BUSINESS ENTITY ISSUES

Transcription

1 BUSINESS ENTITY ISSUES 12 Issue 1: S Corporation Fringe Benefits Issue 2: S Corporation Built-In Gains Tax Issue 3: Death of an S Corporation Shareholder Issue 4: S Corporation Election Issue 5: Partnership I.R.C. 751(b) Regulations Issue 6: New Partnership Audit Rules Issue 7: Self-Employment Tax for Limited Owners Issue 8: Partnerships That Own a Disregarded Entity Issue 9: Partnership I.R.C. 754 Basis Adjustments Issue 10: Tax-Exempt Organizations Update Learning Objectives After completing this session, participants will be able to perform the following job-related actions: Advise clients about the fringe benefit rules applicable to S corporations and their shareholders Calculate the built-in gains tax that may affect S corporations Explain the rules regarding transfer of stock, allocation of income, and basis of shares following the death of a shareholder Determine how and when to elect S corporation status and how to request relief from a late or a defective election Determine whether there has been a disproportionate distribution of hot assets under the proposed I.R.C. 751(b) regulations Explain how different partnerships will be audited under the new partnership audit rules Calculate the self-employment tax for a limited owner Explain how new temporary regulations clarify the tax treatment of a partner in a partnership that owns a disregarded entity Advise clients about the I.R.C. 754 basis adjustment, and calculate the adjustment on a transfer of a partnership interest or a distribution of partnership property 2016 Land Grant University Tax Education Foundation, Inc. 399

2 Determine common reasons why a Form 1023-EZ application will be referred for additional review or will be rejected Explain the modified procedures for processing applications for tax-exempt status Explain the new filing requirements for I.R.C. 501(c)(4) organizations Introduction FINAL COPYRIGHT 2016 LGUTEF This chapter discusses four important issues for S corporations: the taxation of S corporation fringe benefits, particularly when those benefits are paid to a 2% shareholder; the S corporation built-in gains tax that imposes a second level of tax on the sale of assets by an S corporation with a C corporation history; eligibility, allocation, and basis changes that result from the death of an S corporation shareholder; and how and when to make an S corporation election, including an explanation of how to request relief from filing a late election. This chapter also includes the following five important topics for partnerships: the I.R.C. 751(b) regulations that impact gain recognition for partners, the new partnership audit rules, selfemployment tax for limited owners, self-employment tax when a partnership owns a disregarded entity, and the I.R.C. 754 basis adjustment. Finally, this chapter reviews recent developments for nonprofit organizations, including an update on the streamlined application for tax exemption, modified procedures for processing applications for tax-exempt status, and the new filing requirements for I.R.C. 501(c)(4) organizations. ISSUE 1: S CORPORATION FRINGE BENEFITS This section discusses the tax treatment of S corporation fringe benefits. S corporations can deduct the cost of fringe benefits provided to employees. S corporation employees can typically exclude certain fringe benefits from gross income. This section examines the tax treatment of fringe benefits such as health insurance and meals paid by an S corporation, and reviews the special rules that apply to employees who own more than 2% of the shares of an S corporation. Fringe benefits can include the following: 1. Health or accident insurance 2. Contributions to a health savings account (HSA) 3. Disability insurance 4. Group term life insurance 5. Meals and lodging furnished for the convenience of the employer 6. Cafeteria plans 7. Educational assistance 8. Dependent care assistance However, any person who owns more than 2% of the S corporation stock may have to include the value of certain benefits in gross income. Under I.R.C. 1372, for purposes of certain employee fringe benefits, a person who directly or indirectly owns more than 2% of the stock in the S corporation (at any time during the year), or stock with more than 2% of the voting power (a 2% shareholder) is treated as a partner in a partnership. Thus, a 2% shareholder is treated as self-employed, and not as an employee of the S corporation, for purposes of employee fringe benefits. As a consequence, many fringe benefits are not available to such 2% shareholder-employees on a tax-favored basis. 2% Shareholder The commonly used term 2% shareholder actually refers to a shareholder who owns more than 2% of the stock of the S corporation on any day of the corporation s tax year [I.R.C. 1372(b)]. 400 LEARNING OBJECTIVES

3 The shareholder can own the stock directly, or indirectly through attribution. Under I.R.C. 318, a person is the owner of stock held by a spouse, children, parents, and grandchildren; and a person is the owner of a portion of stock held by an estate or trust. The ownership share is proportionate to that person s percentage interest in the estate or actuarial interest in the trust. This rule does not apply to employee trusts such as ESOPs. The remainder of this section explains the tax treatment of fringe benefits paid by an S corporation to its employees and how that tax treatment is different if the employee is a 2% shareholder. Health and Accident Insurance Typically, employers can pay health and accident insurance premiums and deduct the cost of the premium. Employees can exclude the value of the coverage from gross income [I.R.C. 106(a)]. Moreover, the employee has no gross income when the insurance company pays benefits to the extent the payments are used for medical care [I.R.C. 105(b)]. For health insurance premiums the S corporation pays for a 2% shareholder, the S corporation can deduct the cost of the premium, and the shareholder must include the payment in his or her gross income. Withholding and Reporting The S corporation does not have to withhold, and the corporation does not have to pay social security or Medicare tax on the value of the health and accident insurance provided to a 2% shareholder if it is provided under an accident or health insurance plan for employees or a class of employees [Announcement 92-16, I.R.B. 53, citing I.R.C. 3121(a)(2)(B)]. For income tax purposes, the health insurance paid for a 2% shareholder is treated as cash compensation. The employer must report the cost of the premiums in box 1 of Form W-2, Wage and Tax Statement. However, the employer does not include the health insurance premiums in the social security and Medicare wages. To reconcile the Form W-2 income (box 1) with the social security and Medicare wages (boxes 3 and 5), the employer reports the premiums paid in box 14. Example 12.1 Form W-2 for a 2% Shareholder LG Enterprises, an S corporation, has one shareholder, Robert (Bob) France. In 2015, LG paid Bob an $86,400 salary and paid $9,600 for health insurance on his behalf. LG is located in Washington, which has no state individual income tax. Bob is also a resident of Washington, so there is no state withholding. The salary and medical insurance total $96,000 ($86,400 + $9,600), which LG reports in box 1 of Form W-2. LG reports the $86,400 salary in both box 3 and box 5. LG Enterprises calculates the social security and Medicare taxes based on $86,400, and reconciles the box 1 amount with the box 3 and box 5 amounts in box 14 ($96,000 $86,400 = $9,600). Figure 12.1 shows Bob s 2016 Form W Health and Accident Insurance 401

4 FIGURE 12.1 Bob s 2016 Form W PLAZA WAY WALLA WALLA, WA Self-Employed Health Insurance Deduction A 2% shareholder can claim the deduction for self-employed health insurance costs. However, the deduction is limited to the shareholderemployee s wage and salary income from the S corporation [I.R.C. 162(l)(2)(A)]. The shareholder cannot claim the deduction for any calendar month in which the shareholder-employee or his or her spouse is eligible to participate in another employer s subsidized health care plan [I.R.C. 162(l)(2)(B)]. The shareholder claims the deduction in the same year that the S corporation includes the premiums in the shareholder s income on Form W-2. The shareholder-employee can claim the selfemployed health insurance deduction only if the benefit is covered by I.R.C If a shareholder purchases a policy that has no connection with the S corporation, it does not qualify for the deduction. To qualify for the deduction, 1. the S corporation must make the payments directly and report the payments on the shareholder-employee s Form W-2, or 2. the shareholder-employee must pay the premiums and furnish proof of payment to the corporation. The corporation must reimburse the shareholder and report the reimbursement on the shareholder-employee s Form W-2. [Notice , C.B. 251] Affordable Care Act Under the Affordable Care Act, an S corporation that is an applicable large employer must provide minimum essential health coverage for its employees, but the S corporation is not required to provide coverage for a 2% shareholder. An S corporation that provides health coverage may have to comply with the market reforms. See the Affordable Care Act chapter of this book for a discussion of the Affordable Care Act employer mandate. 402 ISSUE 1: S CORPORATION FRINGE BENEFITS

5 Uninsured or Self-Insured Plans A 2% shareholder is not considered an employee for purposes of an uninsured or self-insured medical reimbursement plan [I.R.C. 105(g)]. Thus, any amounts that the S corporation provides to a 2% shareholder under a medical reimbursement plan must be treated as compensation for all tax purposes, including FICA, FUTA, and withholding taxes. Health Savings Account A health savings account (HSA) is a tax-exempt account that is set up to pay certain medical expenses. The contributions to the account are tax deductible. Distributions from the plan are not taxable if they are used to pay the plan owner s medical expenses during his or her lifetime or up to 1 year after death. Only a person who is covered by a high-deductible health plan (HDHP) can establish an HSA. For 2016, the deductible amount under the HDHP must be at least $1,300 for self-only coverage and $2,600 for family coverage. The 2016 maximum out-of-pocket expenses cannot exceed $6,550 for self-only coverage and $13,100 for a family plan [Rev. Proc , I.R.B. 970]. An employer may make deductible contributions to an HSA on behalf of one or more employees. The maximum contribution is the same as the maximum contribution for individuals. In 2016, that limit is $3,350 for self-only coverage and $6,750 for family coverage [Rev. Proc ]. Eligible persons age 55 and older can contribute an additional $1,000 per year [I.R.C. 223(b)(3)]. The employer s contributions reduce the amount that the employee can contribute to his or her HSA. The employer reports the HSA contribution in box 12 of the employee s Form W-2, with code W. The contributions (other than a contribution for a 2% shareholder) are excluded from the employee s gross income [I.R.C. 106(d)], and the contributions are not subject to social security or Medicare tax. A 2% shareholder cannot exclude the contribution from gross income [Notice , C.B. 368], but the contribution is excluded from FICA and FUTA if the employer s plan complies with I.R.C. 3121(a) (2)(B). A 2% shareholder can complete Form 8889, Health Savings Accounts (HSAs), and claim a deduction for the contribution. Disability Insurance An S corporation can deduct short-term or longterm disability insurance paid on behalf of an employee. Typically, the cost of the premium is excluded from the employee s gross income. However, a 2% shareholder is treated as a partner in a partnership and cannot exclude from gross income disability insurance premiums paid by the S corporation. Also, a 2% shareholder cannot deduct disability insurance premiums paid by the S corporation on his or her behalf. Life Insurance The tax treatment of employer payments of insurance premiums on the life of an employee depends on whether the employer is the owner of the policy or the employee is the owner. Employer as Owner An employer owns the policy when it will receive the proceeds upon the death of the insured, or when it has the power to name the beneficiary. In this case, payment of the premiums provides no benefit to the employee and results in no taxable income to the employee. The employer, as the owner of the policy, cannot claim a deduction for the premiums paid [I.R.C. 264(a)(1)]. Employee as Owner When an employer pays premiums on a policy insuring the life of an employee, and the employee is the policy owner, the arrangement is compensation. The premiums are included as employee compensation, without regard for stock ownership by the employee. The employer must withhold and pay employment taxes as if the premiums are additional cash compensation. The employer can claim a deduction for the premiums paid. I.R.C. 79 provides an exclusion for premiums paid on group term life insurance for coverage of no more than $50,000 per employee. Life Insurance

6 The employer must report as compensation the amount of the premium for insurance in excess of $50,000, according to a factor based on age of the employee [Treas. Reg (d)]. In general, there must be at least 10 employees participating in the plan. There are certain exceptions for employers with fewer than 10 employees or fewer than 10 insurable employees [Treas. Reg (c)(2)]. There are also special rules for employees covered by multiemployer or union plans. A 2% shareholder is not an employee for purposes of the group term life insurance rules. Therefore, a 2% shareholder cannot claim any exclusion for group term life insurance. Meals and Lodging I.R.C. 119 provides an exclusion from gross income for the value of meals and lodging that an employer provides to an employee. The meals and lodging must be for the employer s benefit. Meals must be served on the employer s premises [I.R.C. 119(a)(1)]. For lodging to be excludable, it must be on the employer s premises and must be a condition of employment [I.R.C. 119(a)(2)]. I.R.C. 119 does not treat a self-employed person as an employee for purposes of the exclusion, and the value of employer-provided meals and lodging is included in the gross income of a 2% S corporation shareholder. Accountable Plan Reimbursement for business travel expenses is not included in an employee s income if the employer has an accountable plan. See page 178 in the 2014 National Income Tax Workbook for a discussion of accountable plans. Cafeteria Plans FINAL COPYRIGHT 2016 LGUTEF A cafeteria plan is an arrangement adopted by an employer to allow employees to choose certain tax-advantaged fringe benefits or cash compensation. A participant who chooses nontaxable 404 ISSUE 1: S CORPORATION FRINGE BENEFITS benefits is not deemed to be in constructive receipt of the forgone cash [I.R.C. 125(a)]. Cafeteria Plans See pages of the 2013 National Income Tax Workbook for a discussion of cafeteria plans. I.R.C. 125 does not treat self-employed taxpayers as employees. Thus, 2% shareholders of S corporations may not participate in those plans. 2% Shareholder Participation in Cafeteria Plan All participants in a cafeteria plan must be current or former employees [I.R.C. 125(d)(1)(A)]. Because a 2% S corporation shareholder is not treated as an employee for fringe benefit purposes, participation by a 2% shareholder can disqualify the plan and thus adversely affect all of the employees. A C corporation converting to S corporation status should review its cafeteria plan and make sure that 2% shareholders and family members of 2% shareholders are not plan participants as of the date the S election takes effect. Educational Assistance An employer may establish a qualified educational assistance program. The employer s contributions are fully deductible, and the distributions may be tax free to the employee who receives the benefit, up to $5,250 per year [I.R.C. 127(a)(2)]. The program must not discriminate in favor of highly compensated employees. A 5% shareholder or a person whose compensation exceeds $120,000 is a highly compensated employee [I.R.C. 127(b)(2); I.R.C. 414(q)]. The antidiscrimination rule limits the amounts payable for highly compensated individuals (as a group) to 5% of the total benefits paid for the year [I.R.C. 127(b)(3)]. Somewhat narrow attribution rules extend the shareholder ownership rules to a spouse and minor children [I.R.C. 127(c)(4)(A); I.R.C. 1563(e)].

