2017 University of Illinois Federal Tax Workbook Volume B

2017 Workbook 2017 University of Illinois Federal Tax Workbook Volume B Authors & Editors Carolyn Schimpler Editor, Assistant Director — Tax Materials University of Illinois at Urbana-Champaign Kelly Golish Marshall Heap Assistant Editor, Tax Materials Specialist Tax Content Development and Instruction Specialist University of Illinois at Urbana-Champaign University of Illinois at Urbana-Champaign

Production Supervision Dan Harding Assistant Director — Information Technologies University of Illinois at Urbana-Champaign

Chapter Contributors Marc Lovell, Massachusetts Kelly Wingard, Illinois Roger McEowen, Iowa Ken Wright, Missouri Peg Phillips, Illinois

Chapter Peer Review Keith Baum, Illinois Mary Olsen, Illinois Linda Beers, Illinois Tom O’Saben, Illinois Jerard Brune, Illinois Sam Phillips, Illinois Paul Bumgarner, North Carolina Ron Powell, North Carolina Randy Carlson, Kansas Robert Rehkamp, Minnesota Nick Fetchina, Indiana Robert Rhea, Illinois Larry Gray, Missouri Catherine Riddick, Illinois Will Gray, Missouri Jacqueline Rutledge, Illinois Steve Haworth, Indiana Steve Siebers, Illinois Deborah Held, Illinois John Stobbs, Illinois Ted Knapp, Illinois Greg Tissier, Illinois Terri Kobel, Illinois Sue Voth, Illinois Larry Lannan, Indiana Richard Walden, Illinois Gina Marsh, Illinois Cindy Wright, Missouri

© 2017 by the Board of Trustees of the University of Illinois The University of Illinois Tax School is part of the Department of Agricultural and Consumer Economics in the College of Agricultural, Consumer and Environmental Sciences. iii Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook

2017 Federal Tax Workbook — Volume B Published by:

University of Illinois Tax School 412 Mumford Hall, MC-710 1301 West Gregory Drive Urbana, IL 61801

ISBN-13: 978-0-9904591-7-0

Printed in the United States of America.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the Publisher. Requests for permission should be addressed to University of Illinois Tax School, 412 Mumford Hall, MC-710, 1301 West Gregory Drive, Urbana, IL 61801, (217) 333-0502, fax (217) 244-5933, or online at taxschool.illinois.edu/contact_us.html.

Limit of Liability/Disclaimer of Warranty: The publisher and the authors make no representations or warranties with respect to the accuracy or completeness of the contents of this work and specifically disclaim all warranties, including without limitation warranties of fitness for a particular purpose. No warranty may be created or extended by sales or promotional materials. The advice and strategies contained herein may not be suitable for every situation. This work is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If professional assistance is required, the services of a competent professional person should be sought. Neither the publisher nor the authors shall be liable for damages arising herefrom. The fact that an organization or website is referred to in this work as a citation and/or a potential source of further information does not mean that the authors or publisher endorse the information that the organization or website may provide, or recommendations it may make. In addition, readers should be aware that Internet websites listed in this work may have changed, moved, or been removed after this work was written.

It should be recognized that tax law continually changes, and includes many issues yet unresolved. The content of this book reflects current law at the time of publication. Corrections are posted on the University of Illinois Tax School website at taxschool.illinois.edu.

iv Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 2017 Tax Seminar Programs Coordinators: Cooperating States Arkansas Kim Magee ...... Community and Economic Development, Cooperative Extension Service University of Arkansas, Little Rock Connecticut Emma Bojinova ...... Department of Agricultural and Resource Economics, University of Connecticut, Storrs Florida Julie Cotton ...... Northwest Florida State College, Niceville

Alabama, Colorado, Florida, Georgia, Hawaii, Kansas, Louisiana, North Carolina, Ohio, Pennsylvania, South Carolina, Tennessee, Washington, West Virginia Randall R. Carlson ...... Professional Tax Institutes, Inc. Illinois Terri Kobel ...... Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign Indiana Drew Norris ...... Indiana University Conferences Kansas Richard Llewelyn ...... K-State Research and Extension, Department of Agricultural Economics, Kansas State University, Manhattan Maine Steve Edmondson ...... SCORE’s Maine Tax Workshop Committee Missouri Patti Woods ...... Missouri Society of CPAs, St. Louis Missouri Ken Wright ...... Tax Education, Inc. Montana Amy Saltzman ...... School of Extended & Lifelong Learning University of Montana, Missoula North Dakota Patricia Young ...... Office of Extended Learning, University of North Dakota, Grand Forks Pennsylvania Robert Henkels ...... Professional Tax & Accounting Seminars, Inc. South Dakota Kasey Williams ...... Continuing and Distance Education, South Dakota State University, Brookings

Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook Tax Workbook Chapter Topics from Past 10 Years Year 2017 2016 2015 2014 2013 2012 2011 2010 2009 2008 Agricultural Issues 17A 16A 15A 14A 13A 12A 11 10 09 08 Amending Returns 16A AMT 11 Basis 09 C Corporations 15B 09 Capital Gains and Losses 14C Capitalization vs. Repair 15A 14A Compliance Target Areas 13B Credits 12C 10 Filing Status/Dependency Exemption 11C 09 Depreciation 15B 11&11C 08 Divorce 12A Education Provisions 15A 11C 08 Employee Tax Issues 17A 12C 08 Entity Issues 14B Estate/Gift/Succession Planning 17B 12B 11 Estimated Taxes 13C Ethics 17A 16A 15A 14A 13A 12A 11 10 09 08 Fiduciary Tax Issues/Trusts 16B 15B 10 08 Financial Distress; Bankruptcy 13A 08 Form 4797 13C 08 Healthcare 14A 13A 12A Hobby Losses 13C Homeowners 10 Individual Taxpayer Issues 17B 16B 15B 14B 13B 12A 11 10 09 08 Information Returns 12C 11C Installment Sales 17B International Taxation 15B 11 Investments/Wealth 17A 16B 12C 08 IRS Communications 14A 12C IRS Update 17A 16A 15A 13A 12A 11 10 09 08 Marriage 14A 10 Miscellaneous Income 13C NOL 14C 09 New Tax Legislation 17A 16A 15A 13A 12A 11 10 09 08 Older Taxpayers/Elder Issues 14C 11 10 Partners/Partnerships/LLCs 17B 13B 11 08 Passive Activities 14B Related Party Issues 09 Rental Activities 11C Retirement 16A 14C 12B 11 09 08 Rulings and Cases 17B 16B 15B 14B 13B 12B 11 10 09 08 S Corporations 16A, 16B 12B 10 Schedule A 12C Schedule C 12C 10 Schedule K-1 11C Small Business Issues 17B 16B 15B 14B 13B 12B 11 10 09 08 Special Taxpayers 15A 14C 13C Travel 12C

11 = 2011 Federal Tax Workbook, 11C = 2011 Federal Tax Fundamentals xxA = 20xx Vol. A xxB = 20xx Vol. B xxC = 20xx Vol.Copyrighted C by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 Chapter 1: Installment Sales

Installment Sale Defined...... B3 Agreement ...... B43 General Rules for Installment Sales ...... B3 Reporting Requirement ...... B45 Calculating Installment Sale Income ...... B4 Disposition of an Installment Obligation ...... B46 Selling Price Reduced ...... B17 Transfer Between Spouses or Former Spouses...... B46 Electing Out of the Installment Method...... B17 Gifts...... B46 Payments Received...... B18 Cancellation...... B47 Buyer Pays Seller’s Expenses ...... B18 Forgiving Part of the Buyer’s Debt...... B47 Buyer Assumes Mortgage ...... B18 Transactions That Are Not Dispositions ...... B47 Buyer Assumes Other Debts ...... B21 Repossession...... B48 Property Used As a Payment ...... B21 FMV of Repossessed Property...... B49 Installment Obligation Used as Security ...... B22 Personal Property...... B49 Escrow Arrangements...... B23 Real Property ...... B51 Depreciation Recapture and Unrecaptured §1250 Gain ...... B24 Interest on Deferred Tax ...... B53 Sales to Related Persons Self-Canceling Installment Notes...... B54 and Later Dispositions ...... B35 Gift Tax...... B56 Sales of Depreciable Property Estate Tax...... B57 to a Controlled Entity...... B39 Income Tax...... B57 Like-Kind Exchange...... B39 Appendix ...... B59 Contingent Payment Sale ...... B41 Test Rates For Unstated Interest Single Sale of Several Assets ...... B41 and Original Issue Discount...... B59 Sale of a Business...... B42 Residual Method ...... B43

Please note. Corrections for all of the chapters are available at www.TaxSchool.illinois.edu. For clarification about acronyms used throughout this chapter, see the Acronym Glossary at the end of the Index. For your convenience, in-text website links are also provided as short URLs. Anywhere you see uofi.tax/xxx, the link points to the address immediately following in brackets.

About the Author Peg Phillips, CPA, is a writer and editor for the University of Illinois Tax School. She has been with the program since 2003. Peg graduated from the University of Illinois with high honors in accounting and passed the CPA exam in 1989. She currently owns and operates Phillips Tax Service in Pekin, IL.

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Chapter Summary

An installment sale is defined as a sale of property in which the seller receives at least one payment after the year of sale. The installment sales method cannot be used for sales at a loss and in certain other situations. Taxpayers who elect out of the installment method must report the entire gain in the year of sale. The character of the gain (short-term or long-term) and the gross profit percentage are determined in the year of the installment sale. This percentage is then applied to payments to determine the gain to be reported on Form 6252. All income attributable to depreciation recapture is reported in the year of sale. Installment payments usually consist of return of the property’s adjusted basis, gain, and interest income. The rules for allocating payments between these three categories and for determining the gross profit percentage are explained in the chapter. When the buyer assumes debt, the value of the debt is considered a payment in the year of sale. The FMV of property the seller receives from the buyer is considered paid in the year received unless the like-kind exchange provisions apply. For installment sales between related parties, Form 6252 must be included with the seller’s return for the year of sale and the two subsequent years. Each year, the seller must indicate if the buyer sold or otherwise disposed of the property. When this happens before all payments are made under the installment agreement, the seller must treat a portion of the amount the buyer realizes from the second disposition as if the seller received it at the time of the second disposition. When a business is sold, the total selling price and payments received in the year of sale must be allocated between asset classes to determine whether any of the gain from the sale can be reported on the installment method. The sale of business property ineligible for the installment method must be reported in the year of sale even if the seller receives payments subsequently. When a seller repossesses the property after making an installment sale, the seller must calculate the gain or loss on the repossession and the basis in the repossessed property. The applicable rules are discussed in the chapter. An installment sale can include a self-canceling installment note (SCIN) that instantly cancels all future payments due when the holder of the note (seller) dies. Consequently, the SCIN reduces the seller’s taxable estate while avoiding gift taxes during the seller’s lifetime. However, when the installment sale is between related parties, a SCIN may have unexpected tax consequences if the SCIN is presumed to be a gift rather than a bona fide transaction.

