Basis Issues for Partnerships and S Corporations Edward K. Zollars, CPA www.cperesources.com ed@tzlcpas.com
Importance of Basis One of three limits on deducting a loss Required attachment to tax return for an S corporation shareholder claiming a loss Must know basis to determine if Distribution is taxable (Partnership or S corporation) Repayment of debt taxable (S corporation) Used to compute gain/loss on disposition of asset 2
Must Have Basis to Prepare a Return for a Holder of a Flowthrough Entity 3
Basis and Debt - Partnerships Basis Issues for Partnerships and S Corporations 4
Partnerships and Debt Partnerships get basis from any debt Note that may not get at-risk amount (which is a different issue) Debt is responsible for what is often erroneously called negative basis 5
Basis cannot go below zero 6
Basis is Not A partner s tax basis capital account A partner s 704(b) capital account ( book capital) A partner s GAAP capital account The total of the partner s share of the basis of partnership assets 7
Definition of a Liability Per Reg. 1.752-1(a)(4) a liability Creates or increases basis of an asset Creates a deductible expense Creates a nondeductible expense Special contingent liability ant-abuse rule specifically blocks Son of BOSS structure 8
All Partnership Liabilities are Classified as Either Recourse or Nonrecourse 9
Allocate Recourse Debts 10
Presumption of Repayment All partners are presumed to meet their legal responsibilities to repay Limited exception for disregarded entities 11
Guarantees Don t Change This Unless Partner Gives Up Right of Reimbursement 12
Distribution Problem Reduction in debt allocated to a partner is deemed to be a distribution of cash [IRC 752(b)] Distributions in excess of basis trigger taxable gain to partner [IRC 731(a)(1)] 13
Nonrecourse Liabilities Only classified as such if no partner has economic risk of loss Note this definition is not the definition used for testing cancellation of debt Debt can be nonrecourse partnership debt Still can be recourse for COD purposes The simplest example would be accounts payable in an LLC 14
Allocation of Nonrecourse Debt 1st Tier 2 nd Tier 3 rd Tier Partner s share of minimum gain on assets encumbered by nonrecourse debt Partner s share of minimum gain determined under 704(c) Remainder using a reasonable method (generally profit sharing is reasonable) 15
At-Risk is Separate from Basis 16
Basics of At Risk (Outside Manual) Losses may only be deducted to extent taxpayer is at risk If amount at risk is reduced, must recapture prior losses claimed Generally not at risk for nonrecourse debt Certain real estate loans can be qualified nonrecourse debt Compute on Form 6198 17
Key Rules Your software cannot properly handle the allocation of debt to the partners except in trivial situations Many K-1s you receive will not be prepared correctly Must track debt from year to year for partner Remember the cash distribution problem 18
Basis in Stock and Debt S Corporations Basis Issues for Partnerships and S Corporations 19
S Corporations and Basis Different from partnerships in a number of ways Have stock basis and debt basis determined under different rules Debt basis is totally unrelated to partnership debt basis rules 20
S Corporation Annual Basis Adjustments 21
Basis Can Only Be Increased if Shareholder Actually Reports Income (But Reduction for Loss Takes Effect Regardless) 22
Special Rules Inherited stock & IRD issues Separate share rule Duty of consistency 23
Debt Basis Once stock basis is exhausted move on to amounts loaned from shareholder to corporation Proportionate allocation to each debt Basis restored with income, and takes place Before repayment gain/loss calculated Before adjusting stock basis 24
Debts That Provide Basis Must be bona fide debts Must be from shareholder Can be borrowed from third party then lent Shareholder must be only person on debt What does not work Guarantee of debt Co-maker 25
Repayment of Debt If basis < face, a prorate amount of basis allocated to principal paid and taxpayer recognizes gain If no note ordinary gain If evidenced by a note capital gain 26
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Debt can be converted tax free to stock at any time and why you might want to (or not want to) advise doing that 28
Carryovers and Basis Adjustments Additions first, then distributions Losses in excess of basis cannot be deducted Election to reorder basis adjustments If don t make election, must first reduce basis (but not below zero) by nondeductible items If still have nondeductible items, they disappear If elect, nondeductibles pushed to last item to be used but must be carried forward 29
Schedule E Instructions Require Basis Schedule When S Losses Claimed 30
If stock is sold, first make basis adjustments, then compute gain/loss on sale 31
Partnership Basis Adjustments ( 704(c) and 754) Basis Issues for Partnerships and S Corporations 32
Section 704(c) Built-in gains/losses go to contributing partner Also appears when have recapitalizations (reverse 704(c) allocations) Different than S result Must be used unless de minimis rule applies Difference not more than 15% and Total difference not more than $20,000 33
Traditional Method Only use actual items to allocate differences May end up not solving the problem entirely due to ceiling rule 34