7 A 2% shareholder is treated as an employee for this purpose, and distributions are excluded from his or her income [Treas. Reg (h) (1)(iii)]. Example 12.2 Educational Assistance Herb Gardner owns all of the stock of Treeco, Inc., a landscaping firm with an S election. Herb s wife, Rose, is an assistant manager in Treeco s perennial floral group. Rose, who has completed some college, is studying for her degree in landscape architecture. Because she is married to Herb, she is constructively a 100% shareholder in Treeco. In order for Treeco to provide Rose with the maximum $5,250 excludable educational assistance benefit, Treeco s total educational assistance provided to its employees must be at least $105,000 ($105,000 5% = $5,250) during the year. Dependent Care Assistance I.R.C. 129 allows employees to exclude employer paid amounts to provide dependent care assistance [I.R.C. 129(a)(1)]. The maximum exclusion is $5,000 per year ($2,500 for married persons filing separate returns) [I.R.C. 129(a) (2)(A)]. S corporation 2% shareholders can exclude dependent care assistance from their gross income [I.R.C. 129(e)(3)]. However, the amount of benefits provided to principal shareholders (those who own more than 5% of the stock) cannot exceed 25% of the total paid by the employer to all employees for the year [I.R.C. 129(d)(4)]. Example 12.3 Dependent Care Assistance Careful, Inc. is an S corporation. Careful wants to provide dependent care assistance for Caroline Penn, its sole shareholder. Careful must pay dependent care expenses of at least $20,000 for its other employees in order to keep Caroline below the 25% limit and allow her to exclude the maximum $5,000 ($20,000 25%) amount. ISSUE 2: S CORPORATION BUILT-IN GAINS TAX The S corporation built-in gains tax imposes an entity-level tax on the sale of certain S corporation assets that have built-in gain attributable to a C corporation. This section discusses how to calculate that gain. Certain S corporations may be subject to a corporate-level tax on gains recognized on the sale of assets. Generally, this rule known as the builtin gains tax applies to former C corporations that recognize gains during their first 5 years as an S corporation, but only if the gains economically accrued while the corporation was still a C corporation. In general, the S corporation shareholders pay tax on the gain from the sale of the corporation s assets, including a sale of substantially all of the assets. The gain increases the shareholders basis, thus allowing the shareholders to avoid double tax. However, an S corporation that is subject to the built-in gains tax, a form of corporate income tax, pays a flat rate of 35%, in addition to the tax imposed on the shareholders. This tax may reduce, or even negate, the benefits of the S election. Built-In Gains Tax The built-in gains tax is imposed only when the corporation has assets that have appreciated in value in a C corporation. There is usually no builtin gains tax if a corporation has always been an S corporation, or a corporation has been an S corporation for at least 5 years. However, if the S corporation acquired assets from a C corporation in a tax-free reorganization, a subsidiary liquidation, or a QSub election, the acquired assets may be subject to the built-in gains tax for 5 years following the acquisition. S Corporation Built-In Gains Tax

8 Formerly, to avoid double tax, a C corporation could elect to be an S corporation shortly before liquidating or selling a substantial portion of its assets. Now, I.R.C imposes a corporate-level tax on certain built-in gains of a former C corporation for the first 5 years following conversion to S corporation status. This 5-year period is called the recognition period [I.R.C. 1374(d)(7)]. Built-In Gains Recognition Period Originally the built-in gains recognition period was 10 years. There was a temporary 7-year rule in 2009 and 2010, and a temporary 5-year rule in 2011 through The Protecting Americans from Tax Hikes Act of 2015 (PATH Act), Pub. L. No , made the 5-year period permanent. Thus, for 2016 and for all years not barred by the statute of limitations, the recognition period is 5 years. The 5-year period applies to all corporations whose S elections took effect in 2006 and later years. Calculating Net Unrealized Built-In Gain An important calculation at the time of conversion from a C corporation to an S corporation is net unrealized built-in gain (NUBIG). The corporation must annually report NUBIG on Form 1120S, U.S. Income Tax Return for an S Corporation. NUBIG limits the amount of taxable builtin gain that the corporation must report during the recognition period. NUBIG is the net gain that the corporation would have recognized if it had liquidated on the first day it became an S corporation. In general, the term means the fair market value (FMV) of all of the corporation s assets, less the adjusted bases of these assets [I.R.C. 1374(d)(1)]. The value also includes any item that would be treated as a built-in gain, even if it is not on the balance sheet [I.R.C. 1374(d)(5)(A) and 1374(d)(5)(C)]. It is reduced for any amount allowable as a deduction (such as accounts payable of a cash basis corporation), which is treated as a built-in loss, even though the item is not reflected on the corporation s balance sheet [I.R.C. 1374(d)(5)(B) and 1374(d)(5)(C)]. Example 12.4 Net Unrealized Built-In Gain Leon Lewis, Ginger Grace, and Ursula Underhill have developed a successful consulting firm, LGU, Inc. LGU has been a professional C corporation for over 30 years. Each of the three shareholders contributed $5,000 to the corporation in exchange for one-third of the stock. Because LGU has always been a C corporation, its income does not adjust the shareholders stock basis, which remains at $5,000 for each shareholder. The three principals are considering selling the firm. The corporation uses the cash method and carries a fairly large balance in receivables from year to year. If LGU sells its assets, it will be taxed on the disposition of the goodwill, the receivables, and any other assets that might transfer along with the practice, and distribution of the sale proceeds to the shareholders will constitute a dividend. The current status of LGU as a C corporation leaves the parties little tax-planning flexibility. Accordingly, they have decided that LGU will become an S corporation effective January 1, LGU s balance sheet on January 1, 2017, is shown in Figure ISSUE 2: S CORPORATION BUILT-IN GAINS TAX

9 FIGURE 12.2 LGU s Balance Sheet at Time of S Election Basis FMV Cash $ 18,500 $ 18,500 Accounts receivable 0 124,000 Office furniture and equipment 72, ,000 Goodwill 0 253,500 Total $ 90,500 $500,000 Accounts payable $ 0 $ 49,000 Bonus accruals for shareholders 0 21,000 Capital stock 15, ,000 Retained earnings 75,500 0* Total $ 90,500 $500,000 * The FMV of retained earnings is reflected in the FMV of the capital stock To calculate net unrealized built-in gain (NUBIG), LGU subtracts the adjusted bases of all of the assets from the FMV of those assets. LGU uses the cash method of accounting, and it can deduct accounts payable when it pays them. The board of directors approved bonus accruals for the shareholders before the end of 2016, and LGU can deduct those accruals on the day the shareholders take them into income. Therefore, these cash method items reduce the NUBIG. The NUBIG calculation is shown in Figure FIGURE 12.3 LGU s NUBIG Calculation Assets FMV $500,000 Assets adjusted bases (90,500) Accounts payable (49,000) Bonus accruals for shareholders (21,000) NUBIG $339,500 Calculating Net Recognized Built-In Gain The base for the built-in gains tax is derived from the corporation s net recognized built-in gain for each year in the recognition period [I.R.C. 1374(a)]. Treas. Reg (a) provides three ways to determine this amount, and the corporation uses the lowest of the following three amounts to determine net recognized built-in gain for the year: 1. The prelimitation amount 2. The taxable income limitation 3. The net unrealized built-in gain limitation Prelimitation Amount To calculate the prelimitation amount (PLA), the S corporation makes a pro-forma calculation of taxable income using the C corporation rules. The S corporation includes only recognized built-in gains and recognized built-in losses for the year. The recognized built-in gains are those gains that are reportable in the current year according to the S corporation s method of accounting. Recognized built-in gains include collection of a cash method receivable, sale of inventory, or a taxable disposition of other property. The builtin portion of these gains is limited to the amount of gain attributable to years before the S election took effect. The S corporation has the burden of proof to demonstrate that any gain or portion of a gain recognized is not a recognized built-in gain. For determination of the PLA, any recognized built-in gains are offset by recognized built-in losses. These are losses that are recognized in the current year (using the S corporation s method of accounting) but economically accrued before the S election took effect. The corporation has the Calculating Net Recognized Built-In Gain

10 burden of proof to demonstrate that any losses recognized in the current year accrued prior to the S election. Example 12.5 Prelimitation Amount In 2017, LGU from Example 12.4 collects $124,000 of its 2016 receivables. The S corporation pays its $49,000 accounts payable. The S corporation also pays its shareholders $21,000 of bonuses ($7,000 each) from To avoid the related party payment restrictions under Treas. Reg (c), it pays all $21,000 by March 15, Therefore, LGU treats the $21,000 as a recognized built-in loss. LGU s prelimitation amount for 2017 is shown in Figure FIGURE 12.4 LGU s 2017 Prelimitation Amount Revenue $124,000 Operating expenses (49,000) Shareholder compensation (21,000) Prelimitation amount $ 54,000 LGU prepares a dummy Form 1120, U.S. Corporation Income Tax Return, and completes lines 1 through 28 on page 1, including only recognized built-in gains and allowable recognized built-in losses. It then enters this total on Form 1120S, Schedule D, Part III, line 16. Taxable Income Limitation The second calculation of net recognized built-in gain requires another pro-forma Form 1120 computation to determine the taxable income limitation (TIL). The S corporation reports all of its current-year income and deductions. Thus, the S corporation reports all current-year income and expenses, but the S corporation must still follow the C corporation taxable income computation rules [Treas. Reg (a)(2)]. Example 12.6 Taxable Income Limitation In 2017, LGU from Examples 12.4 and 12.5 had the income and expenses shown in Figure FIGURE 12.5 LGU s 2017 Income and Expenses Revenue $1,560,000 Operating expenses (725,000) Shareholder compensation (820,000) Taxable income $ 15,000 The S corporation prepares another dummy Form 1120 and completes lines 1 through 28 on page 1, including income and gains and all allowable deductions and losses, regardless of the year of origin. It then enters this total on Form 1120S, Schedule D, Part III, line 17. Net Unrealized Built-In Gain Limitation The S corporation must determine its net unrealized built-in gain (discussed earlier) at the opening of business on the day the S election takes effect (the conversion date). If the net unrealized built-in gain is less than either the PLA or the TIL, it limits the built-in gains tax. After the first year in the recognition period, the net unrealized built-in gain limitation (NUL) is reduced by any net recognized built-in gain from prior S election years [Treas. Reg (a)(3)]. Calculating the Built-In Gains Tax The corporation computes the tax on its net unrealized built-in gain at the highest corporate rate (currently 35%). Example 12.7 Built-In Gains Tax LGU from Examples 12.4, 12.5, and 12.6 has no unused C corporation net operating loss carryforward. LGU calculates its final net recognized built-in gain as the lowest of its PLA, TIL, and NUL, as shown in Figure ISSUE 2: S CORPORATION BUILT-IN GAINS TAX

11 FIGURE 12.6 LGU s Net Recognized Built-In Gain Calculation Prelimitation amount $ 54,000 Taxable income limitation $ 15,000 Net unrealized built-in gain limitation $339,500 Net recognized built-in gain (lowest amount) $ 15,000 LGU multiplies the net recognized built-in gain by 35% to arrive at the built-in gains tax. LGU s built-in gains tax is $5,250 ($15,000 net recognized built-in gain 35%) if it sells all of its assets in Effect of the Built-In Gains Tax on Shareholder Income and Accumulated Adjustments Account The shareholders reduce their portion of S corporation taxable income by the amount of the built-in gains tax. The built-in gains tax is treated as a loss that corresponds to the gain that created the tax [I.R.C. 1366(f)(2)]. To the extent the tax is attributable to ordinary income, the tax becomes part of the Taxes and licenses entry on Form 1120S, page 1, line 12. If any of this tax is allocated to other categories, such as a capital gain, it is treated as an offsetting loss of the same character. Example 12.8 Built-In Gains Tax Impact on Shareholder Income and Corporate AAA LGU from Examples 12.4, 12.5, 12.6, and 12.7 has only ordinary income for Except for the effect of the built-in gains tax, LGU s taxable income for subchapter S purposes is the same as the income calculated for its TIL (discussed earlier). Figure 12.7 shows the effect of the built-in gains tax on LGU s income. FIGURE 12.7 LGU s Total Expenses with Built-In Gains Tax Revenues $1,560,000 Operating expenses (725,000) Shareholder compensation (820,000) Built-in gains tax (5,250) Ordinary Income $ 9,750 LGU allocates $3,250 of ordinary income ($9,750 3) to each of the three shareholders on Schedule K-1 (Form 1120S). The shareholders report their share of the income on Schedule E (Form 1040), Supplemental Income and Loss. If LGU does not distribute any money or property to the shareholders during the year, each shareholder adds $3,250 to his or her stock basis. LGU adds the $9,750 income to its AAA at the end of Because 2017 is its first year as an S corporation, $9,750 is the balance in the account at the beginning of 2018.[ Year-End Calculations Accumulated Adjustments Account An accumulated adjustments account (AAA) is an S corporation account that tracks income that has been taxed to the shareholders but not yet distributed. For an S corporation that was formerly a C corporation, the AAA separates the S corporation income (which is not taxed when distributed) from C corporation earnings and profits (which are taxed as a dividend when distributed). An S corporation that is subject to the built-in gains tax must subtract the year s net recognized built-in gain from the net unrealized built-in gain as of the beginning of the current taxable year. The reduced balance is the NUL for the next tax year [I.R.C. 1374(c)(2)]. If the corporation s TIL is the lowest measure of the corporation s net recognized built-in gain in any of the first 4 years of the recognition period, the corporation must compute the difference between this limitation and the other two measures (PLA or NUL, whichever is less). The result is the recognized built-in gain carryforward, which is treated as part of next year s PLA [I.R.C. 1374(d)(2)(B)]. Year-End Calculations

12 Finally, if the corporation has any unused net operating loss or net capital loss carryforwards from C corporation years, it may use these to offset its net recognized built-in gain [I.R.C. 1374(b)(2)]. The corporation must keep track of unused carryforwards for possible use in future years. C Corporation Carryforwards In general, an S corporation cannot claim a deduction for any carryforward arising in a year in which it was a C corporation [I.R.C. 1363(b)(2) and 703(a)(2)(D)]. However, the S corporation can use the net operating loss and net capital loss carryforwards to reduce the built-in gains tax. S corporations can also use any general business credit or alternative minimum tax credit carryforwards from C corporation years to reduce their built-in gains tax liabilities [I.R.C. 1374(b)(3)]. However, none of the loss or credit carryforwards can reduce S corporation shareholders taxable income or their income tax liabilities. The $39,000 built-in gain carryforward becomes a recognized built-in gain, part of the PLA for If LGU continues to limit its net recognized built-in gain with the TIL, the recognized built-in gain carryforward rolls forward to each year until the recognition period expires. After 5 years as an S corporation, any remaining recognized built-in gain carryforward simply disappears. LGU must adjust its NUL to reflect the builtin gains recognized in the current year. It must do this for each of the first 4 years in the recognition period, so that the total net recognized builtin gain in the 5-year period does not exceed the opening value. For each year, LGU reduces the opening net unrealized built-in gain by the net recognized built-in gain for the year, as shown in Figure FIGURE 12.9 LGU s Net Unrealized Built-In Gain Reduction Net unrealized built-in gain, January 1, 2017 $339,500 Net recognized built-in gain, 2017 ( 15,000) Net unrealized built-in gain, January 1, 2018 $324,500 Example 12.9 Calculations to Start Next Year s Form 1120S If LGU from Examples 12.4, 12.5, 12.6, 12.7, and 12.8 does not sell its assets in 2017, LGU must compile built-in gains tax information for LGU must calculate its recognized built-in gain carryforward, because its TIL was the lowest calculated recognized built-in gain. LGU calculates its recognized built-in gain carryforward as shown in Figure FIGURE 12.8 LGU s Recognized Built-In Gain Carryforward Calculation Prelimitation amount (PLA) $ 54,000 Net unrealized built-in gain limitation $339,500 (NUL) Lower of PLA or NUL $ 54,000 Taxable income limitation (TIL) ( 15,000) Recognized built-in gain carryforward $ 39,000 LGU s maximum total net recognized builtin gain from 2018 through 2021 cannot exceed $324,500. If LGU has any net operating loss, net capital loss, general business credit, or alternative minimum tax credit carryforwards, it must keep track of how much of each of these credits it uses in 2017, and how much, if any (considering expiration periods) is available for Year Period An S corporation only recognizes built-in gain on a sale of assets within the 5-year recognition period. If possible, the S corporation should wait to sell assets until 5 years after its conversion to S corporation status. 410 ISSUE 2: S CORPORATION BUILT-IN GAINS TAX