B2 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 INSTALLMENT SALE DEFINED

An installment sale is a sale of property in which the taxpayer receives at least one payment after the year of sale. The rules for installment sales do not apply if the taxpayer elects not to use the installment method or the transaction is one for which the installment method is prohibited. The installment sales method cannot be used to report the following. • Sale at a loss • Sale of inventory • Sale of personal property by a person who regularly sells the same type of personal property on installment plans • Sale of real property held for sale to customers in the ordinary course of a trade or business • Sales after 1986 of stocks or securities traded on an established securities market

Note. Dealers of time-shares and residential lots may treat certain sales as installment sales and report them under the installment method if they elect to pay a special interest charge. For more information, see IRC §453(l).

The buyer’s obligation to make future payments to the taxpayer may be in the form of a deed of trust, note, land contract, mortgage, or other evidence of the buyer’s debt to the taxpayer.

Note. Installment notes are an important tax-planning tool. Proper structuring can save taxpayers a significant amount of income tax, capital gains tax, alternative minimum tax, gift tax, generation-skipping tax, and estate tax. For information on using intentionally defective grantor trusts and installment agreements as part of tax planning, see the 2016 University of Illinois Federal Tax Workbook, Volume B, Chapter 5: Wealth Accumulation and Preservation.

1 GENERAL RULES FOR INSTALLMENT SALES1

For the year of the sale, the gain in an installment sale is calculated using Form 6252, Installment Sale Income. For each year in which the taxpayer receives a payment on the installment sale, Form 6252 is used to calculate the portion of the gain reported for that year. The taxable gain is referred to on the form as “installment sale income.” The nature of the gain as short-term or long-term is determined at the time of the sale, not when the payments are received. The gain is long-term if the taxpayer owned the property for more than one year as of the property’s sale date.

Caution. The tax preparer must also consult state tax rules regarding installment agreements. Some states have special rules, such as the requirement of a separate state-level election, or the pledging of adequate security to ensure the collection of tax paid in connection with the installment sale transaction.

1. IRS Pub. 537, Installment Sales.

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The taxpayer reports the income attributable to depreciation recapture in the year of the sale regardless of the amount the taxpayer received in that year. Calculating depreciation recapture is discussed later in the chapter.

CALCULATING INSTALLMENT SALE INCOME Each payment on an installment sale usually consists of the following three parts. 1. Interest income 2. Return of the property’s adjusted basis 3. Gain on the sale In each year the taxpayer receives a payment, the taxpayer must include in income both the portion that is interest and the portion that is the gain on the sale. The taxpayer does not include in income the portion that is the return of the property’s basis.

Note. Ideally, taxpayers should consult with their tax advisors before finalizing the terms of the sale. Practitioners should consider the impact of the net investment income tax (NIIT) and the brackets for capital gains rates when advising clients on the terms of the installment note. Stretching the length of the contract may result in significant tax savings if the taxpayer can avoid the NIIT and/or apply the lower capital gains rates to the gains. For more information about the NIIT, see the 2016 University of Illinois Federal Tax Workbook, Volume B, Chapter 5: Wealth Accumulation and Preservation.

Caution. Practitioners should also consider adverse tax consequences from stretching the length of the contract. For example, income from the installment contract may affect taxable social security benefits or the amount of allowable deductions that are subject to adjusted gross income limitations.

Interest Income The taxpayer must report interest as ordinary income. Interest is generally not included in a down payment; this type of interest is referred to as unstated interest. However, the taxpayer may have to treat part of each later payment as interest, even if it is not referred to as such in the agreement with the buyer. The interest rate provided in the agreement is referred to as stated interest. Adequate Interest Rate. If the agreement does not provide for an adequate interest rate, the taxpayer must recognize imputed interest income (unless certain exceptions apply, explained later). The imputed interest income may be unstated interest, original issue discount (OID), or a combination of both. If the stated rate is not adequate, the selling price per the agreement is reduced by the unstated interest2 or OID.3 This is important because interest is subject to ordinary tax rates and gains may qualify for capital gain tax rates. Current interest rates are so low that unless the contract does not include any interest, it is unlikely that the stated interest will be less than the adequate interest. It is often easy to determine that a stated rate is adequate by comparing it to current market conditions. However, the rules and calculations necessary to determine that a contract’s interest rate is inadequate are complex.

2. IRC §483. 3. IRC §1274.

B4 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 The adequacy test is determined using applicable federal rates (AFRs). AFRs are based on the average market yield of U.S. marketable obligations (e.g., U.S. savings bonds).4 Prime rate is the average lending rate posted by a majority of the top 25 U.S. commercial banks for short-term business loans.5 Prime rate generally exceeds the rates for U.S. government securities. Accordingly, if the agreement’s interest rate is at least as much as the prime rate, the interest rate is adequate. If the agreement’s interest rate is greater than 0% and less than the prime rate, the rate in the agreement must be compared to a test rate to determine if the rate is adequate. The material in the appendix at the end of the chapter explains how to calculate the test rate for an installment agreement. If the agreement’s stated interest rate is 0% or if the agreement does not call for interest, the interest rate is clearly inadequate. When the agreement’s interest rate is inadequate, the rate used to determine the imputed interest is the lowest 3-month AFR applicable to the sale or exchange,6 compounded semiannually.7 The lowest 3-month rate is the lowest AFR in effect for the calendar month in which there is a binding contract in writing for such sale or exchange or either of the two preceding months.8 Example 1. On April 19, 2017, Johan sold his tax practice to Gretta. Under the terms of the contract, Johan immediately received a vacation home in Hawaii worth $2 million and a note payable for $1 million. The $1 million payment is due on April 19, 2027 (a long-term contract). Neither the contract nor the note states an interest rate. Because the contract does not call for interest, the interest must be imputed. The imputed interest rate is the lowest AFR in effect for long-term contracts at the semiannual compounding rate for the 3-calendar-month period ending April 2017. The AFRs for these periods were as follows. 9 10 11

February 2017 2.79% 9 March 2017 2.76% 10 April 2017 2.80% 11

Accordingly, Johan’s tax preparer will use 2.76% as the interest rate when making the necessary calculations to report the installment sale on Johan’s 2017 return. 12

Note. Imputed interest income may need to be calculated when the stated interest rate is less than market rates, or when the stated interest rate appears adequate but the sum of all principal payments due is different than the stated principal amount.12

4. IRC §1274(d)(1)(C). 5. Selected Interest Rates (Daily) - H.15. Board of Governors of the Federal Reserve System. [www.federalreserve.gov/releases/h15/] Accessed on Mar. 28, 2017. 6. For agreements subject to the imputed interest rules, both IRC §§1274 and 483(b)(2) require that the appropriate interest rate be determined using the method in IRC §1274(d)(2). 7. IRC §1274(b)(2)(B). 8. IRC §1274(d)(2). 9. Rev. Rul. 2017-4, 2017-6 IRB 776. 10. Rev. Rul. 2017-7, 2017-10 IRB 1007. 11. Rev. Rul. 2017-8, 2017-14 IRB 1037. 12. IRC §1274(c).

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Contract Term. There are three categories of federal rates based on the weighted average maturity (term) of the contract.13 • For a term of three years or less, the AFR is the short-term rate. • For a term of over three years but not over nine years, the AFR is the mid-term rate. • For a term of over nine years, the AFR is the long-term rate. The weighted average maturity is calculated by adding the weight of all payments. The weight of each principal payment is calculated using the following formula.14

------Payment amount - Weight of principal payment= Years from issue date until payment made  Debt instrument redemption price at maturity

If the annual principal payments are the same each year, the following table can be used to determine the weighted average term instead of the preceding formula. This table is not appropriate for contracts if the principal payments vary.

Weighted Average Terms for Equal Annual Payments

Contract Length AFR Term 2-5 years Short-term 6-17 years Mid-term Over 17 years Long-term

Example 2. Edna has a note receivable of $500,000 dated February 14, 2016. Under the terms of the note, she is to receive $100,000 each year for the next five years. Using the table above, her tax advisor determines that the weighted average term of the note is three years. Accordingly, the short-term AFR is used to determine if the interest rate is adequate. If the annual payments are not equal, the weighted average maturity formula must be used. Example 3. Edith has a note receivable of $300,000 dated February 14, 2016. Under the conditions of the note, she is to receive $100,000 on February 15, 2017, and $200,000 on February 15, 2018. The weighted average maturity of each payment is as follows. •Payment 1: 1 year × $100,000 payment ÷ $300,000 face value = .33 year •Payment 2: 2 years × $200,000 payment ÷ $300,000 face value = 1.33 years The weighted average maturity is the sum of the weights for the payments, or 1.66 years. Accordingly, the term of the note is 1.66 years. 15

Note. Options to renew or extend the installment agreement are taken into account when determining the contract term for these purposes.15

13. IRC §1274(d)(1). 14. Treas. Reg. §1.1273-1(e)(3). 15. IRC §1274(d)(3).

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16 17 1

Observation. Before making the decision to use the installment method, taxpayers should consider the following disadvantages of this income deferral provision. These include the following. 1. An installment sales contract does not receive a stepped-up basis. 2. IRC §1245 depreciation recapture is reported in full in the year of sale.16 This could result in the tax liability in the year of sale being greater than the installment payment received in the year of sale. 3. The requirement to report taxable income in future years could increase taxes on future social security benefits (i.e., the taxable percentage of the benefit17 and applicable tax bracket). 4. Converting real estate to an installment sale contract may have estate tax implications including the reduced ability to utilize special use valuation under IRC §2032A. 5. The requirement to report taxable income in future years increases AGI and could reduce AGI- limited tax benefits in those years. The resulting tax cost may be higher than the applicable tax cost resulting from electing out of the installment method.

