Acquisition of S corporation stockAcquisition of S corporation stock Shareholder loans to an S corporationShareholder loans to an S corporation Changes to basis as a result of operationsChanges to basis as a result of operations Changes to basis as a result of distributionsChanges to basis as a result of distributions SummarySummary
Acquisition of Acquisition of S Corporation StockS 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 consequencesNo immediate tax consequences Cost becomes shareholder’s basisCost becomes shareholder’s basis
Shareholder Loans toShareholder Loans to S Corporation S Corporation
Third party lender No change in the equity interest No change in the equity interest
Shareholder creditor The indebtedness will create basis for the The indebtedness will create basis for the
purpose of deducting losses from the S purpose of deducting losses from the S corporationcorporation
Shareholder Loans toShareholder Loans to S Corporation S Corporation
Loan must be: Made directly from shareholder to Made directly from shareholder to
corporationcorporation A bona fide indebtedness A bona fide indebtedness Written note specifying a: Written note specifying a:
Principal sum to be repaidPrincipal sum to be repaid A rate of interestA rate of interest A term loan or a demand loanA term loan or a demand loan
Changes to Basis Changes to Basis as a Result of Operationsas 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
Changes to Basis Changes to Basis As a Result of DistributionsAs 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 shareholdersGain is reported by shareholders
Termination of an S Corporation Shareholder’s Interest Key Learning Objectives
Termination of S corporation election Termination of shareholder’s ownership
interest Termination of an S corporation
Voluntary Termination of S Corporation Election
Filing a written statement indicating the Filing a written statement indicating the corporation's desire to revoke its election. corporation's desire to revoke its election.
If made on or before the 15th day of the If made on or before the 15th day of the third month of the taxable year,third month of the taxable year,
It is generally effective as of the first day of It is generally effective as of the first day of such taxable yearsuch taxable year
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 > 25% of gross receipts for three consecutive tax years
Termination of Shareholder’s Interest
By sale, abandonment, or redemption An unused S corporation loss carryover
disappears
Termination of S Corporation
By selling off its assets and distributing the By selling off its assets and distributing the proceeds to its shareholdersproceeds to its shareholders A liquidationA liquidation
By being absorbed by another corporation By being absorbed by another corporation A merger or consolidationA merger or consolidation