13 ISSUE 3: DEATH OF AN S CORPORATION SHAREHOLDER This section reviews how to determine eligible S corporation shareholders, methods to allocate S corporation income and losses, and the calculation of basis following the death of an S corporation shareholder. The death of a shareholder does not change the existence of a corporation. However, a change in shareholders can affect the corporation s continued eligibility for S corporation status. The corporation must allocate income between the deceased shareholder and the successor shareholder. The new shareholder must determine his or her basis in the stock and any debt from the corporation to the deceased shareholder. S Corporation Eligibility The transfer of shares to successor shareholders who are ineligible to hold S corporation stock may cause the entity to lose its S corporation status and become a C corporation. S Corporation Eligibility See the Business Entities chapter in the 2014 National Income Tax Workbook for an extensive discussion of the tax advantages of S corporation status and a business s eligibility to make the election. Often, the S corporation stock of a deceased shareholder passes to his or her estate. However, this is not always the case. A shareholder may have held the stock in a grantor trust, such as a revocable living trust. Moreover, the decedent may have established a testamentary trust (an irrevocable trust that comes into existence after death, such as a trust for a minor child or a marital trust for a spouse). To determine the continued eligibility of the corporation for S corporation status, the tax practitioner must know the ownership of the stock immediately after death, and the transfers that will take place after death according to the decedent s will, trust, or local law. Contrasting S Corporations with Partnerships State laws may provide that a partnership dissolves upon the death of a partner, unless the remaining partners affirmatively elect to keep the partnership in existence. Limited liability companies may have a similar requirement under state law, or pursuant to the operating agreement of the company. An S corporation is a corporation and has no such automatic expiration feature. It typically remains in existence until it has completed all of the acts necessary to achieve dissolution. An unincorporated entity that has elected S corporation status may be subject to an automatic dissolution, but for federal income tax purposes, it will continue to be a corporation until it has distributed all of its property and ceased all operations. Estate as Shareholder An estate is an eligible shareholder in an S corporation [I.R.C. 1361(b)(1)(B)]. Accordingly, as long as the estate remains the actual shareholder, there is no impact on the S election. During the period that the estate is the owner of the shares, the executor, administrator, or other duly appointed fiduciary acts as the shareholder for purposes of any elections and consents [Treas. Reg (b)(2)(iii)]. Example Estate as Shareholder When Merle Handsome died on April 6, 2016, he owned all of the shares in Bakersfield, Inc., an S corporation. Merle owned the shares outright, so all of the shares passed to his estate. The estate is an eligible S corporation shareholder, so Merle s death does not terminate Bakersfield s S corporation status. 12 S Corporation Eligibility 411

14 Individual Shareholders The primary purpose of an estate is to pay debts and make distributions as mandated by the decedent s will or local law. Thus, there is a transfer from the estate to the decedent s heirs or devisees. If an estate distributes all of the S corporation stock directly to US citizens or residents, the corporation s S election continues unabated. However, if any of the intended transferees are ineligible persons, such as nonresident aliens or corporations, the S corporation will lose its S election as of the day the ineligible person or entity receives any share of the corporation [Treas. Reg (b)(2)]. If the executor or administrator is unable to prevent the transfer of shares to an ineligible shareholder, the corporation will become a C corporation. Example Eligible Distributees of an Estate Merle from Example did not have a will, and under state law, his estate passes to his children. The executor of Merle s estate administers the estate and then distributes the stock in equal proportions to Merle s six children, all of whom are US citizens. The children are eligible S corporation shareholders, and the transfers of shares resulting from Merle s death will not terminate Bakersfield s S election. Trust as Shareholder FINAL COPYRIGHT 2016 LGUTEF The deceased shareholder s will may designate one or more trusts to receive the stock. Alternatively, the decedent s revocable trust may continue as an irrevocable trust following the death of the shareholder. Most trusts are not eligible S corporation shareholders. However, there are several types of trusts that do qualify. Trusts that are eligible S corporation shareholders include the following: 1. Grantor trusts 2. Beneficiary controlled trusts 3. Grantor trusts, after the death of the grantor 4. Testamentary trusts 5. Qualified subchapter S trusts 6. Electing small business trusts Grantor Trusts A grantor trust is one in which the grantor retains certain powers to control trust property [I.R.C. 673 through 677]. All of the taxable income, deductions, and other tax attributes of the trust pass through directly to the grantor, and the grantor reports those items directly on his or her tax return [I.R.C. 671]. A grantor trust can be a shareholder in an S corporation if the grantor is a US citizen or resident. The grantor is treated as the shareholder [I.R.C. 1361(c)(2)(A)(i)]. Beneficiary Controlled Trusts Often known as a deemed grantor trust, a beneficiary controlled trust, or a 678 trust, the grantor of a beneficiary controlled trust gives powers to the beneficiary to bypass the fiduciary for certain actions. Any trust that is controlled by the beneficiary, whether the beneficiary is the actual grantor or a deemed grantor, is also known as a subpart E trust (subpart E of part I of subchapter J). If the deemed grantor is a US citizen or resident, a subpart E trust is eligible to hold shares in an S corporation [I.R.C. 1361(c)(2)(A)(i)]. Grantor Trusts, after Death of Grantor A grantor trust continues to be an eligible shareholder for a limited period of time after the death of the grantor (or deemed grantor). Unless the trust meets one of the other trust qualifications, it must distribute the shares within 2 years after the decedent s death [I.R.C. 1361(c)(2)(A)(ii)]. The estate is treated as the owner of the S corporation stock during this 2-year period [Treas. Reg (h)(3)(i)(B)]. Testamentary Trusts A testamentary trust is typically an eligible shareholder for only 2 years after it receives the stock [I.R.C. 1361(c)(2)(A)(iii)]. However, a trust that gives sufficient powers to one person may be a beneficiary controlled trust, in which case the trust is an eligible shareholder (if the person with the powers is an eligible shareholder). Alternatively, a testamentary trust may qualify as an eligible qualified subchapter S trust (QSST) or electing small business trust (ESBT). 412 ISSUE 3: DEATH OF AN S CORPORATION SHAREHOLDER

15 Qualified Subchapter S Trusts A qualified subchapter S trust (QSST) is a trust with certain hybrid features. No one has sufficient power over trust income or property to cause the trust to be a grantor trust or deemed grantor trust. However, the current income beneficiary may elect to treat the trust as a deemed grantor trust [I.R.C. 1361(d)(2)]. If the beneficiary is a US citizen or resident, the trust then qualifies as a shareholder. A QSST must meet all of the following conditions: 1. The trust instrument must provide that there is only one current income beneficiary. 2. The trust instrument must provide that all distributions of trust property may be made only to the income beneficiary. 3. The trust instrument must provide that the income beneficiary s interest in the trust cannot terminate during his or her lifetime. 4. The trust instrument must provide that all trust property must be distributed to the income beneficiary if the trust terminates during his or her lifetime. 5. The trust instrument may require that the trustee distribute all trust income annually, or the trustee must make annual distributions of income, if the trust instrument does not require these distributions. 6. The beneficiary must elect to treat the trust as a QSST. [I.R.C. 1361(d)(3)] As a result of the QSST election, the portion of the trust consisting of S corporation stock is treated as a beneficiary controlled trust [I.R.C. 1361(d)(1)]. The beneficiary must include in the beneficiary s gross income all of the trust s share of income, deductions, losses, and gains from the S corporation. Electing Small Business Trusts The electing small business trust (ESBT) can have more than one potential current income beneficiary (PCB), and the trustee can have discretion to accumulate or sprinkle income. However, this trust is subject to the following rules under I.R.C. 1361(e)(1): 1. Each PCB must be a US citizen or resident [Treas. Reg (m)(1)(ii)(D)]. 2. The number of PCBs cannot be so great as to cause the corporation to exceed the 100-shareholder limit (considering family attribution) [Treas. Reg (m)(4)(vii)]. 3. The trustee must elect to treat the trust as an ESBT [Treas. Reg (m)(2)]. As a result of the ESBT election, the trust is liable for all of the tax on the income passing through from the corporation [Treas. Reg (c)-1(d)]. Distributions from the trust to beneficiaries are tax free, to the extent the distributions are from the S corporation income [Treas. Reg (c)-1(i)]. Complexities of Trusts Holding S Corporation Shares The rules for trusts holding S corporation stock are complicated, and unwary S corporations often find themselves requesting relief from inadvertent termination or inadvertent defective election relief for failure to abide by one or more of the trust rules. If a shareholder s estate plan includes the pre- or post-death transfer of any S corporation stock to a trust, the tax professional must examine the trust provisions carefully and, if necessary, refer the client to a specialist. Example Testamentary Trust as Shareholder In Example 12.10, Merle s estate became the shareholder at the time of his death. The executor of Merle s estate found Merle s will, which directs the executor to place the Bakersfield stock in trust for the benefit of Merle s six children, some of whom are minors. The trust qualifies as a shareholder in the S corporation for 2 years from the date of funding. If the estate transferred the stock to the trust on September 23, 2016, the trust qualifies as a testamentary trust through September 22, S Corporation Eligibility 413

16 Allocation of Income or Loss in Year of Death A decedent s share of S corporation income (to date of death) must be reported on the tax return for the year of the decedent s death [I.R.C. 1366(a)(1)]. Because most S corporations and almost all US individuals use the calendar year for tax purposes, this rule rarely causes a problem. However, if the corporation uses a fiscal year, the S corporation s tax year may end in a year after the shareholder s death. The deceased shareholder s share of S corporation income and loss for the year is typically calculated using a pro rata allocation that allocates the decedent s share of total yearly income or loss based on the number of days that the decedent was a shareholder. In some circumstances the corporation can elect to use the closing of the books method, which allocates S corporation income to periods before and after the date of transfer of the decedent s shares. Example Fiscal-Year S Corporation and Death of Shareholder Bakersfield, Inc. from Example uses a March 31 fiscal year. Therefore, Merle s death occurred in the fiscal year ending March 31, Individuals who use the calendar year report their share of income from the tax year beginning April 1, 2016, on their 2017 returns. However, Merle s estate must report the income from the 6 days in which Merle was alive on Merle s final return. Bakersfield may not be able to issue Merle s Schedule K-1 (Form 1120S) until after the due date for his 2016 return. Often the decedent must extend or amend the final return to comply with this rule. Pro Rata Allocation FINAL COPYRIGHT 2016 LGUTEF An S corporation must apportion all of the income, losses, deductions, and other items among all of its shareholders. Usually, it allocates all of its items on a per-share per-day basis [I.R.C. 1377(a)(1)]. In general, the S corporation must allocate all items (such as ordinary income, capital gains, and nondeductible items) in identical proportions to each shareholder. The proportions are determined by a weighted-average allocation formula that calculates the average percentage ownership of each shareholder for the year. The weightedaverage allocation formula does not change when shares are transferred during the year. Instead, the corporation calculates a new weighted average. (Example shows how to calculate weighted-average percentage ownership.) Comparison to Partnerships A partnership may have more flexibility to allocate taxable income and other tax items. The IRS will respect special allocations if they have substantial economic effect. Closing of the Books The S corporation may close its tax year on the date of certain events [I.R.C. 1377(a)(2)]. Treas. Reg allows the S corporation to elect to close its books when a shareholder completely terminates his or her shareholder interest. This provision is elective and requires the consent of affected shareholders [I.R.C. 1377(a) (2)(A)]. To indicate consent, the corporation must attach a statement to its Form 1120S stating that the affected shareholders have consented [Treas. Reg (b)(5)(i)(D)]. Within each portion of the tax year, the corporation must apportion all items of income, deduction, and so forth on a per-share per-day basis. The method that the corporation chooses can make a big difference if the S corporation earns income unevenly throughout the year (e.g., if it is a seasonal business that earns 80% of its income during the December holiday season). The closing of the books can occur upon any of the following events: 1. Sales of stock 2. Gifts of stock 3. Transfer at death 4. Redemptions of stock, whether treated as exchanges or distributions 5. Divisive reorganizations, where some shareholders exchange stock in the distributing corporation 414 ISSUE 3: DEATH OF AN S CORPORATION SHAREHOLDER

17 6. A conversion of a trust, in certain circumstances shown in Figure [Treas. Reg (b)(4)] FIGURE Closing of the Books upon Trust Conversion Conversion From Conversion To Termination? Grantor or deemed grantor (includes QSST via I.R.C. 1361(d)(1)(A)) ESBT Grantor, QSST, deceased grantor, testamentary, ESBT Grantor (including QSST), deceased grantor, testamentary No Deceased grantor Any other Yes Testamentary Any other Yes No Transferor Treated as Owner on Date of Transfer The transferor is considered the owner on the day of transfer [Treas. Reg (a)(2)(ii)]. For a deceased shareholder, the day of transfer is the date of death. Thus, the corporation allocates to the former owner all income and other items occurring up to and including the day of the transfer. The new owner s allocation begins the day after the transfer. Example Allocation of S Corporation Income and Loss Assume that Bakersfield, Inc. from Example uses the calendar year for tax purposes, and that the estate transferred all of the shares to a trust on September 23, Bakersfield must calculate its weighted-average ownership for 2016 as shown in Figure FIGURE Bakersfield s Calendar-Year Weighted-Average Ownership Shareholder Period Days Percent of Year Merle January 1 April Merle s estate April 7 September Testamentary trust September 24 December Total 366* * 2016 is a leap year, so there are 366 days in Bakersfield has the following options for apportioning its taxable income and other items in 2016: 1. It may allocate all of the income or loss from January 1 through December 31 in accordance with the percentages shown in Figure It may close the year for accounting purposes on April 6, allocate the first 97 days income to Merle, and allocate the remaining 269 days income to the estate and the trust. The corporation would then apportion the income between the estate and trust based on the days each held the stock. 3. It may close the year for accounting purposes on September 23, allocate the first 267 days Allocation of Income or Loss in Year of Death