Calculating Unstated Interest or OID. The unstated interest or OID is the excess of the contract’s stated principal amount over the imputed principal amount. The imputed principal is equal to the net present value of all the payments under the contact when the present value of the payments is based on the AFR.18 The formula to calculate present value is PV = FV ÷ (1 + i)n where FV is the future value, i is the interest rate, and n is the number of periods.19 Financial calculators, present value charts, and numerous online tools are available to make these calculations.

Adjusted Basis and Gain on Sale As mentioned earlier, the taxpayer (or tax practitioner) must determine how much of each payment to treat as interest. After this is calculated, the taxpayer treats the rest of each payment as the selling price. The gain on the sale is calculated using the following formula.

Selling price − Tax-free return of the property’s adjusted basis Gain on the sale

The gross profit divided by the contract price is the gross profit percentage. The reportable gain each year is the gross profit percentage multiplied by the principal payments on the installment agreement. Key definitions and the mechanics of reporting the gain are explained in this section. Selling Price. The selling price is the total cost of the property to the buyer and includes the following. • Any money the seller received or will receive • The fair market value (FMV) of any property the seller received or will receive • Any existing mortgage or other debt (such as unpaid property taxes) that the buyer pays or assumes • Any of the selling expenses the buyer pays

16. IRC §453(i). 17. IRC §86. 18. IRC §1274. 19. Present Value and Discounting. Investopedia. [www.investopedia.com/walkthrough/corporate-finance/3/time-value-money/present-value- discounting.aspx] Accessed on Mar. 28, 2017.

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The selling price does not include any of the following. • Stated or unstated interest • Any amount recalculated or recharacterized as interest •OID Example 4. Priscilla sold her vacation home on contract for deed to an unrelated party. The total sales price under the terms of the contract was $200,000. In the year of the sale, the buyer gave her $10,000, a motor home worth $30,000, and a $160,000 note payable. The note was payable in four installments of $40,000 each, beginning the following year. The note’s stated interest rate was 0%. The AFR was 1% at the time of the sale. The present value of $40,000 payable annually for four years at 1% interest is $156,079.20 Therefore, the unstated interest is $3,921 ($160,000 − $156,079). For tax purposes, the selling price of the real estate is calculated as follows.

Cash received $ 10,000 FMV of property received 30,000 Note payable 160,000 Less: unstated interest (3,921) Selling price $196,079

Adjusted Basis. The property’s adjusted basis for installment sale purposes is the sum of the following elements. • Adjusted basis as normally defined for determining gain or loss • Selling expenses, which include commissions, attorney fees, and any other expenses paid on the sale • Depreciation recapture that must be included in income in the year of the sale (Depreciation must be recaptured for certain IRC §1250 property and for all IRC §1245 property.) Gross Profit. Gross profit is the total gain the taxpayer recognizes using the installment method. The depreciation recapture taxed in the year of sale is not included in the gross profit. Gross profit equals the selling price less the adjusted basis as calculated for installment sale purposes. Contract Price.21 The contract price is calculated as follows.

The selling price − Mortgages, debts, and other liabilities assumed by the buyer + Amount by which the mortgages, debts, and other liabilities assumed by the buyer exceed the adjusted basis for installment sale purposes Contract price

Gross Profit Percentage. The gross profit percentage is the portion of principal received that is reported as gain each year. As mentioned earlier, the gross profit percentage is calculated by dividing the gross profit by the contract price.

20. Calculated using Present Value of Annuity Calculator. Financial Mentor. [financialmentor.com/calculator/present-value-of-annuity- calculator] Accessed on Mar. 28, 2017. 21. Temp. Treas. Reg. §15A.453-1(b)(5), Example (3).

B8 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 Example 5. Willie sold four acres of specialty cropland to Wayland for $100,000. In the sale agreement, Wayland assumed the mortgage of $80,000 and agreed to pay the remaining $20,000 over five years at $4,000 per year plus interest of 3%. Willie’s adjusted basis in the land was $30,000. The excess of the assumed mortgage over Willie’s basis was $50,000 ($80,000 – $30,000). The contract price for the exchange was calculated as follows.

Selling price $100,000 Less: mortgage assumed by Wayland (80,000) Plus: excess of mortgage over basis 50,000 Contract price $ 70,000

Willie’s gross profit was also $70,000 ($100,000 selling price – $30,000 adjusted basis). Accordingly, his gross profit percentage is 100%, and he will report each $4,000 payment as gain attributable to the sale. This is in addition to the $50,000 he reports in the year of the sale. Amount to Report as Installment Sale Income. To calculate the annual amount reported as installment sale income for the tax year, the payments the seller receives each year (less interest) are multiplied by the gross profit percentage. In certain circumstances, the taxpayer may be treated as having received a payment, even though the taxpayer received nothing directly. A receipt of property or the assumption of a mortgage on the property sold may be treated as a payment to the seller. Payments received or considered received are covered later in the chapter.

Reporting Installment Sale Income Form 6252 is used to calculate the gross profit percentage in the year of sale. It also is used to report the taxable portion of principal payments received each year. The taxable gain flows to Schedule D, Capital Gains and Losses, or Form 4797, Sales of Business Property, or both, depending on the taxpayer’s use of the property. Example 6. On January 16, 2015, Jim sold 100 acres of swampland in Florida in an installment sale. He purchased the acres for $45,000 on March 2, 1974. He held the property as an investment and did not use it in any business ventures. Hattie, the buyer, built a custom home in the center of the acreage. The selling price was $300,000. Jim’s total selling expenses were $30,000, which consisted of $21,000 in commissions he paid to the realtor and $9,000 he paid an attorney to draw up the necessary legal documents. Jim received a $100,000 down payment on the sale. According to the terms of the note, he will receive the remaining $200,000 in four annual installments of $50,000 plus interest beginning in January 2016. Jim’s 2015 Form 6252 and Schedule D follow. As shown on Form 6252, Jim’s gross profit on the sale was $225,000 (line 16) and his gross profit percentage was 75% (line 19).

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For Example 6

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For Example 6

B12 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 In years after the year of sale, the taxpayer generally only completes lines 1 through 4 and part II of Form 6252. The taxpayer reports the interest received on Schedule B, Interest and Ordinary Dividends. If the seller holds a mortgage on the property and the buyer uses the property as a personal residence, the seller must provide their tax identification number to the buyer.22 In addition, the seller must report the buyer’s name, address, and tax identification number on Schedule B or as an attachment to the return.23 Example 7. Use the same facts as Example 6. In 2016, Jim received $50,000 of principal and $20,000 of interest on the note. On his 2016 Form 6252, lines 1 to 4 show the same information as shown on his 2015 Form 6252. He does not complete part I for 2016. In part II, he reports the $50,000 he received in 2016 and multiplies that by the 75% gross profit percentage to determine that $37,500 of the principal he received in 2016 is taxable. This flows to Schedule D (not shown). He reports the $20,000 of interest income on Schedule B. Jim’s 2016 Form 6252 and Schedule B follow.

22. Instructions for Schedule B. 23. Ibid.

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For Example 7

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If the property sold was used in a trade, business, or rental activity, then the profit calculated on Form 6252 flows to Form 4797 instead of directly to Schedule D. Special rules (discussed later) apply to property for which depreciation was allowed or allowable. In addition, if the seller sold the property in the course of their trade or business and they receive mortgage interest during the year of $600 or more, the seller is required to report the interest they received on Form 1098, Mortgage Interest Statement.24 Example 8. Use the same facts as Example 6 and Example 7, except Jim received rental income from the property during the time he owned it. In 2016, the taxable gain flows to line 4 of Form 4797, which follows.

Note. If the taxpayer reports payments from an installment sale as income in respect of a decedent or as a beneficiary of a trust, including a partial interest in such a sale, then the taxpayer may not be able to provide all the information asked for on Form 6252. In this situation, the taxpayer should provide as many details as possible in a statement attached to Form 6252.

24. Instructions for Form 1098.

B16 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 SELLING PRICE REDUCED If the selling price is reduced after the year of sale, then the gross profit on the sale also changes. The taxpayer (or tax preparer) must recalculate the gross profit percentage for the remaining payments. The taxpayer’s remaining gain is spread over future installments. The new gross profit percentage is calculated using the following formula.

Reduced selling price − Adjusted basis (as defined earlier) − Any installment sale income previously reported Remaining deferred gain ÷ Future installments New gross profit percentage

Example 9. In 2015, Milo sold land with a $40,000 basis for $100,000. The gross profit was $60,000. He received a $20,000 down payment and a note for $80,000. The note provides for four annual payments of $20,000 each, plus 8% interest, beginning in 2016. The gross profit percentage is 60% ($60,000 ÷ $100,000). Milo reported a gain of $12,000 ($20,000 × 60%) on each payment received in 2015 and 2016. In 2017, Milo and the buyer agree to reduce the purchase price to $85,000. Accordingly, the remaining unpaid purchase price is $45,000 ($85,000 – $20,000 paid in 2015 – $20,000 paid in 2016), and the payments for 2017, 2018, and 2019 are reduced to $15,000 each. The new 46.67% gross profit percentage is calculated as follows.

Reduced selling price $85,000 Less: adjusted basis (40,000) Less: any installment sale income previously reported ($12,000 in 2015 + $12,000 in 2016) (24,000) Remaining deferred gain $21,000 Future installments ÷ 45,000 New gross profit percentage 46.67%

Milo will report a gain of $7,000 (46.67% × $15,000) on each of the $15,000 installments due in 2017, 2018, and 2019.