Traditional Method with Curative Allocations Can use other similar items actually on the return to fix the original differences For instance, ordinary business deductions could substitute for depreciation Much more likely to solve problem However still possible to end up with no way to solve or nothing similar exists (especially capital gain/loss issue) 35
Remedial Allocation Method If it does work we make it work Make correction and then create an offsetting items to return balance Or, to put it simply, plug it If use this method, for depreciation establish a new asset placed in service when asset is contributed (or there is a recapitalization) 36
Revaluations Required in certain situations, allowed in others if agreement provides Creates reverse 704(c) allocations 37
Distributions and 704(c) Can t avoid the issue by pushing asset out to another partner For seven years, distributing property out to another partner triggers gain recognition Could have been a 1031 Exchange exception Watch for disguised sales rules as well 38
For 737 have unique issue of worrying about fair value vs. basis for a distribution 39
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Making the Election Required attachments Late election relief under 301.9100-2(d) Revocation of Election 41
Section 732(d) Election is Very Easy to Overlook 42
Partnership Distributions Basis Issues for Partnerships and S Corporations 43
Partnership Distributions Unlike corporations, generally no trigger of deemed sale Also, gain only recognized to extent of cash received But cash includes deemed cash from reduction in debt allocated 44
Current Distributions Reduce basis by cash (excess would be gain) Reduce basis for inventory/accounts receivable basis Reduce basis by basis of other assets 45
Liquidating Distributions Reduce basis by cash (excess would be gain) Reduce basis for inventory/accounts receivable basis (if nothing else received, remaining basis is loss) Allocate basis to other assets received 46
Hot Assets Generally triggered if a distribution leads to a change in share of hot assets Hot assets Unrealized receivables (note broader than expected definition) Appreciated inventory 47
Regulations in Flux Current regulations Gross value method Deemed distribution of proportionate share of hot/non-hot assets followed by a taxable exchange to get what was actually received Can create interesting situations if don t just pay cash Proposed regulations Before and after calculation for liquidation Look at any person whose Share of hot asset income goes down or Share of hot asset loss goes up Can elect to use, but must stay with if start using them 48
Section 736 Distributions Retirement issue Traditional liquidation payment is Section 736(b) payment Payments in excess of capital treated as Section 736(a) payments Ordinary income to recipient as guaranteed payment Special rule can exempt payment from selfemployment tax 49
S Corporation Distributions Basis Issues for Partnerships and S Corporations 50
Taxation of a Distribution (Not a Dividend) Return of capital up to basis in the stock Capital gain for any amounts in excess of basis
Tax Dividends Different from state law corporate dividends Treated as taxable income and do not affect basis Generally a corporation will treat distributions as dividends up to the amount of earnings and profits But S corporations interpose a special account known as the accumulated adjustments account 52
Accumulated Adjustments Account Is a corporate (not shareholder) account Relevant only for Treatment of S corporation distributions when corporation has earnings and profits In the post-termination transition period Generally impacted by same items as basis except for tax exempt income and deductions related to the same 53
S Corporation Tiers Accumulated Adjustments Account Treated as a distributions Recovery of basis, then gain Earnings and Profits Taxable as a dividend (Form 1099DIV) No affect on basis Distributions Back to recovery of basis Gain for exess 54
Earnings and Profits Only created now in C corporation years Computed on year by year basis See worksheet on Form 5452 Also have AICPA Corporations and Shareholders Tax Resource Panel practice guide 55
Distribution Elections Bypass AAA Deemed distribution from E&P Election to bypass PTI (extremely rare nowonly comes from pre-1982 earnings with pre- 1982 shareholder) 56
Post Termination Transition Period One year after ceases to be S corporation 120 days from end of audit that changes S item 120 days from determination S status has been terminated 57
Sale of Interests/ Net Investement Income Tax Basis Issues for Partnerships and S Corporations 58
S Corporation Dispositions and Failures Worthless security rule Bad debt deduction issue Section 1244 stock 59
Partnership Interest Sale or Exchange Determination of gain or loss Character of gain or loss Hot asset rules come back with required reporting Potential for split holding period Installment sale of partnership interest 60
Gift of a Partnership Interest Partnership interest with liabilities Assignment of income issues Family partnership issues Charitable contributions 61
Abandonment 1990 Revenue Ruling can only get ordinary loss if there is no debt Otherwise a capital loss Still an issue on how Section 1234A affects this Tax Court says effectively can never abandon But Fifth Circuit overturned 62
Net Investment Income Tax General rules for partnerships General rules for S corporations Key issue is if the entity carries on a trade or business in which equity holder participates 63
1411 Reporting 64