18 income to Merle and the estate, and allocate the remaining 99 days income to the trust. The corporation would then apportion the income between Merle and the estate based on the days each held the stock. 4. It may close the books for accounting purpose on April 6 and September 23 and then allocate the first 97 days income to Merle, the next 170 days income to the estate, and the remaining 99 days income to the trust. The timelines in Figure depict the four allocation options. Each vertical line represents a closing date. The income between the vertical lines is calculated and allocated according to the percentages indicated. FIGURE Allocation of S Corporation Income and Loss Basis after Death of Shareholder As discussed earlier, there is no termination of existence of the corporation as a result of the death of a shareholder. Consistent with this rule, there is no transfer of property inside the corporation. Therefore, there is no change in basis, holding period, or any other tax attributes of corporate assets. Comparison of S Corporations and Partnerships A partnership may be able to adjust the basis of its assets (the inside basis) for the new partner. The I.R.C. 754 election is discussed later in this chapter. Date-of-Death Fair Market Value The successor to the shareholder s shares typically receives a date-of-death FMV basis in the shares [I.R.C. 1014]. There are some exceptions relating to alternate valuation dates and special elections [I.R.C. 1014(a)(2) (4)]. A special rule applies to appreciated property acquired by the decedent as a gift within 1 year preceding death. If such property passes back to the donor or to the donor s spouse, the decedent s basis carries over to that donor (or spouse) [I.R.C. 1014(e)]. Consistent Basis Reporting See the New and Expiring Legislation chapter in this book for a discussion of I.R.C and other provisions related to the consistent-basisreporting requirement mandated by the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, Pub. L. No ISSUE 3: DEATH OF AN S CORPORATION SHAREHOLDER

19 Regardless of whether the S corporation uses the accrual method of accounting or the cash method, the successor s initial basis is still the FMV, usually at the date of death. Example Basis to Estate Accrual Method of Accounting At the time of her death, Sharon Smith owned 100% of the shares in Smith Enterprises, Inc., an accrual method S corporation. Her shares were valued at $6,000,000. Sharon s estate has a $6,000,000 opening basis in the shares. Income in Respect of a Decedent The successor shareholder must reduce his or her stepped-up basis in the inherited stock to the extent that the value of the stock is attributable to items that are income in respect of a decedent (IRD) in the S corporation at the time of the prior shareholder s death [I.R.C. 1367(b)(4)(B)]. S corporation IRD items could include accounts receivable when collected, interest and dividend income from an S corporation s investments, and income from installment sales made by the S corporation. Example Basis to Estate Cash Method of Accounting The facts are the same as in Example except that Smith Enterprises, Inc. uses the cash method of accounting. On Sharon s date of death, Smith Enterprises had $2,500,000 of uncollected accounts receivable and $500,000 of unpaid accounts payable. Smith Enterprises computes net IRD of $2,000,000 ($2,500,000 $500,000). Thus, the estate s initial basis in the stock is $4,000,000 ($6,000,000 $2,000,000 imputed IRD). ISSUE 4: S CORPORATION ELECTION This section discusses how and when to make an S corporation election, and it explains how to request relief from an election that is late or defective. A business electing S corporation status must file Form 2553, Election by a Small Business Corporation, with the IRS service center (Cincinnati or Ogden) where the company files (or will file) its tax returns. The electing business cannot be a sole proprietorship because the proprietor is the individual taxpayer and an individual cannot meet the domestic corporation criteria of I.R.C Therefore, prior to electing S corporation status, the proprietor must form a separate legal entity [such as a limited liability company (LLC) or a corporation] to conduct the business activities. Practice of Law An eligible corporation can elect S corporation status. A partnership or an LLC must elect to be taxed as a corporation in order to elect S corporation status. An eligible partnership, or any eligible domestic LLC, whether it has one member or multiple members, can elect to be taxed as a corporation by filing Form 8832, Entity Classification Election, within 75 days after (or within 12 months before) the desired effective date of corporate status. A newly formed entity must have a federal employer identification number (FEIN) to file Form The IRS will also accept a late entity classification relief request in the same manner as it accepts late S corporation elections, discussed later. Preparing and filing forms to incorporate a corporation or organize a partnership or limited liability company (LLC) likely constitutes the practice of law. See the Ethics chapter in this book for a discussion of the unauthorized practice of law. S Corporation Election

20 Partnership or LLC Compliance with Single-Class-of-Stock Rule Many partnership agreements and LLC operating agreements are designed to assure partnership classification for federal income tax purposes. Both the partner s interest in the partnership and substantial-economic-effect rules tie liquidating distributions to a partner s capital account. Therefore, this agreement ties liquidating distributions to the members, rather than to the units of ownership, which creates more than one class of stock. Accordingly, the entity must revise its partnership agreement or operating agreement to be compatible with the single-class-of-stock rule. If an LLC or partnership filed Form 8832 and claimed C corporation status in a prior year, it may file Form 2553 separately to switch to S corporation status. If the company or partnership is electing S corporation status as of the first day it is seeking entity classification as a corporation, Form 2553 will suffice as the entity classification election. The company or partnership does not have to file Form 8832 in addition to Form 2553 [Treas. Reg (c)(1)(v)(C)]. Effect of Entity Election The election to become a C or S corporation binds the entity to all of the tax rules applicable to the chosen tax classification. For instance, if an LLC has an S election in place, and the LLC violates one of the S corporation rules, such as the type or number of shareholders or classes of stock, the LLC then becomes a C corporation. It does not revert to partnership or disregarded entity status unless it is able to revoke the classification election. If the LLC revokes the classification election, it is treated as if it is a corporation that has completely liquidated. Example Partnership Electing S Corporation Status LMN is a partnership. Its partners provide services to the partnership. Under the partnership rules, the owners of LMN are treated as self-employed 418 ISSUE 4: S CORPORATION ELECTION taxpayers. If LMN elects to be taxed as a corporation, the LMN owners must become employees, and the entity is subject to all of the payroll and withholding tax rules applicable to a corporate employer. Timely Filing Form 2553 Form 2553 is due by the fifteenth day of the third month of the tax year for which it is to take effect. If the company is in existence as a C corporation, it may file the election in the tax year before it intends the status to be effective. Paper Filing of Form 2553 As of 2016, taxpayers can file Form 2553 by mail or by fax. There is no electronic option for filing Form 2553, and there is no substitute form. When the IRS receives and processes Form 2553, it sends the company a CP261 notice entitled Notice of Acceptance as an S Corporation. The normal turnaround time for this notice is 60 days after the IRS receives a correct and complete Form If the company does not receive this notice, it should contact the IRS service center. A copy of a certified mail receipt may help the IRS track the filing and is acceptable evidence of filing if the IRS is unable to locate the form. The company should retain a copy of the acceptance notice in its permanent records. Relief for Late or Defective S Elections There are several relief measures for failure to file timely or accurate S corporation elections. In 1996, Congress amended the inadvertent termination relief rule of I.R.C. 1362(f) to apply to corporations that filed a timely S election but that inadvertently failed to meet the eligibility requirements when the corporation filed Form 2553, or

21 met the eligibility rules but neglected or misstated some of the information on Form In 1996, Congress also enacted I.R.C. 1362(b)(5), which instructs the IRS to treat late S corporation elections as if they had been timely filed, if there was reasonable cause for the delinquency. Inadvertence and Reasonable Cause FINAL COPYRIGHT 2016 LGUTEF In reference to late S elections, faulty elections, and S corporation status terminations, the terms inadvertence and reasonable cause are not synonymous. Inadvertence requires an admission of the problem; a statement about the corrective action; and a representation by all affected parties that they were unaware of the defect, and that they are not using the problem as a retroactive taxplanning scheme. An officer of the corporation must sign the statement on behalf of the corporation. All persons or entities who have been owners from the time of the violation until the day the corporation files the relief request must also sign the statement under penalty of perjury, indicating that they agree with the statement and that they have filed consistently and will file consistently with their status as S corporation shareholders for all years in question. Reasonable cause is intended to be a less stringent standard than inadvertence. Although an officer of the corporation and all of the shareholders must sign the statement under penalty of perjury, the cause is simply that the corporation did not file a timely Form The cure is to file Form 2553, and to have all shareholders file their returns consistent with S corporation status. As is discussed later, the corporation can satisfy the reasonable cause rule if there is evidence that the corporation s owners believed that the corporation was an S corporation. Relief Granted by the IRS National Office If the IRS service center does not have jurisdiction to grant relief (see the discussion later), the taxpayer must request relief for late elections, inadvertent terminations, and inadvertent defective S elections by submitting a letter ruling request to the IRS National Office. Generally, the only tax professionals who can submit a letter ruling request are attorneys, CPAs, and EAs who are permitted to practice before the IRS. The preparer must submit a valid power of attorney with the ruling request. The IRS charges a user fee for letter ruling requests. The first revenue procedure each year explains the IRS policy on letter ruling requests and sets forth the schedule of user fees. The user fees vary according to gross income (actually, gross receipts). The user fees established in Rev. Proc , I.R.B. 1, are shown in Figure FIGURE User Fees for Letter Ruling Requests (2016) Gross Income (Plus Cost of Goods Sold) for 12-Month Taxable Year prior to Filing Request Citation in Rev. Proc , Appendix A Fee Less than $250,000 $ 2,200 (4)(a) At least $250,000 but less than $1,000,000 $ 6,500 (4)(b) At least $1,000,000 $28,300 (3)(c)(ii) Relief Granted by IRS Service Centers Since the enactment of the relief provisions, there have been thousands of letter rulings granting the requested waivers. Thus, the relief rules have been a boon to taxpayers and their advisers in coping with the election rules. However, when a taxpayer can avoid the user fee and the rigid procedural requirements for composing a letter ruling request, the relief is all the more welcome. Accordingly, the IRS has gradually expanded the list of problems that the service centers can address. Rev. Proc , I.R.B. 173, coordinates relief for all of the following: Late S elections Late entity classification elections Late QSub elections Relief for Late or Defective S Elections

22 Late QSST elections Late ESBT elections FINAL COPYRIGHT 2016 LGUTEF Under Rev. Proc , the IRS service centers can grant relief if the election is no more than 3 years and 75 days late. Thus, corporations that qualify for this relief may avoid the user fee and administrative burden of a letter ruling request. However, the relief is not automatic, except in one limited circumstance. Late Election, Return Not Filed If the corporation has not yet filed Form 1120S for the first intended S corporation year or any subsequent year, the shareholders must have reported their income each year consistent with the S corporation election [Rev. Proc , 5.02]. This means that no shareholder has omitted income or loss from the S corporation on a return filed during the period for which the S corporation seeks the retroactive S election. Under this rule, the corporation must file its Form 2553 no later than 3 years and 75 days after the effective date. The effective date is the day the election was intended to become effective [Rev. Proc , 4.01(3)]. For a corporation that has never filed Form 1120S, the corporation should attach Form 2553 to the late 1120S for the year the election was to become effective. In addition, the corporation must file any delinquent Forms 1120S at the same time. If the corporation misses the 3 year and 75 day period specified in Rev. Proc , or fails to meet any of the other specified conditions to request late election relief, the corporation must file a letter ruling request with the National Office [Rev. Proc , 3.02]. Late Election, Return Filed An entity that has mistakenly filed an S corporation return before filing Form 2553 may request relief for a late election. All of the owners must state that they have filed returns in a manner consistent with the S election being in effect [Rev. Proc , 5.02]. Thus, if any shareholder has omitted S corporation items, or has not filed a return at the time of the relief request, the corporation is in violation of this requirement. It should be a relatively simple matter to have any shareholders who have not filed returns file their returns for the year before or at the time of the relief request, so that they can make the required representations. Any shareholders who have filed returns that do not reflect S corporation items may create a different problem. An amended return will not generally be treated as a return unless the IRS accepts it. However, in the spirit of the late election relief, the IRS is likely to accept an amended return as being compliant with this requirement. The entity should address the status of shareholder returns for the year in question in the relief request. ISSUE 5: PARTNERSHIP I.R.C. 751(b) PROPOSED REGULATIONS This section discusses the I.R.C. 751(b) proposed hot asset regulations. On October 31, 2014, the IRS issued proposed regulations under I.R.C. 751(b) that would change how a partnership calculates the value of distributed unrealized receivables and substantially appreciated inventory. Specifically, the proposed regulations will, when finalized, revise the computation of I.R.C. 751 transactions from a gross asset value approach as originally enacted in the 1950s to a hypothetical sale approach. History of I.R.C. 751 I.R.C. 751, which is frequently referred to as the collapsible partnership provision, was enacted in Prior to 1954, all partnership sales were treated as an entity sale. The purpose of I.R.C. 731, 741, and 751 is to prevent partners from converting ordinary income into capital gain by disposing of their partnership interests instead of their interest in the underlying partnership assets. 420 ISSUE 4: S CORPORATION ELECTION

23 Under the general rule of I.R.C. 741, the sale of a partnership is a capital transaction, except for assets subject to I.R.C The general rule of I.R.C. 731 is that no gain is recognized on a distribution of assets unless money is distributed in excess of basis or I.R.C. 751 assets are distributed disproportionately. I.R.C. 751 assets for these purposes are unrealized receivables and substantially appreciated inventory items. An important distinction in I.R.C. 751 is the interplay of I.R.C. 751(a) and (b). I.R.C. 751(a) applies to sales or exchanges of interests and defines hot assets as unrealized receivables and inventory items. The proposed regulations make no changes to I.R.C. 751(a) transactions. I.R.C. 751(b) relates to distributions of assets and defines hot assets as unrealized receivables and substantially appreciated (fair market value must exceed 120% of basis) inventory items. The proposed regulations apply to I.R.C. 751(b) transactions. The application of the collapsible partnership rules is important not only because of the preferential rate on capital gains and the limitation on the deductibility of capital losses, but also because the rules under I.R.C. 751 can cause a partner or the partnership to recognize a gain that might otherwise be deferred. While the concept behind I.R.C. 751 is simple, its application can become quite complicated when there are distributions of partnership property. Example Sale of Partnership Interest Partners Alice Abell and Belinda Brooks each have a 50% interest in AB Partnership, a cash basis partnership. The only asset of AB Partnership is a $200 milk check receivable, with a $0 basis. If Alice sells her partnership interest for $100 (either to Belinda or someone else), under the general rule, the sale of the interest is treated as a capital gain. However, the collapsible partnership provisions cause such gain to be taxed as ordinary income, even though the receivable is not included in income until it is received. I.R.C. 751(b) Hot Assets Under I.R.C. 751(b), hot assets include the following: 1. Unrealized receivables: Receivables represent the right to receive payments in exchange for goods (other than capital assets) or services. Unrealized receivables are those receivables that have not previously been included in income. Unrealized receivables also include, by definition, depreciation recapture (I.R.C and 1250) and recapture of soil and water conservation expenses (I.R.C. 1252). Depreciation recapture is considered to be an unrealized receivable with no basis. 2. Substantially appreciated inventory: The definition of inventory primarily includes stock in trade or property held for sale. But it also includes property not considered a capital asset or I.R.C property. In order to be considered a hot asset, the inventory must have appreciated by more than 20%. Transactions Subject to I.R.C. 751(b) Disproportionate Distribution A disproportionate distribution occurs when a partner receives something other than his or her pro rata share of hot assets. The proposed I.R.C. 751(b) regulations would replace the gross value approach with a hypothetical sale approach to determine whether there has been a disproportionate distribution of hot assets. The gross value approach compares the gross value of the partner s share of partnership assets before and after the distribution. The hypothetical sale approach requires the partnership to compare the amount of ordinary income that each partner would recognize if the assets of the partnership were sold for FMV immediately before the distribution, and 12 Transactions Subject to I.R.C. 751(b) Disproportionate Distribution 421