25 ELECTING OUT OF THE INSTALLMENT METHOD25

When taxpayers elect not to use the installment method, they must report the entire gain in the year of sale. To make the opt-out election, the taxpayer simply reports the sale on Form 4797 and/or Form 8949, Sales and Other Dispositions of Capital Assets, depending on the taxpayer’s use of the asset. Form 6252 is not used.26

Note. For taxpayers filing Schedule F, Profit or Loss From Farming, this choice can be a very powerful tax planning tool. Farmers may have grain delivered, priced, sold, and held for payment in the following year using a valid deferred payment agreement. Farmers may either report the income under the installment method as income in the following year or elect out of the installment method and report the income in the current year. This opt-out election can be made for each contract and is accomplished by reporting the income on the current year Schedule F.26

25. IRS Pub. 537, Installment Sales. 26. IRS Pub. 225, Farmer’s Tax Guide.

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To calculate the amount of gain to report, the taxpayer adds the FMV of the buyer’s installment obligation to the other consideration received during the year. The taxpayer must calculate the FMV of the buyer’s installment obligation, regardless of whether the taxpayer would actually be able to sell it. When the taxpayer uses the cash method of accounting, the FMV of the obligation is never treated as less than the FMV of the property sold minus any other consideration received. Thus, for most individual taxpayers, the FMV of the obligation is treated as equal to the note’s stated principal amount. A taxpayer using the accrual method of accounting treats the total amount payable under the installment obligation as the amount realized in the year of sale.27 For this purpose, interest (whether stated or unstated) and OID are not considered part of the amount payable.

Note. If the amount payable is otherwise fixed but the timing of the payments is contingent on outside factors, additional calculations are necessary. For more information, see Temp. Treas. Reg. §15A.453-1(d)(2).

The election must be made by the due date, including extensions, for filing the tax return for the year the sale takes place. If the taxpayer timely files the tax return without making the election, the taxpayer may still make the election by filing an amended return within six months of the due date of the return (excluding extensions). To make the election out of the installment method with an amended return, the taxpayer writes “Filed pursuant to section 301.9100-2” at the top of the amended return and sends it to the IRS location at which the original return was filed. Once made, the election can only be revoked with the IRS’s approval. A revocation is retroactive. The election cannot be revoked if either of the following applies. • One of the purposes is to avoid federal income tax. • The tax year in which any payment was received has closed.

28 PAYMENTS RECEIVED28

For each year an installment sale payment is received or treated as received, the taxpayer must calculate gain from the installment sale. In certain situations, the taxpayer is considered to have received a payment, even though the buyer does not pay the taxpayer directly. These situations occur when the buyer assumes or pays any of the taxpayer’s debts (such as a loan) or pays any of the taxpayer’s expenses (such as a sales commission). However, in many cases, the buyer’s assumption of a debt is treated as a recovery of the basis rather than as a payment. This is discussed later.

BUYER PAYS SELLER’S EXPENSES When the buyer pays any of the taxpayer’s expenses related to the sale of the property, it is considered a payment to the taxpayer in the year of sale. These expenses are included in the selling and contract prices when calculating the gross profit percentage.

BUYER ASSUMES MORTGAGE If the buyer assumes or pays off the taxpayer’s mortgage or otherwise takes the property subject to the mortgage, the rules that apply depend on whether the mortgage is less than or equal to, or more than the basis. Other rules apply if the mortgage is canceled.

27. Temp. Treas. Reg. §15A.453-1(d)(2)(ii)(A). 28. IRS Pub. 537, Installment Sales.

B18 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 Mortgage Less than or Equal to Basis When the buyer assumes a mortgage that is not more than the installment sale basis in the property, it is not considered a payment to the taxpayer. Instead, it is considered a recovery of the taxpayer’s basis. The contract price is the selling price minus the mortgage. Example 10. In 2017, Billie sold property with an adjusted basis of $19,000. She incurred selling expenses of $1,000. Therefore, her installment sale basis was $20,000. The buyer, Minnie, assumed the existing mortgage of $15,000 and made a $2,000 down payment. In addition, Minnie agreed to pay Billie $8,000 over the next four years at $2,000 per year, plus 12% interest. The selling price was $25,000 ($15,000 + $2,000 + $8,000). The gross profit was $5,000 ($25,000 – $20,000 installment sale basis). The contract price was $10,000 ($25,000 selling price – $15,000 mortgage). The gross profit percentage was 50% ($5,000 ÷ $10,000). Billie reports 50% of each $2,000 payment she receives as gain from the sale. She also reports the interest as ordinary income.

Mortgage More than Basis When the buyer assumes a mortgage that is more than the installment sale basis in the property, the seller recovers the entire basis in the year of the sale. The part of the mortgage greater than the seller’s basis is treated as a payment received in the year of sale. The gross profit percentage is always 100% in this situation. To calculate the contract price, the taxpayer subtracts the mortgage from the selling price. This is the total amount the taxpayer will receive directly from the buyer. The taxpayer adds this to the payment the taxpayer is considered to have received (the difference between the mortgage and the installment sale basis). The contract price is then the same as the gross profit from the sale. Example 11. In 2016, William sold 10 acres of hunting ground for $9,000. His basis was $4,400 and he incurred $600 of selling expenses; therefore, his installment sale basis was $5,000. The buyer, Harry, assumed an existing mortgage of $6,000 and agreed to pay the remaining $3,000 in $750 annual installments, plus 8% interest, over the next four years. The part of the mortgage that was more than the installment sale basis was $1,000 ($6,000 – $5,000). This $1,000 is considered part of the installment contract. It is added to the $3,000 difference between the selling price and the mortgage. Therefore, $4,000 is the contract price. On William’s 2016 Form 6252, his gain of $4,000 ($9,000 selling price – $4,400 basis – $600 selling expenses) is reported on lines 14 and 16. The contract price reported on line 18 is $4,000 ($1,000 excess mortgage + $3,000 to be received in future years). His gross profit percentage is 100%. The entire $1,000 difference between the mortgage and the installment sale basis is treated as 2016 income.

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For Example 11

B20 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 Mortgage Canceled When the buyer of the property is the person who holds the mortgage, the debt is canceled, not assumed. The seller is considered to receive a payment equal to the outstanding canceled debt. Example 12. Mary loaned John $45,000 in 2011 in exchange for a note and a mortgage on a tract of land John owned. On April 1, 2017, she bought the land from him for $70,000. At that time, $30,000 of her loan to him was outstanding. She agreed to forgive this $30,000 debt and to pay him $20,000 plus interest on August 1, 2018, and $20,000 plus interest on August 1, 2019. Mary did not assume an existing mortgage; instead, she canceled the $30,000 debt John owed her. John must treat the $30,000 as a payment received at the time of the sale.

BUYER ASSUMES OTHER DEBTS When the buyer assumes any other debts, such as a loan or back taxes, the assumption of debt may be considered a payment to the seller in the year of sale. The rules that apply to mortgages also apply to the following types of debt that the buyer assumes. • Debts related to ownership of the property the taxpayer sold, such as a mortgage, lien, overdue interest, or back taxes • Debts incurred in the ordinary course of a business, such as a balance due for inventory that the taxpayer purchased When the buyer assumes any other type of debt, such as a personal loan or the legal fees relating to the sale, it is treated as if the buyer paid off the debt at the time of the sale. The value of the assumed debt is then considered a payment to the taxpayer in the year of sale.

PROPERTY USED AS A PAYMENT When the taxpayer receives property other than money from the buyer, it is considered a payment in the year received unless the like-kind exchange provisions apply. Like-kind exchanges are discussed later in the chapter. Generally, the “payment” is equal to the property’s FMV on the date the taxpayer receives it. When the property the buyer gives the taxpayer is payable on demand (e.g., a third-party note) or readily tradable (e.g., publicly traded stocks), the amount the taxpayer considers as payment in the year received is determined under the following rules. 1. If the taxpayer uses the cash method of accounting, then the payment is equal to the property’s FMV on the date the taxpayer receives it. If the property is third-party debt, then any payments the taxpayer later receives from the third party are not considered part of the installment sale. The excess of the note’s face value over its FMV is interest. 2. If the taxpayer uses the accrual method of accounting, then the payment is equal to the face amount of the obligation on the date the taxpayer receives it. 3. If the obligation includes OID or unstated interest, then the payment equals the stated redemption price at maturity appropriately adjusted to reflect OID or total unstated interest. 29

Observation. If the seller is also the lender in an installment sale transaction and wants to avoid treating the note receivable as being fully taxable in the year of sale, the note payable must not be payable on demand and must not be readily tradable.29 This prevents the note payable from being treated as a payment in the year of sale and allows income to be recognized as an installment obligation in future years.

29. IRC §453(f)(4).

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Any third-party debt that the taxpayer receives from the buyer that is not payable on demand is not considered a payment. This is true even if the debt is guaranteed by a third party, including a government agency. Example 13. Barry owed Debbie $50,000 as evidenced by a note he gave her in 2014. Under the terms of the note, he pays 5% interest each year. Principal of $25,000 is due in 2019, and the balance of $25,000 is due in 2020. There are no provisions allowing Debbie to demand payment prior to the due dates. In October 2017, Debbie bought a 2010 Luxury Fiesta motorhome from Ron. Debbie assigned the note from Barry to Ron. In addition, she gave Ron $2,000 and a note for $20,000 from her payable to Ron. Debbie’s note was payable over four years beginning in 2018, plus 8% interest. At the time of the sale, the FMV of Barry’s note was $30,000, as determined by a valuation expert. This amount, not the $50,000 principal balance on the note, is considered a payment to Ron in the year of sale. The sales price is $52,000 ($30,000 note FMV + $2,000 paid to Ron + $20,000 note from Debbie to Ron). Ron treats $32,000 ($30,000 + $2,000) as payments in 2017, the year of sale. The taxable portion of payments from Debbie to Ron in 2018 through 2021 will be determined under the installment sales rules. At the time of the sale, Barry’s note had an FMV equal to 60% of its face value ($30,000 ÷ $50,000). Therefore, 60% of each principal payment Ron receives from Barry is a nontaxable return of capital. The remaining 40% is interest income. If Barry pays Ron as scheduled in 2019 and 2020, then Ron will report $10,000 ($25,000 × 40%) as interest income each year.

INSTALLMENT OBLIGATION USED AS SECURITY If the taxpayer uses an installment obligation to secure any of their debt, the net proceeds from the debt may be treated as a payment on the installment obligation. This is called the pledge rule.30 The purpose of the pledge rule is to keep taxpayers from extracting cash from an installment sale without incurring any immediate tax. The rule applies if the selling price of the property sold on installment is over $150,000. It does not apply to the following dispositions. 30 • Sales of property used or produced in farming • Sales of personal-use property • Qualifying sales of time-shares and residential lots The net debt proceeds equal the gross debt minus the direct expenses of obtaining the debt. The amount treated as a payment is considered received on the later of the following dates. • The date the debt becomes secured • The date the taxpayer receives the debt proceeds A debt is secured by an installment obligation to the extent that payment of principal or interest on the debt is directly secured (under the terms of the loan or any underlying arrangement) by any interest in the installment obligation. Payment on a debt is treated as directly secured by an interest in an installment obligation to the extent an arrangement allows the taxpayer to satisfy all or part of the debt with the installment obligation. This applies to sales after December 16, 1999.

30. IRC §453A.

B22 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 Limit The net debt proceeds treated as a payment on the pledged installment obligation cannot be more than the excess of item (1) over item (2), below. 1. The total contract price on the installment sale 2. Any payments received on the installment obligation before the date the net debt proceeds are treated as a payment

Accelerated Reporting The pledge rule accelerates the reporting of the installment obligation payments. Payments received on the obligation after it was pledged are not reported until the payments received exceed the amount reported under the pledge rule. Example 14. Mary Jane received a $500,000 note from Conrad for the sale of her commercial building in 2015. The note is payable over 10 years, with interest. She did not receive any payments on the note from Conrad in 2015. In January 2016, Mary Jane used the note as collateral to borrow $200,000 from Nancy. Under the pledge rule, Mary Jane reported the $200,000 she borrowed from Nancy in 2016 as if it constituted principal payments from Conrad in 2016. Mary Jane also received $50,000 from Conrad in March 2016. Conrad’s $50,000 payment was disregarded for installment reporting purposes. Conrad’s payments will be disregarded until they total more than the $200,000 Mary Jane reported in 2016 under the pledge rule. Example 15. Use the same facts as Example 14, except Mary Jane uses the note as collateral in 2023 after she has received a total of $350,000 of principal payments from Conrad. The limit in 2023 on the amount she must report under the pledge rule is $150,000 ($500,000 contract price – $350,000 payments). In this instance, she will not have any principal payments to report in the following years because she has already reported receiving the entire contract principal.

Exception The pledge rule does not apply to pledges made after December 17, 1987, in order to refinance a debt under the following circumstances. • The debt was outstanding on December 17, 1987. • The debt was secured by the installment sale obligation on that date and at all times thereafter until the refinancing occurred. A refinancing as a result of the creditor’s calling of the debt is treated as a continuation of the original debt as long as a person other than the creditor or a person related to the creditor provides the refinancing. This exception applies only to refinancing that does not exceed the principal of the original debt immediately before the refinancing. Any excess is treated as a payment on the installment obligation.

ESCROW ARRANGEMENTS

Occasionally, a sales agreement or a later agreement may require the buyer to establish an irrevocable escrow account from which the remaining installment payments (including interest) are to be made. These types of sales cannot be reported on the installment method. The buyer’s obligation is paid in full when the balance of the purchase price is deposited into the escrow account. When an escrow account is established, the taxpayer relies on the escrow arrangement for the rest of the payments, rather than on the buyer.

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When the taxpayer makes an installment sale and in a later year establishes an irrevocable escrow account to pay the remaining installments plus interest, the amount placed in the escrow account represents payment of the balance of the installment obligation. However, if an escrow arrangement imposes a substantial restriction on the seller’s right to receive the sale proceeds, the sale can be reported on the installment method if it otherwise qualifies. For an escrow arrangement to impose a substantial restriction, it must serve a bona fide purpose of the buyer. This means that it must have a real and definite restriction placed on the seller or a specific economic benefit conferred on the buyer. Example 16. Alba, who is purchasing business assets, enters into an asset purchase and sale agreement with Benny, the seller. The total purchase price for the assets is $400,000. Alba and Benny agree that the $400,000 purchase price will be placed into an escrow account for a 2-year period. The escrow agreement is being used to protect Alba from any breach of representations made by Benny regarding the assets purchased by Alba, and to ensure the assets are free of any encumbrances. After two years, Benny will receive the funds. During the two years that the funds are in escrow, however, Benny will be entitled to quarterly interest payments for the interest earned on the $400,000 while in escrow. In order for Benny to be able to use the installment method rules for the sale using an escrow agreement, there must be a substantial restriction or condition to Benny’s right to receive the sales proceeds that are in escrow. If the escrow terms serve a genuine purpose of the buyer, or place a real and definite restriction on the seller, a substantial restriction or condition exists.31 Benny’s access to the escrow funds was limited to quarterly interest payments, and the escrow arrangement was used to protect Alba, the purchaser. Benny’s right to the trust funds is therefore subject to a substantial restriction or condition. Benny may use the installment sale rules for the sale transaction.32 33 34

Note. For the general rule that funds deposited in escrow are constructively received by the seller, disqualifying the transaction from installment sale treatment, see Oden v. Comm’r.33 For the substantial restriction or condition exception to the Oden rule, see Stiles v. Comm’r.34 For additional authority and details regarding the substantial restriction or condition exception, see also Rev. Rul. 77-294.

35 DEPRECIATION RECAPTURE AND UNRECAPTURED §1250 GAIN35

When the taxpayer sells property for which the taxpayer claimed or could have claimed a depreciation deduction, the taxpayer must report any depreciation recapture income in the year of sale. This is true regardless of whether an installment payment was received that year. Depreciation recapture is taxed as ordinary income. Depreciation recapture is limited to the gain realized on the disposition and includes the following. 1. All depreciation allowed or allowable on IRC §1245 property (personal property) 2. Depreciation in excess of straight-line on IRC §1250 property (depreciable real estate)

31. Rev. Rul. 79-91, 1979-1 CB 179. 32. This example is based on Ltr. Rul. 200521007 (Feb. 25, 2005). 33. Oden v. Comm’r, 56 TC 569 (1971). 34. Stiles v. Comm’r, 69 TC 558 (1978), acq. 1978-2 CB 3. 35. IRS Pub. 544, Sales and Other Dispositions of Assets.

B24 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 Example 17. Darrel sold his concrete slab jacking equipment to Scott in December 2016 for a note payable of $15,000 plus interest. Under the terms of the note, Scott agreed to pay $500 per month beginning on January 31, 2017. These payments will continue until the note is paid in full. Darrel originally purchased the equipment for $25,000. As of 2016, it was fully depreciated. Darrel reported the entire $15,000 selling price as depreciation recapture on his 2016 Form 4797. He did not file Form 6252, because all of the profit was taxed in 2016. In subsequent years, Darrel will only report the interest received on the note.

Observation. The use of an installment sale may be impractical for businesses who made use of bonus depreciation or the §179 deductions in prior years because the §1245 recapture rules apply. The tax liability may exceed the cash received in the year of sale.

Essentially, only the gain in excess of the original purchase price qualifies for the lower long-term capital gains tax rates. Any portion of the gain that is a recovery of a deduction is generally taxed at ordinary income tax rates. However, there is a limit on the tax rate for recovery of straight-line depreciation on IRC §1250 property. Gain from the sale of IRC §1250 property that is attributable to the accumulated depreciation allowed or allowable under the straight-line method is called unrecaptured gain and is taxed as ordinary income up to the maximum rate of 25%. The taxpayer enters the amount of unrecaptured gain on the “Unrecaptured Section 1250 Gain Worksheet,” which is part of the Schedule D instructions. The taxable gain on principal payments received on the installment basis is first allocated to the unrecaptured §1250 gain. This continues each year until the taxpayer claims the entire amount of unrecaptured gain.36 The remainder of the gain is taxed as a short-term or long-term capital gain, depending on the holding period of the sold assets. Example 18. Ursula sold residential rental property on contract for deed on September 9, 2016, for $200,000. The property was originally purchased for $145,000 in September 2001. The land value at the time of purchase was $10,000. Of the $135,000 depreciable basis, her accumulated allowed or allowable depreciation at the time of the sale was $73,635.37 37 Ursula’s adjusted basis in the property was $71,365 ($145,000 cost – $73,635 accumulated depreciation). Her total gain was $128,635 ($200,000 sales price – $71,365 adjusted basis). This is also her gross profit under the installment agreement. The gain is composed of the following.

Unrecaptured gain $ 73,635 Long-term capital gain 55,000 Total gain $128,635

Under the terms of the contract, Ursula received a down payment of $20,000 in 2016. She will receive the remaining principal over 15 years beginning in January 2017. Ursula’s gross profit percentage is 64.32% ($128,635 ÷ $200,000). Her 2016 taxable gain is $12,864 ($20,000 principal received × 64.32% gross profit percentage). The entire $12,864 is taxed as unrecaptured §1250 gain. Ursula will not claim any of the gain as long-term capital gains until she has claimed the entire $73,635 of depreciation. On her 2016 return, Ursula reported the sale in part III of Form 4797 and on Form 6252. Line 32 of Form 4797 is zero in accordance with the instructions for Form 6252, line 12, about reporting the installment sale on Form 4797. The taxable portion of the sale flowed from Form 6252 to line 4 of Form 4797. Ursula’s Forms 4797 and 6252 follow.

36. Treas. Reg. §1.453-12(a). 37. Calculated using MACRS, straight-line, mid-month convention, 27.5 years.

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B28 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 On the tax return for the year of the sale, the total amount of unrecaptured IRC §1250 gain is generally the lesser of line 9 or line 16 of Form 6252. However, in subsequent years, neither Form 6252 nor Form 4797 shows the amount of unrecaptured gain. Accordingly, the portion of the gain that must be taxed under these rules is not evident on returns following the year of the sale. As mentioned earlier, depreciable real estate is IRC §1250 property and personal property is IRC §1245 property. However, any IRC §179 deduction or bonus depreciation deduction taken on real property is considered IRC §1245 property for depreciation recapture purposes.38 The amount of depreciation recapture for IRC §1250 property treated as personal property under the IRC §1245 rules is the excess of accelerated depreciation over straight-line depreciation, multiplied by the applicable percentage. The applicable percentage is 100% for most real property. However, the applicable percentage for qualified low- income housing decreases when held for more than 100 full months.