24 the amount of ordinary income that each partner would recognize if the assets remaining after the distribution were sold for fair market value plus the amount of income the distributee partner would recognize on the sale of the distributed property immediately after the distribution. If there is no difference between the gain recognized in the two scenarios, then I.R.C. 751(b) does not apply. To the extent the ordinary gain is shifted among the partners, an adjustment is required. The proposed regulations allow any reasonable approach to determine the adjustment of an I.R.C. 751(b) distribution. The IRS has declared that the hot asset sale approach and the deemed gain approach are both reasonable methods to determine the adjustment. Hot Asset Sale Approach Under the hot asset sale approach, the partners who have a reduced interest in the hot assets are deemed to have received a distribution equal to the diminished amount of hot assets, and they are deemed to have sold the relinquished property to the partnership immediately prior to the deemed distribution. Deemed Gain Approach Under the deemed gain approach, the partnership recognizes ordinary income in the aggregate amount of any reduced interest in hot assets, and that deemed ordinary gain is allocated to the partners with a reduced interest in hot assets due to the distribution. Additionally, the basis of the hot assets in the hands of the remaining partners is increased to reflect the ordinary income recognized. Anti-Abuse Rule The proposed regulations include a provision to prevent the application of I.R.C. 751(b) with the interplay of I.R.C. 704(c) if a transaction would be subject to I.R.C. 751(b) absent the application of I.R.C. 704(c). This is a limited application, and is specifically designed to avoid abusive tax planning. ISSUE 6: NEW PARTNERSHIP AUDIT RULES The new partnership audit regime changes how the IRS will audit partnerships and their partners. The Bipartisan Budget Act of 2015 (BBA), Pub. L. No , repeals both the TEFRA audit regime and the electing large partnership audit procedures. The BBA 1101 revision to partnership audits is effective for partnership tax years beginning after December 31, Partnerships may elect to have the BBA audit rules apply earlier. History of the Audit Regime Prior to the passage of the Tax Equity and Fiscal Responsibility Act (TEFRA), Pub. L. No , in 1982, the IRS conducted partnership audits, but the process was costly and often resulted in inequitable results. Following a partnership examination, the IRS proposed adjustments to each partner individually, and each partner could appeal the results. The statute of limitations applied at the individual partner level, and often would result in different final dates for adjustment for different partners or no adjustment if the statute of limitations had expired. There was a significant growth in partnerships, particularly large limited partnerships engaged in tax-sheltering activities, and the audit system under TEFRA was added to allow the IRS to control all aspects of the partnership examination at the partnership level. TEFRA added I.R.C through Under TEFRA, adjustments to partnership items are finalized through the partnership proceedings. The statute of limitations for any adjustment of partnership items reported on the partners returns is determined at the partnership level. The TEFRA audit guidelines generally apply to all partnerships with more than 10 partners, as well as partnerships with partners that are flow-through entities. Partnerships with 10 or fewer partners were generally subject to the pre-tefra audit regime, unless the partnership made a proactive election to be subject to TEFRA. In 1997, a third audit regime, which allows partnerships with at least 422 ISSUE 5: PARTNERSHIP I.R.C. 751(b) PROPOSED REGULATIONS

25 100 partners to elect to be taxed under the electing large partnership rules, was enacted. Therefore, prior to the passage of the BBA, there were three distinct audit regimes for partnerships, as follows: 1. Small partnerships: A partnership that meets the definition of a small partnership may elect to be a TEFRA partnership [subject to the unified audit and litigation procedures set forth in I.R.C. 6231(a)(1)(B)(ii)] by filing Form 8893, Election of Partnership Level Tax Treatment. If the small partnership does not elect to be a TEFRA partnership, the partnership is subject to the pre-tefra rules. 2. TEFRA audits: The TEFRA audit regime applies to all partnerships with more than 10 partners, any partnership with flow-through entities as partners, and electing small partnerships. However, electing large partnerships are audited under separate rules. Under TEFRA, the partnership is audited with a tax matters partner representing the entire partnership. The IRS adjusts each partner s return for the year in which the partnership adjustments apply. 3. Electing large partnership audits: The partnership is audited, again with limited representation by the partners. A significant difference over TEFRA is that any adjustments are made by the partners in the year of the audit, as opposed to in the year related to the partnership tax year under audit. Entity-Level Audit Rules The entity-level audit rules will apply to all partnerships, but there is an opportunity to elect out of the entity-level regime for partnerships with 100 or fewer partners that do not have either a trust or partnership as a partner. For purposes of determining the 100-partner level, any partner that is an S corporation is not counted as a partner, but instead all shareholders of the S corporation are counted as partners. Example Number of Partners for the Entity-Level Audit Rules Happy Acres is an LLC with 74 members. It issues 74 Schedules K-1 (Form 1065), Partner s Share of Income, Deductions, Credits, etc., one to each member. However, 4 of the members are S corporations, each of which have 9 shareholders (for a total of 36 shareholders). Members counted for purposes of the entity-level audit rules are shown in Figure FIGURE Happy Acres Members for the Entity-Level Audit Rules Total LLC members 74 Subtract: S corporation members (4) Add: total S corporation shareholders 36 Total members for test 106 Happy Acres has more than 100 members, and it is subject to the entity-level audit rules. New Audit Procedures under the BBA The BBA repeals both the TEFRA audit regime and the electing large partnership audit procedures. The BBA revision to partnership audits is effective for partnership tax years beginning after December 31, Partnerships may elect to have the BBA audit rules apply for tax years beginning after November 2, The new audit regime has two audit procedures: the entity-level audit rules and the electing small partnership rules. The IRS has yet to issue detailed procedures describing the process of the new entity-level audit regime. Once detailed guidelines are published, it will become clearer how the audits will proceed. At the time of this book s publication, only general guidance is available. The IRS will audit the partnership directly, similar to a TEFRA audit. However, there will no longer be a tax matters partner (TMP). Instead, each partnership will appoint a partnership representative (PR). The PR is the only person who may represent the partnership. The PR has statutory authority to bind all partners for tax matters or adjustments at both the audit level and in any judicial matters. The PR is named by the partnership and can be any individual with a substantial presence in the United States. The PR does not New Audit Procedures under the BBA

26 have to be a partner in the partnership. If the partnership does not appoint a PR, the IRS will select a PR under yet-to-be-established procedures. The PR has much more authority than the TMP did under the TEFRA guidelines. When a partnership is audited, the IRS will no longer notify each partner of the audit. Instead, the IRS will send a statutory notice indicating that the entity is being audited, known as a Notice of Administrative Proceeding (NAP). The IRS sends the notice only to the partnership and the PR. After completing the audit procedures, the IRS will issue a Notice of Proposed Partnership Adjustment (PPA) to the PR and the partnership at least 270 days prior to issuing a Notice of Final Partnership Adjustment (FPA). Upon the issuance of a PPA, the statute of limitations for the partnership is automatically extended 330 days. The PPA will include a partnership-level tax assessment at the highest individual rate for all proposed adjustments, along with an interest factor from the year of the audit adjustment up to the date of the audit. The PPA allows the PR to determine how the partnership will proceed with any proposed adjustments. Options that must be undertaken and submitted within 270 days of the PPA include 1. requesting that partners amend their returns for the year of the audit change and pay any taxes that are a result of the audit changes, including appropriate interest, and provide proof of such filings and payments to reduce or eliminate the partnership-level assessment; 2. providing a summary of tax-exempt partners to the IRS, whereby the IRS will reduce the partnership-level tax assessment to account for the exempt partners share of the adjustment; or 3. requesting that modifications be made to the partnership-level assessment by indicating that certain partners are not at the highest individual tax rate, such as C corporations or lower income partners, or that an adjustment should be made to account for potential capital-gain-type items in the adjustment. After reviewing the response from the PR, the IRS will issue the FPA, which is the final notice of audit changes, and will allow the PR the option to contest the assessment judicially. The FPA will include the final balance due from the partnership, and at that point the PR can 424 ISSUE 6: NEW PARTNERSHIP AUDIT RULES 1. begin a judicial action to challenge the underlying adjustments resulting in the assessment; 2. make an election, within 45 days of the issuance of the FPA, to have the reviewed year partners assessed instead of the partnership (This includes the partnership computing the allocation for each partner who was a partner in the year audited individually based on the overall partnership-level adjustment. It is the partnership s responsibility to inform each partner of his or her share of the assessment, along with his or her share of any penalties assessed at the partnership level. If the PR chooses to make the individual partner assessment, the statutory interest rate is increased by 2% to offset the administrative costs incurred by the IRS in collecting the assessed taxes.); and/or 3. have the partnership pay the assessed amount. If the audit results in a net decrease in income, no amended returns are required or allowed. Alternatively, the partnership will pass through to the partners a deduction on the Schedule K-1 (Form 1065) for the year the audit is finalized, and the partners can claim the deduction in that year. There are still many unanswered questions that are awaiting IRS guidance, including the following: 1. How is a partnership tax payment reflected on the partnership tax return: is it a nondeductible expense, a distribution, or something else? 2. Can there be a special allocation adjustment between partners on the partnership-level tax payments? 3. How will the IRS handle an audit of a partnership that has liquidated prior to the commencement of the audit, or an audit of an insolvent entity? 4. How will reporting be made to state taxing authorities for state-level assessments? 5. How will adjustments flow through tiered partnership structures, trusts, and S corporation partners? 6. How will the IRS handle tax issues such as disguised sales and taxable distributions, as these are not partnership-level computations, but individual tax issues?

27 Electing Small Partnerships A small partnership one with 100 or fewer partners, none of whom is a trust or partnership can elect to be subject to an individual taxation regime. This election results in a pre-tefra audit environment, and the IRS is required to audit each partner. The partnership must make the election proactively each year and must inform all partners of the election. The partnership or operating agreement should include language indicating if the partnership will make the election. Election to Apply New Audit Rules Prior to Years Beginning in 2018 Section 1101(g)(4) of the BBA provides that a partnership may elect to have the new partnership audit procedures apply to tax years beginning after November 2, 2015, and before January 1, On August 5, 2016, the IRS issued Temp. Treas. Reg T to provide rules for the time, form, and manner to make the election. The text of the temporary regulations also serves as the text of accompanying proposed regulations (that is, Prop. Treas. Reg ). Under the temporary regulation, the partnership can make the election when the partnership receives a notice that a partnership return for an eligible tax year has been selected for examination (a notice of selection for examination). The partnership must make the election within 30 days of receiving the notice of selection for examination. The election is made by providing a written statement to the individual identified in the notice of selection for examination as the IRS contact person. Across the top of the statement, the partnership writes, Election under Section 1101(g)(4). The statement must be dated and signed by the TMP, as defined under I.R.C. 6231(a)(7) (TEFRA rules) and the regulations or by an individual who has authority to sign the partnership return for the tax year under I.R.C. 6063, the regulations, and any applicable forms and instructions. The statement must also include the following: 1. Partnership name, taxpayer identification number (TIN), and tax year for which the election is being made 2. Name, TIN, address, and daytime telephone number of the individual who signs the statement 3. Language indicating that the partnership is electing application of section 1101 of the BBA for the partnership return for the eligible taxable year identified in the notice of examination 4. Information required to properly designate the partnership representative as defined by I.R.C (as amended by the BBA), including the name, TIN, address, telephone number, and any other information required by applicable regulations, forms and instructions, and other IRS guidance 5. Representations of the following: a. The partnership is not insolvent and does not reasonably anticipate becoming insolvent before the audit is resolved. b. The partnership has not filed and does not reasonably anticipate filing voluntarily a petition for relief under title 11 of the United States Code. c. The partnership is not subject to, and does not reasonably anticipate becoming subject to, an involuntary petition for relief under title 11 of the United States Code. d. The partnership has sufficient assets, and reasonably anticipates having sufficient assets, to pay a potential imputed underpayment that may be determined with respect to the partnership tax year. The statement must also include a representation, signed under penalties of perjury, that the individual signing the statement is duly authorized to make the election and that to the best of the individual s knowledge and belief, all of the information contained in the statement is true, correct, and complete. No extension of time for making the election is available. The election may be revoked only with IRS consent. The temporary regulations also provide that a partnership that has not received a notice of selection for examination may make an election to have the new partnership audit rules apply to an eligible year if the partnership wishes to file an administrative adjustment request (AAR) under I.R.C (as amended by the BBA). However, partnerships not selected for audit cannot make this election before January 1, Any AAR filed before January 1, 2018, will be treated New Audit Procedures under the BBA

28 under the TEFRA rules or as an amended return of partnership income for those not subject to TEFRA, and will prevent the partnership tax year involved from being an eligible taxable year. Summary FINAL COPYRIGHT 2016 LGUTEF The new audit rules are designed to simplify the IRS administrative costs to ensure partnership compliance. They ensure that partnership-level adjustments will result in tax collection equal to or greater than the assessment would be if assessed to each partner. Some commentators have suggested that all eligible partnerships elect out of the new regime to force the IRS to assess only the correct amount of tax to each partner. Others have indicated that for smaller adjustments, the administrative cost savings to the partners and the partnership are more than sufficient savings to offset the potential additional tax that could be assessed. It will be critical for each partnership to initially address, and review each year, if its members want to elect out of the new audit regime. Each partnership will also need a mechanism to select the partnership s PR, who will be the sole contact point for the IRS if the entity-level audit is in place. The PR will also be responsible for determining if the partnership will pay the assessment or if the adjustments will pass through to the partners. Operating Agreements and Partnership Agreements Most LLCs (taxed as a partnership) and partnerships will have to revise LLC operating agreements and partnership agreements to address issues related to the PR. Items to address include designating, or method of designating, the PR; establishing if the PR should elect to have the partnership pay the tax or pass the adjustments through, or guidance on how that determination will be made; and determining whether former partners will be mandated to pay taxes on adjustment or whether they are relieved of that liability when they leave the partnership. ISSUE 7: SELF-EMPLOYMENT TAX FOR LIMITED OWNERS This section discusses self-employment tax on a limited owner s share of partnership or limited liability company income and guaranteed payments. General partners are subject to self-employment (SE) tax on their distributive share of partnership income, as well as guaranteed payments for services rendered, and guaranteed payments for the use of capital. Limited partners are generally not subject to SE tax on their share of income or on guaranteed payments for the use of capital. However, if a limited partner performs services and receives a guaranteed payment, that guaranteed payment is subject to SE tax. LLC Members The SE tax rules apply the same way to partners in a partnership, partners in a limited liability partnership, and to members in a limited liability company that is taxed as a partnership. Proposed Regulations Limited liability company (LLC) members may be treated as either general or limited partners depending on their role in the LLC. While there are no temporary or final regulations, there are proposed regulations regarding the treatment 426 ISSUE 6: NEW PARTNERSHIP AUDIT RULES