Note. See IRS Pub. 544, Sales and Other Dispositions of Assets, for more information on qualified low- income housing. In addition, IRS Pub. 544 contains information about rules applicable to corporations other than S corporations under IRC §291, which is not covered in this material.

Real property for which accelerated depreciation was taken may be subject to both depreciation recapture and tax on unrecaptured gain. The depreciation recapture portion of the gain is taxed in the year of sale. Example 19. On July 1, 2008, Quinn opened a nightclub in a leased facility in Juneau, Alaska. The facility is owned by Neeley, an unrelated party. Prior to opening night, Quinn invested $60,000 in improvements to the interior of the building. On his 2008 tax return, Quinn claimed $30,000 of bonus depreciation on the leasehold improvements in addition to straight-line depreciation on the remaining $30,000. As part of his agreement with his landlord, if Quinn did not renew his lease, Neeley had to purchase the leasehold improvements at a price based on any appreciation attributable to the renovations made by Quinn. In 2016, Quinn closed the club and gave notice that he would not renew the lease effective December 1, 2016. He sold the equipment at auction and sold the leasehold improvements for $75,000 to Neeley in an installment sale. Quinn received $5,000 in 2016 as a down payment. The remaining $70,000 was due over seven years, with interest at 10%. Step 1. Quinn’s total gain on the sale of the property is calculated on page 2 of Form 4797, as shown later. Line 20 represents the total sales price. Lines 21 through 23 show the calculation of his adjusted basis of $14,000 ($60,000 cost – $46,000 accumulated depreciation). Line 24 shows his total gain of $61,000 ($75,000 sales price – $14,000 adjusted basis). Step 2. The depreciation recapture on line 31 is calculated as follows on lines 26a through 26g of Form 4797.

Bonus depreciation taken in 2008 $30,000 Straight-line depreciation from July 1, 2008 through December 1, 2016 16,000 Total accumulated depreciation $46,000 Straight-line depreciation allowable without bonus depreciation (32,000) Additional depreciation reported on line 26a $14,000

38. IRC §1245(a)(3)(C) and Treas. Reg. §1.168(k)-1(f)(3).

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Step 3. The additional depreciation on line 26a is multiplied by the applicable percentage of 100% to arrive at the $14,000 reported on lines 26b and 26g. (The applicable percentage is 100% because the leasehold improvements were not related to qualified low-income housing rental real estate.) Line 32 shows zero, in accordance with the instructions for Form 6252 regarding line 31 of Form 4797, because the remaining balance of the gain is reported on Form 6252. After completing the mechanics of page 2 of Form 4797, the $14,000 flows to line 13 of page 1 of Form 4797 (shown later). Step 4. The balance of Quinn’s gain of $47,000 ($61,000 total gain – $14,000 depreciation recapture) was reported as an installment sale on Form 6252 (shown later). The $14,000 adjusted basis is calculated on lines 7 through 10. Line 12 shows the depreciation recapture from Form 4797, page 2. The amounts on lines 10 and 12 are the same because the accelerated depreciation Quinn used in 2008 was 50% bonus depreciation. Step 5. Because the depreciation recapture was taxed in 2016, it was added to the adjusted basis on Form 6252. The gross profit on line 14 is the remaining gain after taking into account the depreciation recapture. Line 18 shows the contract price of $75,000. Step 6. Quinn’s gross profit percentage is 62.67%, as shown on line 19. The $5,000 he received on the contract sale in 2016 is reported on line 21 and multiplied by the gross profit percentage. This results in $3,133 of installment sale income, which is shown on line 24.

Note. Line 25 applies to IRC §§1252, 1254, and 1255 property, which are not discussed in this chapter.

Step 7. Line 26 of Form 6252 is carried to Form 4797, page 1. Step 8. The amount of Quinn’s contract gain that represents unrecaptured §1250 depreciation is not shown anywhere on his return. His unrecaptured gain is equal to the $32,000, as calculated in Step 2 (the amount of depreciation calculated on the straight-line basis as if he had not used bonus depreciation). During the contract period, Quinn treats 100% of the taxable portion of the contract payments as unrecaptured gain until he claims the entire $32,000. Accordingly, in 2017, he will use $3,133 as the amount on line 4 of the Unrecaptured Section 1250 Gain Worksheet (shown later). The remaining gain of $15,000 ($47,000 total gain − $32,000 unrecaptured gain) is taxed at the applicable long-term capital gains rates in effect for the years Quinn reports the payments received. Quinn’s Form 4797, Form 6252, and Unrecaptured Section 1250 Gain Worksheet follow.

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39 1 SALES TO RELATED PERSONS AND LATER DISPOSITIONS39

A special rule applies to installment agreements with related persons if both of the following conditions apply. • The related person resells or disposes of the property within two years of the purchase from the taxpayer. • The disposition by the related person occurs before all of the payments are made under the installment agreement. Related persons for these purposes include the following. The definition for these related parties is found in IRC §1239, rather than in IRC §§267 or 318. 1. Members of a family, including only brothers and sisters, spouses, ancestors, and lineal descendants 2. A partnership or estate, and a partner or beneficiary 3. A trust (other than a §401(a) employees trust) and a beneficiary 4. A trust and an owner of the trust 5. Two corporations that are members of the same controlled group as defined in IRC §267(f) 6. The fiduciaries of two different trusts, and the fiduciary and beneficiary of two different trusts, if the same person is the grantor of both trusts 7. A tax-exempt educational or charitable organization and a person (if an individual, including members of the individual’s family) who directly or indirectly controls such an organization 8. An individual and a corporation when the individual owns, directly or indirectly, more than 50% of the value of the corporation’s outstanding stock 9. A fiduciary of a trust and a corporation when the trust or the grantor of the trust owns, directly or indirectly, more than 50% in value of the corporation’s outstanding stock 10. The grantor and fiduciary, and the fiduciary and beneficiary, of any trust 11. Any two S corporations if the same persons own more than 50% in value of each corporation’s outstanding stock 12. An S corporation and a corporation that is not an S corporation if the same persons own more than 50% in value of each corporation’s outstanding stock 13. A corporation and a partnership if the same persons own more than 50% in value of the corporation’s outstanding stock and more than 50% of the capital or profits interest in the partnership 14. An executor and a beneficiary of an estate unless the sale is in satisfaction of a pecuniary bequest Because of this special rule, when a taxpayer makes an installment sale to a related party, they must include Form 6252 with their return for the year of sale and for the two years after the year of sale.40 For each year, the taxpayer must indicate if the related party sold or otherwise disposed of the property. This applies regardless of whether the taxpayer received any principal payments in those years.

39. IRS Pub. 537, Installment Sales. 40. Instructions for Form 6252.

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Under the special rule, the taxpayer must treat at least a portion of the amount the related person realizes from the second disposition as if the taxpayer received it at the time of the second disposition. The amount recognized by the taxpayer is calculated as follows. 1. Determine the lesser of: a. The amount realized on the second disposition, or b. The contract price on the first disposition. 2. Subtract the sum of the payments received by the taxpayer on the contract through the end of the tax year. An important exception applies to this rule when tax avoidance is not a principal purpose of the transaction. This is discussed later. If the amount received on the second disposition is more than the original contract price of the first disposition, the taxpayer must claim the entire deferred gain from the first disposition in the year of the second disposition. Example 20. In 2015, Margaret sold farmland to her son, Brent, for $500,000. This was to be paid in five equal payments over five years, plus adequate stated interest on the balance due. Her installment sale basis for the farmland was $200,000, and the property was not subject to any outstanding liens or mortgages. Her gross profit is $300,000 ($500,000 – $200,000) and her gross profit percentage is 60% ($300,000 gross profit ÷ $500,000 contract price). She received $100,000 in 2015 and included $60,000 in income for that year ($100,000 × 60%). On her 2015 Form 6252 (not shown), Margaret indicated on line 3 that the property was sold to a related party. She provided Brent’s name, address, and social security number on line 27 and indicated on line 28 that Brent did not resell the property in 2015. Brent made no improvements to the property and sold it to an unrelated party, Maryland Dreams, Inc., in 2016 for $600,000 after making the $100,000 payment for that year. After making the following calculation, Margaret treated $300,000 as if it were received in 2016 because Brent sold the property.

Lesser of amount realized on second disposition ($600,000) or contract price on first disposition ($500,000) $500,000 Less: the sum of payments from Brent in 2015 and 2016 (200,000) Amount treated as received because of second disposition $300,000

Margaret’s Form 6252 for 2016 is shown later. Line 26 shows the $60,000 income from the 2016 installment payment of $100,000, and line 37 shows the installment sale income from the $300,000 treated as received. In 2016, Margaret reported the entire remaining deferred profit on the sale. Therefore, she will not report any additional gain when she receives the subsequent installment payments from Brent.

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If the amount realized on the second disposition is less than the contract price of the first disposition, the taxpayer will not have claimed the entire gain in the year of the second disposition. In this case, the taxpayer applies the gain attributable to future payments first to the previously recognized gain. The taxpayer does not recognize any of the remaining gain until after the gain received exceeds the previously taxed gain. Example 21. Use the same facts as Example 20, except Brent sold the land for $300,000. The amount treated as received in 2016 was $100,000, which is calculated as follows.

Lesser of amount realized on second disposition ($300,000) or contract price on first disposition ($500,000) $300,000 Less: the sum of payments from Brent in 2015 and 2016 (200,000) Amount treated as received because of second disposition $100,000

The $100,000 payment Margaret receives in 2017 is applied against the amount treated as received in 2016. The payments in 2018 and 2019 were not treated as received in 2016 and will be taxed accordingly. This rule requiring current recognition of deferred gain does not apply to a second disposition if the taxpayer can show to the IRS’s satisfaction that neither disposition had as one of its principal purposes the avoidance of federal income tax. The IRS automatically recognizes that there was no tax avoidance purpose in the following situations. 1. Involuntary dispositions including foreclosures on the property and bankruptcy of the related person 2. Involuntary conversions if the first disposition occurred before the threat of conversion 3. A second disposition that is also an installment sale if the payment terms under the installment resale are substantially equal to or longer than those for the first installment sale (However, this exception does not apply if the resale terms permit significant deferral of recognition of gain from the first sale.)

Note. A transfer after the death of one of the parties (if this death occurs before the death of the other party) to the installment agreement is not treated as a second disposition.

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If the taxpayer sells depreciable property to a controlled entity in an installment sale, the taxpayer is generally prohibited from reporting the sale using the installment method.41 However, the installment method may be used if no significant tax deferral benefit is derived from the sale,42 and the taxpayers can prove to the IRS’s satisfaction that avoidance of federal income tax was not one of the principal purposes of the sale.43 There is no prohibition against using the installment method for such sales if the assets are not depreciable by the purchaser. Controlled entities for these purposes include the following related parties. • A person and all controlled entities with respect to that person44 • A taxpayer and any trust in which such taxpayer (or their spouse) is a beneficiary, unless their interest in the trust is a remote contingent interest45 • An executor of an estate and a beneficiary of that estate except in the case of a sale or exchange in satisfaction of a pecuniary bequest46 • Two or more partnerships in which the same person owns, directly or indirectly, more than 50% of the capital interests or the profits interests47 If the taxpayers cannot prove that the sale of depreciable property among these related persons was not for the purpose of avoiding federal income tax, all noncontingent payments to be received are considered received in the year of sale. The FMV of any contingent payments is also considered received in the year of sale. If the FMV of the contingent payments cannot be reasonably determined, the basis in the property is recovered proportionately.48 The purchaser cannot increase the basis of the property acquired in the sale before the seller includes a like amount in income.49

50 LIKE-KIND EXCHANGE50

When a taxpayer trades business or investment property in a like-kind exchange, reporting the gain can be postponed. The taxpayer treats the property received in a like-kind exchange as if it were a continuation of the relinquished property. The taxpayer is not required to report any part of the gain if they receive only like-kind property. However, if the taxpayer also receives money or other property (boot) in the exchange, they must report the gain to the extent of the money and the FMV of the other property received.

Note. For more information about like-kind exchanges, see IRS Pub. 544.

41. IRC §453(g)(1). 42. IRS Pub. 537, Installment Sales. 43. IRC §453(g)(2). See also Tecumseh Corrugated Box Co. v. Comm’r, 94 TC 360 (1990). 44. As defined in IRC §1239(c). 45. As defined in IRC §1239(b). 46. Ibid. 47. As described in IRC §707(b)(1)(B). 48. IRC §453(g)(1)(B)(ii). 49. IRC §453(g)(1)(C). 50. IRS Pub. 537, Installment Sales.

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If the taxpayer receives an installment obligation in the exchange in addition to like-kind property, the following rules determine the installment sale income each year. • The contract price is reduced by the FMV of the like-kind property received in the trade. • The gross profit is reduced by any gain on the trade that can be postponed. • Like-kind property received in the trade is not considered payment on the installment obligation. Example 22. In 2016, Georgia traded personal property with an installment sale basis of $400,000 for like- kind property having a $200,000 FMV. She also received an installment note for $800,000 in the trade. Under the terms of the note, she will receive $100,000 (plus interest) in 2017 and the balance of $700,000 (plus interest) in 2018. Relevant calculations for the installment sale are shown in the following table.

Installment note $ 800,000 FMV of like-kind property received 200,000 Selling price $1,000,000 $1,000,000 Installment sale basis (400,000) Gross profit $ 600,000 $600,000 FMV of property received (200,000) Contract price $ 800,000 ÷ 800,000 Gross profit percentage 75% Payment received in 2017 (100,000) × 100,000 Gain reported in 2017 $ 75,000 Balance on installment note $ 700,000 Gross profit percentage × 75% Gain reported in 2018 $ 525,000

Georgia did not report any gain in 2016 because the like-kind property she received was not treated as a payment for calculating gain. As shown in the table, she reports a $75,000 gain in 2017 and a $525,000 gain in 2018. 51

Note. A deferred exchange is one in which the taxpayer transfers business or investment property and later receives like-kind property. Under this type of exchange, the person receiving the property may be required to place funds in an escrow account or trust. If certain rules are met, these funds are not considered a payment until the taxpayer has the right to receive the funds or, if earlier, the end of the exchange period.51

51. See Treas. Reg. §1.1031(k)-1(j)(2).

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52 1 CONTINGENT PAYMENT SALE 52

A contingent payment sale is one in which the total selling price cannot be determined by the end of the tax year of sale. This happens, for example, when the taxpayer sells a business and the selling price includes a percentage of the business’s profits in future years. If the selling price cannot be determined by the end of the tax year, the taxpayer must use different rules to calculate the contract price and the gross profit percentage than those the taxpayer uses for an installment sale with a fixed selling price.

Note. For rules on using the installment method for a contingent payment sale, see Treas. Reg. §15a.453-1(c). For unstated interest or OID related to a contingent sale, see Treas. Regs. §§1.1275-4(c) and 1.483-4.

53 SINGLE SALE OF SEVERAL ASSETS 53

If the taxpayer sells different types of assets in a single sale, the taxpayer must identify each asset to determine whether they can use the installment method to report the sale of that asset. The taxpayer must also allocate part of the selling price to each asset. However, if the taxpayer sells assets that constitute a trade or business, different rules apply. This is discussed later in the chapter. Ideally, both parties, in an arm’s-length transaction, have agreed to the allocation of the selling price. If not, the taxpayer must allocate the selling price to the assets based on their FMVs. If debt is assumed by the buyer, the FMV of the property is reduced by the debt amount. A taxpayer reports the sale of separate and unrelated assets of the same type under a single contract as one transaction for the installment method. However, if an asset is sold at a loss, its disposition cannot be reported on the installment method. It must be reported separately. The remaining assets sold at a gain are reported together. Example 23. In 2016, Albert sold three separate and unrelated parcels of real property (E, M, and C) under a single contract with a total selling price of $130,000. The total selling price consisted of a cash payment of $20,000, the buyer’s assumption of a $30,000 mortgage on parcel M, and an installment obligation of $80,000 payable in eight annual installments of $10,000, plus interest at 8% per year. The installment sale basis for each parcel was $15,000. The net gain was $85,000 ($130,000 – (3 properties × $15,000 basis)). Albert reported the gain using the installment method. The sales contract did not allocate the selling price or the cash payment received in the year of sale among the individual parcels. According to the county assessor, the FMVs of parcels E, M, and C were $60,000, $60,000, and $10,000, respectively. The installment sale basis for parcel C was more than its FMV. Consequently, it was sold at a loss and had to be treated separately. Albert allocated the total selling price and the amounts received in the year of sale between parcel C and the remaining parcels. Of the total $130,000 selling price, Albert allocates $60,000 each to parcels E and M and $10,000 to parcel C. Because E and M were both sold at a gain, he reported them as one installment sale. He allocated the $20,000 received in 2016 based on the proportionate FMV, net of the mortgage assumed. The allocation is calculated as follows.

52. IRS Pub. 537, Installment Sales. 53. Ibid.

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Parcels E and M Parcel C FMV $120,000 $10,000 Less: mortgage assumed (30,000) (0) Net FMV $ 90,000 $10,000

Allocated percentage of net FMV 90% 10%

Payments in 2016: $20,000 × allocated percentage $ 18,000 $ 2,000 Plus: excess of parcel M mortgage over installment sale basis ($30,000 − $15,000) 15,000 0 Payments received and considered received $ 33,000 $ 2,000

Albert did not report the sale of parcel C on the installment method because the sale resulted in a loss. He reported this loss of $5,000 ($10,000 selling price – $15,000 installment sale basis) in 2016. If the real estate parcels were used in Albert’s trade or business, the $5,000 loss would be reported on Form 4797 and is fully deductible in the year of the sale. If the real estate parcels were Albert’s investment property, the $5,000 loss would be reported on Schedule D, subject to capital loss limitations. The installment note payments will be applied to the parcels based on their allocated percentages in future years. Of the annual $10,000 payment, 90% will be attributed to parcels E and M. The 10% attributed to C will not be reported on future returns.

54 SALE OF A BUSINESS 54

To determine whether any of the gain on the sale of the business can be reported on the installment method, the taxpayer must allocate the total selling price and the payments received in the year of sale between each of the following classes of assets. 1. Assets sold at a loss 2. Real and personal property eligible for the installment method 3. Real and personal property ineligible for the installment method, including: a. Inventory b. Dealer property c. Stocks and securities The gain on the sale of property that is ineligible for the installment method must be reported in the year of sale, regardless of whether the taxpayer will receive payments in later years. The amount that the taxpayer receives (or will receive) for inventory is reported as ordinary business income. The basis in the inventory is included in the cost of goods sold. Any part of the selling expenses allocated to inventory is an ordinary business expense.

54. Ibid.

B42 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 RESIDUAL METHOD To allocate the sales price, taxpayers must use the residual method for any transfer of a group of assets that constitutes a trade or business and for which the buyer’s basis is determined only by the amount paid for the assets. This applies to both direct and indirect transfers, such as the sale of a business or the sale of a partnership interest in which the basis of the buyer’s share of the partnership assets is adjusted for the amount paid under IRC §743(b). A group of assets constitutes a trade or business if goodwill or going concern value could, under any circumstances, attach to the assets or if the use of the assets would constitute an active trade or business under IRC §355. The business’s sales price is first reduced by any cash, checking, or savings accounts included in the sale. The sales price is then allocated among the following assets in proportion to (but not more than) their FMV on the purchase date in the following order. 1. Certificates of deposit, U.S. government securities, foreign currency, and actively traded personal property, including stock and securities 2. Accounts receivable, other debt instruments, and assets that the taxpayer marks to market at least annually for federal income tax purposes (However, see Treas. Reg. §1.338-6(b)(2)(iii) for exceptions that apply to debt instruments issued by persons related to a target corporation, contingent debt instruments, and debt instruments convertible into stock or other property.) 3. Property of a kind that would properly be included in inventory if on hand at the end of the tax year or property held by the taxpayer primarily for sale to customers in the ordinary course of business 4. All other assets except IRC §197 intangibles 5. IRC §197 intangibles except goodwill and going concern value 6. Goodwill and going concern value (regardless of whether they qualify as §197 intangibles) If an asset is includable in more than one category, it should be included in the lower number category. For example, if an asset is described in both categories 4 and 6, include it in 4.