29 of LLC members. Under Prop. Treas. Reg (a)-2(h)(2)(i), solely for purposes of SE tax, an LLC member is considered to be a limited partner unless the member 1. has personal liability for the debts of or claims against the entity by reason of being a member, 2. has authority (under the law of the jurisdiction in which the entity is formed) to contract on behalf of the entity, or 3. participates in the entity s trade or business for more than 500 hours during the entity s tax year (however, see the effect of guaranteed payments later). The proposed regulations would apply to all entities classified as a partnership for federal tax purposes, regardless of the state law characterization of the entity. So the same standards would apply when determining the status of an individual owning an interest in a state law limited partnership and the status of an individual owning an interest in an LLC. To achieve this conformity, the proposed regulations adopt an approach that depends on the relationship between the owner, the entity, and the entity s business. State law characterizations of an individual as a limited partner or otherwise would not be determinative. However, if substantially all of the activities of the entity involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, any individual who provides services as part of that trade or business will not be considered a limited partner. The proposed regulations would allow an individual who is not a limited partner for SE tax purposes to exclude from SE net earnings a portion of that individual s distributive share if the individual holds more than one class of interest in the partnership. An individual holding more than one class of interest in the partnership who is not treated as a limited partner under the general rule is treated as a limited partner with respect to a specific class of partnership interest held by such individual if, immediately after the individual acquires that class of interest, 1. limited partners under the general rule own a substantial, continuing interest in that specific class of partnership interest, and 2. the individual s rights and obligations with respect to that specific class of interest are identical to the rights and obligations of those limited partners. Similarly, the proposed regulations would permit an individual who participates in the trade or business of the partnership to bifurcate his or her distributive share by disregarding guaranteed payments for services. In each case, however, bifurcation of interests would be allowed only to the extent the individual s distributive share is identical to the distributive share of partners who qualify as limited partners under the proposed regulation, without regard to the bifurcation rules, and who own a substantial interest in the partnership. Together, these rules would exclude from an individual s net earnings from SE amounts that are demonstrably returns on capital invested in the partnership. Substantial Authority for Tax Position The proposed regulations were never finalized. However, the taxpayer may cite the proposed regulations to support that there is substantial authority for the limited partner to exclude his or her guaranteed payments for the use of capital and distributive share of earnings from SE earnings. Example SE Tax on LLC Members Andy Anderson, Brian Brandt, and Chad Chance formed ABC, LLC, a limited liability company that engages in a retail sporting goods business. ABC is not a service partnership. ABC is classified as a partnership for federal tax purposes, and it allocates all items of income, deduction, and credit of the LLC to Andy, Brian, and Chad in proportion to their ownership of the LLC. Andy and Chad each contributed $10,000 for one LLC unit. Brian contributed $20,000 for two LLC units. Each LLC unit entitles its holder to receive 25% of ABC s tax items, including profits. Andy does not perform services for ABC. However, each year Brian receives a $6,000 guaranteed payment for 600 hours of services rendered to ABC, and Chad receives a $10,000 guaranteed payment for 1,000 hours of services rendered to ABC. Chad Proposed Regulations

30 also is elected as ABC s manager. Under state law, Chad has the authority to contract on behalf of the company. Andy is treated as a limited partner in ABC under Prop. Treas. Reg (a)-2(h)(2) because Andy is not liable personally for debts of or claims against ABC by operation of law, Andy does not have authority to contract for ABC under state law, and Andy does not participate in ABC s trade or business for more than 500 hours during the tax year. Therefore, Andy s distributive share attributable to Andy s LLC unit would be excluded from Andy s net earnings from selfemployment under I.R.C. 1402(a)(13). Brian s $6,000 guaranteed payment is included in Brian s net earnings from selfemployment under I.R.C. 1402(a)(13). Brian would not be treated as a limited partner under Prop. Treas. Reg (a)-2(h)(2) because, although Brian is not liable for debts of or claims against ABC and Brian does not have authority to contract for ABC under state law, Brian does participate in ABC s trade or business for more than 500 hours during the tax year. Further, Brian would not be treated as a limited partner under the exception in Prop. Treas. Reg (a)- 2(h)(3) because Brian does not hold more than one class of interest in ABC. However, Brian would be treated as a limited partner under the exception in Prop. Treas. Reg (a)- 2(h)(4) because Brian would not be treated as a limited partner under Prop. Treas. Reg (a)- 2(h)(2) solely because Brian participated in ABC s business for more than 500 hours, and because Andy would be a limited partner under Prop. Treas. Reg (a)-2(h)(2) and Andy owns a substantial interest with rights and obligations that are identical to Brian s rights and obligations. Brian s distributive share would be deemed to be a return on Brian s investment in ABC and not remuneration for Brian s service to ABC. Thus, Brian s distributive share attributable to Brian s two LLC units would not be net earnings from self-employment under I.R.C. 1402(a)(13). Chad s $10,000 guaranteed payment is included in Chad s net earnings from self-employment under I.R.C. 1402(a). In addition, Chad s distributive share attributable to Chad s LLC unit would also be net earnings from self-employment under I.R.C. 1402(a) because Chad would not be a limited partner under Prop. Treas. Reg (a)-2(h)(2), Prop. Treas. Reg (a)- 2(h)(3), or Prop. Treas. Reg (a)-2(h)(4). Chad would not be treated as a limited partner under Prop. Treas. Reg (a)-2(h)(2) because Chad has the authority under state law to enter into a binding contract on behalf of ABC and because Chad participates in ABC s trade or business for more than 500 hours during the tax year. Further, Chad would not be treated as a limited partner under Prop. Treas. Reg (a)- 2(h)(3) because Chad does not hold more than one class of interest in ABC. Finally, Chad would not be treated as a limited partner under Prop. Treas. Reg (a)-2(h)(4) because Chad has the power to bind ABC. Thus, Chad s guaranteed payment and distributive share would both be included in Chad s net earnings from selfemployment under I.R.C. 1402(a) [Prop. Treas. Reg (a)-2(h)(6)(i), Example 1]. Limited Partner The proposed regulations define a functional limited partner as a true limited partner that owns at least 20% of the enterprise. The 20% is a safe harbor. If the partner owns less than 20%, then the entity must determine if it can take the position that the partner is a functional limited partner. A functional limited partner must be a truly limited person, including a trust or corporation, but it cannot be a disregarded entity owned by one of the other partners, unless that partner is a functional limited partner. 428 ISSUE 7: SELF-EMPLOYMENT TAX FOR LIMITED OWNERS

31 ISSUE 8: PARTNERSHIPS THAT OWN A DISREGARDED ENTITY Temporary regulations clarify that partners in a partnership that owns a disregarded entity are subject to self-employment tax. Temp. Treas. Reg T, issued in May 2016, addresses the treatment of partnership payments for services rendered by a disregarded entity that is owned by the partnership. A disregarded entity is disregarded for self-employment (SE) tax purposes, and all payments for services are treated as payments made from the partnership to the partner under the general partnership SE rules. Partnership Disregarded Entity New regulations clarify the tax treatment of partners in a partnership that owns a disregarded entity. To allow adequate time for partnerships to make necessary payroll and benefit plan adjustments, these temporary regulations will apply on the later of (1) August 1, 2016, or (2) the first day of the latest-starting plan year following May 4, 2016, of an affected plan (based on the plans adopted before, and the plan years in effect as of, May 4, 2016) sponsored by an entity that is disregarded as an entity separate from its owner for any purpose under Treas. Reg Under the employment tax regulations, a disregarded entity is treated as a separate entity for payroll tax purposes, and the disregarded entity (not the owner) is considered to be the employer of the entity s employees for purposes of employment tax. This rule does not apply for SE tax purposes, and the owner of an entity that is treated in the same manner as a sole proprietorship is subject to tax on SE income. Treas. Reg (c)(2)(iv)(D) includes an example that illustrates the mechanics of the rule. In the example, the disregarded entity is subject to employment tax for the employees of the disregarded entity, but the individual owner is subject to SE tax on the net earnings from self-employment resulting from the disregarded entity s activities. The regulations did not include a separate example in which the disregarded entity is owned by a partnership. Some taxpayers read this to mean that individual partners in a partnership that owns a disregarded entity are employees of the disregarded entity and entitled to participate in tax-favored employee benefit plans. The IRS has clarified that this treatment was not intended by the original regulations, and a disregarded entity owned by a partnership is not treated as a corporation for purposes of employing any partner of the partnership. In addition to impacting the payment of employment taxes, this clarification could have employee benefit impacts for partners that had been treated as employees, such as removal from cafeteria plans, tax-free health insurance, and other employee benefits not allowed to partners. Classification Election A single-member limited liability company (LLC) is not a disregarded entity if it elects to be taxed as a corporation. If the entity is taxed as a corporation for income and all tax purposes, the payments to the partner are taxed as wage compensation and are reported on Form W-2, Wage and Tax Statement, and the employee/partner is eligible for any employee benefits offered. 12 Partnerships That Own a Disregarded Entity 429

32 ISSUE 9: PARTNERSHIP I.R.C. 754 BASIS ADJUSTMENTS This section explains when I.R.C. 754 basis adjustments are beneficial, how the adjustments are made and allocated, and how to make the election to adjust basis. As a general rule, a partnership s basis in property is its cost, or in the case of contributed property, its adjusted basis in the hands of the contributing partner. Usually, the sum of each individual partner s outside basis (the partner s basis in his or her partnership interest) will add up to the partnership s inside basis (the partnership s basis in its property). Certain transactions, described in detail later, can cause the partners outside bases to differ from the partnership s inside basis in its assets. Under I.R.C. 754, a partnership can elect to require a partner to adjust his or her share of basis in the partnership assets to agree with his or her outside basis. In addition, if an I.R.C. 754 election is in effect, distributions to partners may result in an increase or decrease in the basis of the partnership s remaining assets. Mandatory Basis Adjustment Even if the partnership does not make an I.R.C. 754 election, I.R.C. 743(b) requires an adjustment in basis on the transfer of an interest in a partnership with a substantial built-in loss. There is a substantial built-in loss if the adjusted basis in partnership property exceeds the fair market value (FMV) of such property by more than $250,000. Similarly, even in the absence of an I.R.C. 754 election, I.R.C. 734(b) requires an adjustment to remaining partnership assets if the partner recognizes a loss in excess of $250,000 on a partnership distribution or the partner takes a basis in the distributed property that exceeds the partnership basis in the property immediately before the distribution by more than $250,000. Transactions subject to an I.R.C. 754 election include the following: 1. Transfers of partnership interests by sale or exchange, or upon the death of a partner, where the new partner has an outside basis that does not equal his or her share of the inside basis (This adjustment is computed under I.R.C. 743.) 2. Distribution of cash or marketable securities to a partner where gain is recognized, a liquidating distribution where a loss is recognized, or a distribution of property where the partner takes a basis in the property that does not equal the partnership basis in the property immediately before the distribution (This adjustment is computed under I.R.C. 734.) 3. Contributions of property to a partnership where the contributing partner recognizes gain due to liabilities in excess of basis Example Sale of Partnership Interest The sole asset of JKL Partnership is land with a $15,000 FMV and a $9,000 adjusted basis. Jack Jones sells his one-third interest in JFL to Mary Moore (a third party) for $5,000. Jack s outside basis is $3,000, and he therefore reports a $2,000 gain ($5,000 $3,000). Mary s outside basis is her $5,000 cost, but without an I.R.C. 754 election, her share of the partnership s inside basis is only $3,000. If the partnership sells the land, Mary will be allocated a $2,000 gain even though she has no real economic gain and even though Jack already reported the same gain. With the I.R.C. 754 election, the entire $2,000 basis adjustment to the land is allocated to Mary. The other two partners, Katie Klatt and Louie Little, are not affected. Example Gain on Liquidation The facts are the same as in Example 12.21, except that instead of Jack selling his interest, the partnership liquidates Jack s partnership interest (i.e., JKL Partnership borrows $5,000 and distributes it to Jack). Jack still reports a gain of $2,000 ($5,000 $3,000 outside basis). However, if the partnership sells the land without making an I.R.C. 754 election, Katie and Louie will each recognize a $3,000 gain [50% ($15,000 FMV $9,000 adjusted basis)] even though their real gain is only $2,000 each. Once again, an I.R.C. 430 ISSUE 9: PARTNERSHIP I.R.C. 754 BASIS ADJUSTMENTS

33 754 election allows the partnership to step up the basis of the land by $2,000 and thereby eliminate the double reporting of income. Transfer of a Partnership Interest upon the Death of a Partner Generally, a beneficiary s basis in inherited property is equal to the FMV of the property at the decedent s date of death, plus any debts assumed [Treas. Reg ]. If the estate elects to use the alternate valuation date, the beneficiary s basis in the property is generally equal to the FMV as of the date that is 6 months after the decedent s death, plus liabilities assumed. These rules almost always result in a discrepancy between the beneficiary s share of inside basis in partnership assets and his or her outside basis in the partnership interest. A basis adjustment can increase (or decrease) the beneficiary s share of the partnership s basis in property transferred upon a partner s death to its estate tax value. The increase in basis from the decedent s adjusted basis to FMV at the date of death does not apply to items considered income in respect of a decedent (IRD). IRD includes (1) retirement payments payable pursuant to I.R.C. 736(a) to a partner s successor in interest and (2) the decedent s share of partnership income earned during the portion of the year ending on the partner s date of death. Distribution of Property The basis adjustment is also allowed if the partnership distributes property, including cash, to a partner and the distribution results in gain or loss to the distributee partner, or if the distributee partner takes a basis in the property distributed that is not equal to the partnership basis in the property immediately before the distribution. In these situations, the partnership adjusts the basis of the property retained by the partnership. A property distribution to one partner can result in discrepancies in gain or loss recognized by the other partners on subsequent sales of partnership property. The basis adjustment attempts to correct these distortions by adjusting the partnership inside basis in the retained assets (with respect to all of the partners). After the basis adjustment is made, the unrealized gain or loss attached to the retained assets should equal the predistribution unrealized gain or loss allocable to the partners who did not receive a distribution. Computation of Basis Adjustment This section discusses the calculation of the basis adjustment upon the transfer of a partnership interest and upon a distribution of property to a partner. Basis Adjustment on Transfer If an I.R.C. 754 election is in effect, upon the transfer of a partnership interest due to a sale, an exchange, or the death of a partner, the partnership 1. increases its basis in the assets by the excess of the transferee s outside basis (basis in the partnership interest) over the transferee s inside basis (proportionate share of the partnership property s adjusted basis), or 2. decreases its basis in the assets by the excess of the partner s inside basis over the transferee s outside basis. A transferee partner s inside basis is equal to the sum of his or her share of partnership liabilities plus his or her share of the partnership s previously taxed capital. Previously taxed capital is defined as 1. the amount of cash the partner would receive on a liquidation of the partnership in a fully taxable transaction for cash equal to the FMV of the partnership assets, 2. plus the tax loss he or she would be allocated on such liquidation, 3. less the tax gain he or she would be allocated on such liquidation. Example Basis Adjustment on Transfer PQR Partnership is owned by Paul Peterson, Quentin Quinn, and Roberta Richards. The partnership s balance sheet is shown in Figure Computation of Basis Adjustment

34 FIGURE PQR Partnership s Balance Sheet Basis FMV Assets $150,000 $300,000 Liabilities (99,000) (99,000) Net equity $ 51,000 $201,000 Paul s capital $17,000 $67,000 Quentin s capital $17,000 $67,000 Roberta s capital $17,000 $67,000 Roberta sells her partnership interest to Sam Sands for $67,000 cash plus assumption of her one-third of the $99,000 partnership liabilities ($33,000). The amount of Sam s basis adjustment is $50,000: Sam s outside basis [$67,000 + (1/3 $99,000) = $100,000] minus Sam s $50,000 proportionate share of inside basis (calculated in Figure 12.16). FIGURE Calculation of Sam s Share of Inside Basis Cash on liquidation $67,000 Plus loss on liquidation 0 Less gain on liquidation (50,000) Plus share of liabilities 33,000 Inside basis $50,000 Basis Adjustment on Distribution If an I.R.C. 754 election is in effect upon the distribution of property to a partner, the partnership increases its basis in the remaining partnership assets by 1. the gain recognized by the distributee partner due to cash and/or marketable securities received in excess of basis in the partnership interest, or 2. the excess of the partnership s basis in the distributed property over the basis of the property in the distributee partner s hands. The partnership decreases its basis in the remaining assets by 1. the loss recognized on the distribution by the distributee partner under I.R.C. 731(a)(2) (a loss can only be recognized on a liquidating distribution consisting solely of cash, unrealized receivables, or inventory), or 2. the excess of the distributee s basis in the distributed property over the basis of the property in the partnership s hands before the distribution. A basis adjustment can arise from a gain only if the gain is the result of a distribution of cash or marketable securities in excess of basis. Thus, any gain arising under I.R.C. 751 from a deemed sale of hot assets does not give rise to a basis adjustment. Also, a basis adjustment is not made when a partner recognizes gain from a retirement payment under I.R.C. 736(a). Likewise, a basis adjustment can arise from a loss only if the loss is recognized on a liquidating distribution of cash, unrealized receivables, and inventory with basis to the partnership that is less than the partner s basis in the partnership interest. Again, any loss arising from a deemed sale of hot assets under I.R.C. 751 does not give rise to a basis adjustment. Example Basis Adjustment on Distribution The facts are the same as in Example 12.23, except the partnership buys Roberta s partnership interest by distributing to Roberta $40,000 in cash and property with a $27,000 FMV and a $10,000 adjusted basis. PQR Partnership has made no previous I.R.C. 743 basis adjustments. Roberta recognizes a $23,000 gain ($40,000 cash + $33,000 debt relief $50,000 basis) on the cash and receives a zero basis in the property. The partnership can make a basis adjustment to its remaining assets, with respect to Paul and Quentin, as shown in Figure FIGURE PQR s Basis Adjustment following Partnership Interest Buyout Roberta s recognized gain $23,000 Excess of partnership basis in distributed property over Roberta s basis 10,000 Amount of basis adjustment $33, ISSUE 9: PARTNERSHIP I.R.C. 754 BASIS ADJUSTMENTS

35 Allocating the Basis Adjustment This section describes how to allocate the basis adjustment upon the transfer of a partnership interest, and how to allocate the basis adjustment upon a distribution of partnership property. ordinary income property in a hypothetical sale transaction. Depreciation recapture is treated as a separate asset that is ordinary income property. The basis adjustment allocable to the capital gain property equals the total basis adjustment less the amount allocated to ordinary income property. Basis Allocation upon Transfer of Partnership Interest The basis adjustment is allocated among partnership assets so that the difference between the FMV and adjusted bases of the properties is reduced. In other words, the basis adjustment is allocated based on the proportionate differences between the FMV of properties and their adjusted bases. Accordingly, adjustments can have a positive adjustment allocable to one class and a negative adjustment to another class, even if the total adjustment is zero. For purposes of this adjustment, the partnership s assets are divided into the following two classes of property: Capital gain property (capital assets and I.R.C property) Ordinary income property (assets other than capital gain property) The basis adjustment is first allocated to ordinary income property. This adjustment is equal to the total amount of income, gain, or loss allocated to the transferee partner from the sale of all the Example Basis Allocation on Transfer STU Partnership elected to make a $50,000 basis adjustment, which must be allocated among the following partnership assets (shown in Figure 12.18). There are three equal partners in the partnership, Sally Summers, Tom Taylor, and Ursula Underwood, and there is no depreciation recapture on the building. FIGURE STU Partnership s Assets Basis FMV Milk check receivable $ 0 $ 15,000 Raised livestock 0 200,000 Land 40,000 60,000 Building 60,000 25,000 Total assets $100,000 $300,000 Before the partnership can allocate the basis adjustment, it must categorize the assets as capital gain or ordinary income property and calculate the difference between the FMV and the basis of each asset, as shown in Figure FIGURE STU Partnership s Asset Character and Gain Capital Gain Property Basis FMV Difference Raised livestock $ 0 $200,000 $200,000 Land 40,000 60,000 20,000 Building 60,000 25,000 (35,000) Total capital gain property $100,000 $285,000 $185,000 Ordinary Income Property Basis FMV Difference Milk check receivable $ 0 $ 15,000 $ 15,000 Total ordinary income property $ 0 $ 15,000 $ 15, Allocating the Basis Adjustment 433

36 The partnership first allocates the total basis adjustment to ordinary income property based on a hypothetical sale of the ordinary income property. A hypothetical sale of the ordinary income property will generate $15,000 ($15,000 FMV $0 basis) of income. There are three equal partners, and the transferee partner receives one-third of the income from the sale of the ordinary income property or $5,000 ($15,000 3). Because there is only one ordinary income asset, the entire $5,000 basis adjustment is allocated to the milk check receivable. FIGURE STU s Basis Adjustment Allocation The partnership allocates the remaining $45,000 ($50,000 $5,000) basis adjustment to the capital gain property to reduce the difference between basis and FMV within the capital gain property class. The partnership divides the total appreciation or depreciation for each item in the class by the total appreciation or depreciation for the entire class. The resulting fraction is applied to the total $45,000 basis adjustment for the class to determine the allocation to each asset, as shown in Figure Raised livestock ($200,000 $185,000 = 108%* $45,000) $ 48,600 Land ($20,000 $185,000 = 11%* $45,000) 4,950 Building ( $35,000 $185,000 = 19%* 45,000) (8,550) Milk check receivable 5,000 Total basis allocation $ 50,000 * In this example, the percentages are rounded to the nearest whole percent before applying them to the total basis adjustment. Basis Allocation upon Partnership Distribution When a partnership makes a basis adjustment with respect to a partnership distribution (as opposed to a sale or exchange), the following rules apply to the basis adjustment allocation: 1. If the basis adjustment results from the recognition of gain or loss (e.g., cash in excess of basis), the basis adjustment must be allocated to the partnership s capital gain property. 2. If the basis adjustment results from a distribution of property, the basis adjustment is allocated to the same class of property as that from which the distributed property came from (e.g., if the partnership distributed equipment, the partnership must allocate the adjustment to remaining capital gain and I.R.C property). If there are no remaining assets in such category, the basis adjustment is suspended until the partnership acquires property in the category. 3. Increases within a class are first allocated based on unrealized appreciation to the extent of unrealized appreciation. Any remaining adjustment is allocated based on FMV. 4. Decreases within a class are first allocated based on unrealized depreciation to the extent of unrealized depreciation. Any remaining adjustment is allocated based on adjusted basis, but not below zero. Any remaining adjustment is carried forward until the partnership acquires property of the class that can be adjusted. Effect on Contributed Appreciated Property Precontribution gain or loss is allocated to the contributing partner when such gain or loss is subsequently recognized. In computing the basis adjustment, the partnership must consider the allocation of precontribution gain or loss. More of the basis adjustment is applied to the precontribution gain property. 434 ISSUE 9: PARTNERSHIP I.R.C. 754 BASIS ADJUSTMENTS

37 Making the Election A partnership must make an I.R.C. 754 election in order to make basis adjustments under I.R.C. 743 and 734. Once made, the election is irrevocable unless the IRS grants consent to revoke the election. Special Basis Election by a Transferee Partner When a partner purchases or inherits a partnership interest, if there is no I.R.C. 754 election in effect and the partnership distributes property within 2 years after the partner acquires his or her interest, the partner may elect to allocate his or her basis as if an I.R.C. 754 election had been in effect. This is called an I.R.C. 732(d) election. The partnership makes the I.R.C. 754 election by attaching a statement to the partnership s return. The statement must include the following information: Name, address, and taxpayer identification number (TIN) of the partnership A declaration that the partnership elects under I.R.C. 754 to apply the provisions of I.R.C. 734(b) and 743(b) An authorized partner must sign the statement. The partnership should also complete Form 1065, Schedule B, Question 12. Figure is a sample election. FIGURE Sample I.R.C. 754 Election ABCD Partnership 1 Partnership Place Anytown, State ABCD Partnership hereby elects under I.R.C. 754 to apply the provisions of I.R.C. 734(b) and 743(b) beginning with the tax year ending December 31, 2016, to the return for which year this statement is attached. Date Donald R. Clinton Once the partnership makes the I.R.C. 754 election, it must make basis adjustments each time a partnership interest is sold, exchanged, or transferred due to a partner s death, and upon distributions to a partner if the distribution results in the recognition of gain or loss. Step-Down in Basis It is important for the tax practitioner to be aware that a basis adjustment could result in a step-down rather than a step-up in basis if the partner has a lower outside basis than the inside basis. Compliance Statements In the case of a transfer of a partnership interest due to sale, exchange, or death of a partner, the partnership must attach a statement to the partnership return for the year of the transfer that provides the name and TIN of the transferee partner and the computation and allocation of the adjustment. Figure is a sample compliance statement for a transfer of a partnership interest. The transferee partner must notify the partnership in writing of the transfer details within 30 days of the transfer (or January 15 if earlier). A transferee partner who inherits his or her interest has 1 year from the transferor s date of death to notify the partnership in writing. The partnership is not required to make an adjustment until it is Compliance Statements

38 FIGURE Compliance Statement to Report Basis Adjustment on Transfer of Interest Partnership s Basis Adjustment Computation Statement ABCD Partnership 1 Partnership Place Anytown, State EIN Form 1065, Tax Year Ending December 31, 2016 Name of transferee partner: James Dillon TIN of transferee partner: Computation of basis adjustment: Dillon s share of partnership basis in only asset (land) $ 50,000 Dillon s outside basis in land $ 100,000 Required basis adjustment $ 50,000 notified. However, it is treated as having notice if another partner is aware of the transfer. If the transferee partner does not notify the partnership and the partnership knows of the transfer but not all the details of the transfer, the partnership files its return and includes on the first page (and any schedule or statement applying to the transferee partner) a statement: RETURN FILED PURSUANT TO PROP. TREAS. REG (k)(5). In the case of a distribution to a partner, the partnership must attach a statement to its return each year a distribution is made. The statement should show the computation and allocation of the basis adjustment. Figure is a sample compliance statement for a distribution. FIGURE Compliance Statement to Report Basis Adjustment on Distribution* ABCD Partnership 1 Partnership Place Anytown, State Form 1065, Tax Year Ending December 31, 2016 ABCD Partnership elected the application of I.R.C. 754 in a statement filed with its return for the tax year ending December 31, Computation of adjustment*: Gain recognized by partner James Dillon $23,000 Excess of partnership basis in distributed property over partner s basis $10,000 Amount of basis adjustment $33,000 * The sample computations have been simplified for presentation purposes. The partnership should report the full computation of the adjustments. 436 ISSUE 9: PARTNERSHIP I.R.C. 754 BASIS ADJUSTMENTS

39 Cost of Compliance For larger partnerships, the administrative and compliance costs may make a section 754 election cost prohibitive. can use any recovery period and method that applies to the particular recovery category. The basis step-up may also be eligible for the I.R.C. 179 deduction. Antichurning Rules Depreciation and the Basis Adjustment If the basis adjustment is allocated to depreciable property acquired prior to 1981, the adjustment will not qualify for ACRS or MACRS. The adjustment amount must be depreciated under the pre-1981 rules, which generally means using the straight-line method over the property s useful life. If the basis adjustment is allocated to ACRS or MACRS recovery property, the adjustment is treated as if it is newly purchased recovery property (of the same type) placed in service when the related sale or distribution occurs. The taxpayer The antichurning rules apply to post-1986 ACRS assets (not including residential rental property and nonresidential real property). The taxpayer must depreciate assets to which the rules apply by either ACRS or MACRS, whichever is least favorable. In the case where a distribution of property results in a decrease in basis, the negative adjustment reduces subsequent depreciation deductions over the remaining recovery period of the property. A transferee partner recovers a negative basis adjustment from the transfer of a partnership interest by reducing depreciation deductions over the remaining useful life of the property to which it is allocated. ISSUE 10: TAX-EXEMPT ORGANIZATIONS UPDATE This section discusses new issues regarding the processing and review of Form 1023-EZ, modified procedures for processing applications for tax-exempt status, and new filing requirements for I.R.C. 501(c)(4) organizations. This section details the common reasons why a Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code, is referred for additional review or rejected. It also discusses the Form 1023-EZ postdetermination audit program that the IRS has adopted to address concerns that ineligible organizations have received tax-exempt status. This section also explains updated, modified, and new procedures for processing applications for tax-exempt status, including procedures to request additional information and address determination letters that were issued in error, and new procedures arising out of the grant of declaratory judgment rights to all tax-exempt organizations, not just those exempt under I.R.C. 501(c)(3). Finally, this section explains the new filing requirements for organizations claiming taxexempt status under I.R.C. 501(c)(4). Form 1023-EZ On July 1, 2014, the IRS developed and released Form 1023-EZ, Streamlined Application for Recognition of Exemption Under Section 501(c)(3) of the Internal Revenue Code. Form 1023-EZ is a simplified electronic form for smaller organizations to request and obtain tax-exempt status under I.R.C. 501(c)(3). Only certain organizations can file Form 1023-EZ, and they must complete an eligibility worksheet. Figure shows page 1 of the seven-page eligibility checklist. The applicant does not have to file the worksheet but must retain it in the applicant s records. Form 1023-EZ

40 FIGURE Page 1 of Form 1023-EZ Eligibility Worksheet 438 ISSUE 10: TAX-EXEMPT ORGANIZATIONS UPDATE

41 Electronic Submission Required Form 1023-EZ can only be submitted electronically. See the IRS Issues chapter in the 2015 National Income Tax Workbook for a further discussion of Form 1023-EZ. In December 2015, the IRS issued the Form 1023-EZ First Year Report. The IRS reports that as a result of issuance of the 1023-EZ, overall Exempt Organizations (EO) customer satisfaction increased from 44% to 77%. The average processing time for the Form 1023-EZ was 13 days, compared to the 191 days average processing time for the traditional application for taxexempt status (Form 1023). Reasons for Referral for Additional Review From November 2014 through June 26, 2015, tax examiners referred 556 Form 1023-EZ applications for additional review. They were referred for the following reasons: 510 were referred because the applicant selected a National Taxonomy of Exempt Entities (NTEE) code that is generally inconsistent with exemption under I.R.C. 501(c)(3). 15 were referred in error, and a determination was made on the original filing. 12 were applicants whose formation date listed on the Form 1023-EZ was inconsistent with IRS records. 11 contained a name match on the Comprehensive List of Terrorists Groups (CLTG) and required additional information. 4 were parents of group rulings applying for individual exemption. 4 showed the applicant reapplied within 27 months of being granted exemption under a subsection other than I.R.C. 501(c). Reasons for Rejection To mitigate the risks associated with the streamlined form, EO performs predetermination compliance checks on 3% of the Form 1023-EZ applications filed. From November 2014 through June 26, 2015, EO approved 77% of the reviewed applications. The most common reasons for rejection in the predetermination review phase were the applicant s ineligibility to use the Form 1023-EZ or the applicant s failure to respond to an IRS request for additional information. Of the rejections in the predetermination process, 33% were due to ineligibility to file the Form 1023-EZ. Some of these applicants had, or expected to have, gross receipts exceeding $50,000, making them ineligible. Others were churches, limited liability companies, and a credit counseling organization, which are not eligible entities. Overall, 95% of all Forms 1023-EZ closed were approved. A review of the NTEE codes showed that no specific type of organization was rejected more often than another. The majority of rejections were because retroactive reinstatement requirements were not met (43%) or because the applicant s EIN was not valid (36%). National Taxpayer Advocate Criticism According to the National Taxpayer Advocate (NTA), 37% of a representative sample of Form 1023-EZ applicants whose applications were approved by the IRS were not, as a matter of law, I.R.C. 501(c)(3) organizations. The Form EZ applicant does not have to submit a copy of the applicant s articles of incorporation, and there is no determination that an applicant is organized for an exempt purpose. This creates a risk that the applicant does not meet the legal requirements for tax-exempt status. In a review of the applicants formation documents, the NTA found that the IRS approved an application by a corporation that was organized to raise funds for the incorporator s father s medical expenses. The IRS also approved an application by a corporation that stated that upon dissolution, the corporation would distribute its assets to the founder of the corporation. The NTA noted that Form 1023-EZ does not solicit any narrative of the organization s activities, any financial data, any substantiating documents, or any explanatory material. With the adoption of Form 1023-EZ, the IRS effectively abdicated its responsibility to determine whether Form 1023-EZ

42 an organization is organized and operated for an exempt purpose [ Most Serious Problems - FORM 1023-EZ, Taxpayer Advocate Service 2015 Annual Report to Congress, volume 1]. Postdetermination Compliance In 2016, EO began postdetermination compliance enforcement on organizations that were granted exempt status through the submission of the Form 1023-EZ application. They expected to have 25 tax examiners reviewing the Form EZ and began conducting correspondence audits of organizations that received a determination letter after filing Form 1023-EZ. The correspondence examinations take a random sampling of Form 990 series information returns or notices filed by organizations that received exempt status by filing Form 1023-EZ and allow the IRS to check compliance for small exempt organizations after a year or more in operation. Future Changes FINAL COPYRIGHT 2016 LGUTEF To further improve customer service and reduce the number of ineligible organizations who apply, the IRS is considering various changes to the Form 1023-EZ. The proposed changes are intended to clarify information requested on the form, enhance the instructions, secure additional contact information, and provide additional guidance to applicants to ensure the accuracy of the information provided on the form. Specifically, planned changes for the form include requiring the identification of a point of contact or responsible person for additional information requests, requiring the applicant to attest that gross receipts or expected gross receipts are less than $50,000, and requiring an independent attestation that total assets are less than $250, EZ Filing Fee As of May 26, 2016, the user fee for filing Form 1023-EZ is reduced from $400 to $275 [Rev. Proc , I.R.B. 1019]. Changes in Processing Applications for Tax-Exempt Status A new revenue procedure and an IRS memorandum modify and update the procedures for submitting an application for tax-exempt status. Specifically, they update how the IRS handles incomplete applications, modify how the IRS requests additional information, and establish a new procedure to address applications that were erroneously approved. Incomplete Applications Rev. Proc , I.R.B. 188, sets forth the information that must be included in an application for tax-exempt status. If an application (other than a Form 1023-EZ application) does not contain all of the items set out in the revenue procedure, the IRS will return it to the applicant for completion. If the IRS returns the application to the applicant because it is not complete, the IRS will return or refund the user fee. The IRS will not accept a Form 1023-EZ that does not have all of the items set out in Rev. Proc The IRS may, but is not required to, request additional information to validate information presented or to clarify an inconsistency in a Form 1023-EZ. If the IRS does not accept Form 1023-EZ for processing, the IRS will notify the applicant of the nonacceptance of its application and will return or refund any user fee that was paid. An eligible organization can then submit a properly completed Form 1023-EZ with a new user fee. Requests for Additional Information Even though an application is complete, the IRS may request additional information before issuing a determination letter. If the applicant fails to respond to a request for additional information, the IRS will not issue a determination letter, and will close the application without a refund of the user fee. The Memorandum for Exempt Organizations Determinations Employees, Control No: TEGE , updates the procedures for 440 ISSUE 10: TAX-EXEMPT ORGANIZATIONS UPDATE

43 requesting information needed to make a determination on an application for tax-exempt status, and the procedures for closing such cases where an organization does not submit the requested information. If an organization does not respond to an information request by the designated due date, it fails to establish that it meets the applicable requirements. EO Determinations will close the case without making a determination and will not refund the user fee. If a case is closed as failure to establish (FTE), the organization must submit a new application package and pay another user fee. Prior to the memorandum, EO Determinations gave an organization 21 days to respond to an initial additional information request. An organization could request a 14-day extension to provide its response. If the organization did not respond, EO Determinations placed the case in a suspense status and sent a letter to the organization stating that it had 90 days to supply the requested information or EO Determinations would close the case without making a determination. If the organization failed to respond within the 90-day period, EO Determinations closed the case as FTE and did not refund the user fee. The IRS is no longer placing cases in suspense status. The new process for requesting additional information is as follows: 1. The IRS will prepare Letter 1312, Additional Information Request. The response due date is 28 calendar days from the mailing date of the letter. 2. On the day the letter is mailed, an IRS agent will call an authorized contact for the organization to explain that the agent has been assigned to the request for additional information, advise the applicant that the agent is mailing the letter, verify the organization s mailing address, inform the applicant of the due date, and emphasize the importance of responding by the due date to avoid closing the case without a determination or a user fee refund. 3. The IRS will mail the letter (and may also fax a copy of the letter) to the organization. 4. If the organization requests an extension prior to the response due date, the IRS will grant a manager-approved extension. The duration of the extension is based on the facts and circumstances of the request. The usual extension period is 14 days or less, but if necessary, managers can approve longer extensions. 5. The IRS will review the response. If the response is complete, the IRS will process the application. If the response is not complete, the IRS will issue a second request for information (Letter 1312) following steps 1 4 listed previously. 6. If the IRS has not received a response by 3 business days prior to the due date, the IRS will call the organization to remind it of the upcoming due date and to explain that the IRS will close the case and not refund the user fee if the applicant does not respond by the due date. 7. If the organization does not respond by the due date, the IRS will close the case as FTE and send a letter to inform the organization that the case has been closed. Determination Letters Issued in Error Rev. Proc sets forth procedures to address determination letters that the IRS reviews and finds to have been issued in error. Revocation or Modification of Determination Letters Issued in Error EO Quality Assurance and Processing conducts postdetermination reviews of some applications for tax-exempt status. If they find, based on the information contained in the existing application file, that EO Determinations issued a determination letter in error, the IRS will send a notice to the taxpayer revoking or modifying the determination. 12 Determination Letters Issued in Error 441

44 Retroactive Revocation or Modification of a Determination Letter The revocation or modification of a determination letter recognizing exemption may be retroactive if any of the following apply: There has been a change in the applicable law. The organization omitted or misstated a material fact. The organization operated in a manner materially different from that originally represented. I.R.C. 503 applies to the organization, the organization engaged in a prohibited transaction with the purpose of diverting corpus or income of the organization from its exempt purpose, and the transaction involved a substantial part of the corpus or income of the organization. A misstatement of material information includes an incorrect representation or attestation as to the organization s organizational documents, the organization s exempt purpose, the organization s conduct of prohibited and restricted activities, or the organization s eligibility to file Form 1023-EZ. Where there has been a material change, inconsistent with the exemption, in the character, the purpose, or the method of operation of an organization, revocation or modification usually takes effect on the date of the material change. If a determination letter was issued in error, typically the revocation or modification will be effective no earlier than the date when the IRS modifies or revokes the original determination letter. In certain cases an organization may seek relief from retroactive revocation or modification of a determination letter under I.R.C. 7805(b). Requests for I.R.C. 7805(b) relief are subject to the procedures set forth in Rev. Proc. 2016, I.R.B. 1. If a determination letter is no longer in accord with the IRS s position and I.R.C. 7805(b) relief is granted, typically, the revocation or modification will be effective when the IRS modifies or revokes the original determination letter. 442 ISSUE 10: TAX-EXEMPT ORGANIZATIONS UPDATE In the case of a revocation or modification of a determination letter, the appeal and conference procedures are generally the same as the procedures described in section 7 of Rev. Proc However, appeal and conference rights are not applicable to matters where delay would be prejudicial to the interests of the IRS (such as cases involving fraud, jeopardy, or an expiring statute of limitations, or where immediate action is necessary to protect the interests of the government). If tax-exempt status is revoked under I.R.C. 6033(j) (organizations that failed to file an annual return or notice for 3 consecutive years), the organization does not have an opportunity to appeal the revocation. Revised Revocation Procedures With respect to the initial or continuing qualification of an organization as exempt from federal income tax, the Protecting Americans from Tax Hikes (PATH) Act of 2015, Pub. L. No , 406, expands declaratory judgment rights under I.R.C to all I.R.C. 501(c) organizations and to I.R.C. 501(d) organizations. As a result, the IRS issued a memorandum to its Exempt Organizations examinations managers and agents that provides revised procedures for internal revenue agents [TEGE (February 22, 2016)]. Declaratory Judgment The PATH Act extends the I.R.C. 501(c)(3) declaratory judgment rights to any I.R.C. 501(c) organization that the IRS determines is initially ineligible or no longer eligible for tax-exempt status. All revocations of section 501(c) or (d) organizations must follow the same procedures and processes as those previously used for section 501(c)(3) organizations. In addition, modifications of tax-exempt status [such as modifying a recognized section 501(c)(4) exemption to a section 501(c)(7)] are no longer applicable. Instead, the IRS will revoke (or treat as a revocation for declaratory judgment purposes) any organization that no longer qualifies under the code section

45 for which tax-exemption was granted or selfdeclared. A revoked organization is free to apply or reapply for recognition of exemption under a different Internal Revenue Code section. For any organization that no longer qualifies for tax-exempt status based on an audit, IRS agents must 1. propose a revocation using Letter 3618 [the standard 30-day letter for all proposed revocations, which must be modified for non 501(c)(3) organizations]; 2. use Form 6018, Consent to Proposed Adverse Action, for all agreements to revocation of exempt status (The form will be modified to remove the modification of exempt status option.); 3. prepare an administrative record folder for all section 501(c) or (d) audits, construct the administrative record in date order, and if the organization does not agree to revocation, prepare an administrative record index; 4. ensure Division Counsel reviews all unagreed revocations; and 5. prepare a 90-day final adverse determination letter, containing the language providing declaratory judgment rights for all revocations without protest. New Procedure for I.R.C. 501(c)(4) Formations I.R.C. 501(c)(4) provides tax exemption for civic leagues, organizations not organized for profit but operated exclusively for the promotion of social welfare, and certain local associations of employees. The PATH Act, 405, added I.R.C. 506, pursuant to which an I.R.C. 501(c)(4) organization must file notice of its formation and intent to operate as such an organization. The organization must file the notice no later than 60 days following the organization s establishment. The notice must include the following information: The name, address, and TIN of the organization The date on which the organization was organized The state where the organization was organized A statement of the purpose of the organization The IRS may extend the 60-day deadline for reasonable cause. Within 60 days of receipt of a notice of an organization s formation and intent to operate as an organization described in I.R.C. 501(c)(4), the IRS must issue to the organization an acknowledgment of the notice. I.R.C. 501(c)(4) Organizations claiming tax-exempt status under I.R.C. 501(c)(4) must now file a statement with the IRS within 60 days of formation. An organization that fails to file a notice within 60 days of its formation is subject to a penalty equal to $20 for each day during which the failure occurs, up to a maximum of $5,000. In the event such a penalty is imposed, the IRS may make a written demand on the organization specifying a date by which the notice must be provided. If any person in the organization fails to comply with such a demand on or before the date specified in the demand, the IRS will impose a penalty of $20 for each day the failure continues, up to a maximum of $5,000. Determination of Status An I.R.C. 501(c)(4) organization that desires additional certainty regarding its qualification as an organization described in I.R.C. 501(c)(4) may file a request for a determination on Form 1024, Application for Recognition of Exemption Under Section 501(a). Such a request is in addition to, not instead of, the required notice described earlier. Filing such a request is optional. The IRS developed Form 8976, Notice of Intent to Operate Under Section 501(c)(4), which organizations should use to provide this notification. Form 8976 must be submitted electronically. There is no paper form. The Form 8976 Electronic Registration System allows organizations to complete the notification process; keeps account New Procedure for I.R.C. 501(c)(4) Formations