AGREEMENT Ideally, the agreement will include the allocation of the sales price to the assets. This agreement is binding on both parties unless the IRS determines the amounts are not appropriate.

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Example 24. Sebastian owned The Mermaid’s Song, a music store that he operated as a sole proprietor. He sold the business on June 4, 2016. The sales price of $220,000 included all inventory, furnishings, equipment, a delivery truck, the business name, and the building. Selling expenses were $11,000. Sebastian’s adjusted basis in the property at the time of the sale follows. (The building was depreciated using the straight-line method.)

Asset Original Purchase Price Accumulated Depreciation Adjusted Basis Inventory $ 8,000 $ 0 $ 8,000 Furnishings and equipment 126,000 40,160 85,840 Truck 24,000 18,624 5,376 Building 45,000 9,000 36,000 Land 15,000 0 15,000 Total $218,000 $67,784 $150,216

After consulting with their attorneys and accountants, Sebastian and the buyer agreed that the FMV of the assets included in the purchase price were as shown in the following table. All of the selling costs were allocated proportionally.

Asset Sales Price Selling Expenses Adjusted Basis Gain Inventory $ 10,000 $ 500 $ 8,000 $ 1,500 Furnishings and equipment 95,000 4,750 85,840 4,410 Truck 6,500 325 5,376 799 Building 48,000 2,400 36,000 9,600 Land 42,000 2,100 15,000 24,900 Goodwill 18,500 925 0 17,575 Total $220,000 $11,000 $150,216 $58,784

Not all of the assets qualify to be reported on the installment method. The following tables explain the breakdown of the sale for reporting purposes.

Lesser of Gain or Accumulated Depreciation Unrecaptured Asset IRC Section Depreciation Recapture §1250 Gain Inventory IRC §471 $ 0 $ 0 $ 0 Furnishings and equipment IRC §1245 4,410 4,410 0 Truck IRC §1245 799 799 0 Building IRC §1250 9,000 0 9,000 Land IRC §1250 0 0 0 Goodwill (IRC §197 ) IRC §1245 0 0 0 Totals $5,209 $9,000

Asset Qualified for Installment Method Reported in Return on... Inventory No, sale must be reported as business income Schedule C Furnishings, equipment No, entire gain is subject to depreciation recapture Form 4797, Part III Truck No, entire gain is subject to depreciation recapture Form 4797, Part III Building Yes Form 4797, Part III and Form 6252 Land Yes Form 4797, Part I and Form 6252 Goodwill Yes Form 4797, Part I and Form 6252

B44 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 In 2016, Sebastian received a $100,000 down payment on the sale. Form 6252 is required for each asset reported on the installment method. Sebastian must allocate the principal he receives each year to the assets according to their proportion of the selling price as shown in the following table.

Percentage of Form 6252 Total Sale Allocation of Asset Contract Price of $220,000 Principal Received Building $ 48,000 21.82% $21,818 Land 42,000 19.09% 19,091 Goodwill 18,500 8.41% 8,409 Total $108,500

Each year, Sebastian multiplies the allocated principal by the gross profit percentage to determine the gain to report. The gross profit percentage for each asset equals the gross profit for that asset divided by the asset’s contract price. The following table shows his gains reported in 2016 under the installment method.

Gross Profit 2016 Gain Asset Gross Profit Percentage 2016 Principal Reported Building $ 9,600 20.00% $21,818 $ 4,364 Land 24,900 59.29% 19,091 11,318 Goodwill 17,575 95.00% 8,409 7,989 Total $52,075 Gross profit percentage of contract price 48.00%

In 2016, Sebastian also reported the $1,500 in profit from inventory on his Schedule C and $5,209 ($4,410 + $799) of depreciation recapture from the furnishings, equipment, and truck on his Form 4797. When he receives principal payments in later years, no part of the payment for the sale of these assets will be included in gross income.

REPORTING REQUIREMENT If the sale of a business involves goodwill or going concern value, both the buyer and seller must report the allocation on Form 8594, Asset Acquisition Statement under Section 1060. The buyer and seller should each attach Form 8594 to their federal income tax return for the year in which the sale occurred.55

Note. A partner who sells a partnership interest at a gain may be able to report the sale on the installment method. The sale of a partnership interest is treated as the sale of a single capital asset. However, the taxpayer treats any part of any gain or loss from unrealized receivables, inventory, and depreciation recapture as ordinary income. These parts of the gain cannot be reported under the installment method. The gain allocated to the other assets can be reported under the installment method. For more information, see IRS Pub. 541, Partnerships. For corporate shareholders, a sale of shares may be treated as a sale of stock and reported under the installment method.

55. Instructions for Form 8594.

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56 DISPOSITION OF AN INSTALLMENT OBLIGATION56

When the taxpayer uses the installment method and later disposes of the installment obligation, the taxpayer generally has a gain or loss to report. A disposition includes a sale, exchange, cancellation, bequest, distribution, or transmission of an installment obligation. The tax treatment of the disposition of the installment agreement is based on the original sale of the property for which the taxpayer received the installment obligation. For example, if the original installment sale produced ordinary income, the disposition of the obligation results in ordinary income or loss. Likewise, if the original sale resulted in a capital gain, the disposition of the obligation results in a capital gain. The following rules are used to calculate the gain or loss from the disposition of an installment obligation. 1. If the taxpayer sells or exchanges the obligation or the taxpayer accepts less than face value in satisfaction of the obligation, the gain or loss is the difference between the basis in the obligation and the amount the taxpayer realizes. 2. If the taxpayer disposes of the obligation in any other way, the gain or loss is the difference between the basis in the obligation and its FMV at the time of the disposition. This rule applies, for example, when the taxpayer gives the installment obligation to someone else or cancels the buyer’s debt to the taxpayer. The basis in an installment obligation is calculated using the following formula.

Basis in installment obligation= Unpaid balance on obligation  100%– Gross profit percentage

Example 25. Ernie sold Olaf a building on contract for deed in 2012. The gross profit percentage on the sale was 60%. As of January 1, 2016, Olaf still owed Ernie $10,000 on the contract. Ernie’s basis in the obligation on January 1, 2016, was $4,000 ($10,000 unpaid balance × (100% – 60%).

TRANSFER BETWEEN SPOUSES OR FORMER SPOUSES No gain or loss is recognized on the transfer of an installment obligation between spouses or former spouses when the transfer is incident to a divorce. A transfer is incident to a divorce if it occurs within one year after the date on which the marriage ends or is related to the end of the marriage. The same tax treatment of the transferred obligation applies to the recipient of the transfer as would have applied to the taxpayer who made the transfer. The basis of the obligation to the transferee is the adjusted basis of the transferor. This nonrecognition rule does not apply if the spouse or former spouse receiving the obligation is a nonresident alien.

GIFTS A gift of an installment obligation is a disposition. The gain or loss is the difference between the basis in the obligation and its FMV at the time the taxpayer makes the gift. The IRS has not specified how to determine the FMV of the obligation at the time of the gift for these purposes. Determining an obligation’s FMV requires knowing what the obligation could be sold for to an unrelated third party in an arms-length transaction. Without a third party making an offer to buy the note, the FMV may not be readily available. In an open market, the FMV of an installment agreement is equal to the present value of the future cash flow using a discount rate that incorporates the debt instrument’s underlying risk profile.57

56. IRS Pub. 537, Installment Sales. 57. Valuation of Promissory Notes: Not as Simple as It Seems. Feb. 2011. Kotzin Valuation Partners. [www.kotzinvaluation.com/articles/ promissory-notes.htm] Accessed on Feb. 6, 2017.

B46 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 If the taxpayer is not able to determine the note’s FMV by other means, the most conservative approach is to use the principles of Temp. Treas. Reg. §15A.453-1(d)(2), under which the FMV of the installment obligation is defined for purposes of electing out of the installment method. Using those principles, the FMV of the installment agreement at the time of the gift is the FMV of the property sold minus any other consideration received. Other consideration includes principal previously reported. Using this approach, if the original transaction was conducted at arm’s-length, the balance remaining on the note will be the FMV of the note. A taxpayer gifting the installment agreement would recognize a gain to the extent the remaining balance of the agreement exceeded the basis of the agreement. Example 26. Use the same facts as Example 25. On January 1, 2016, Ernie gifted the installment contract to his daughter. The FMV of the obligation is the remaining $10,000 due. Ernie’s basis in the installment agreement was $4,000. Ernie reported a $6,000 gain on the disposition of the installment contract on his 2016 return.

Note. If the gift amount exceeds the annual exclusion, a gift tax return may be required.

CANCELLATION If an installment obligation is canceled or otherwise becomes unenforceable, it is treated as a disposition other than a sale or exchange. The gain or loss is the difference between the taxpayer’s basis in the obligation and its FMV at the time the taxpayer cancels it. Example 27. Use the same facts as Example 25. In 2016, Olaf defaulted on the agreement due to a series of unfortunate events that rendered him insolvent. In addition, the real estate was declared an environmental hazard. Ernie decided that the costs of repossessing the property were prohibitive and the chances of collecting the balance of the obligation were nonexistent. Ernie canceled the remaining obligation. Because the installment obligation was worthless at the time of cancellation, its FMV was zero. On his 2016 return, Ernie reported a loss from the cancellation equal to his remaining $4,000 basis in the contract.

Note. If the parties are related, the FMV of the obligation is considered to be no less than its full face value.

FORGIVING PART OF THE BUYER’S DEBT If the taxpayer accepts partial payment on the balance of the buyer’s installment debt to the taxpayer and forgives the rest of the debt, the taxpayer treats the settlement as a disposition of the installment obligation. The gain or loss is the difference between the basis in the obligation and the amount the taxpayer realizes on the settlement.

TRANSACTIONS THAT ARE NOT DISPOSITIONS When the taxpayer reduces the selling price but does not cancel the rest of the buyer’s debt to the taxpayer, it is not considered a disposition of the installment obligation. The taxpayer must recalculate the gross profit percentage and apply it to the payments the taxpayer receives after the reduction. (See the “Selling Price Reduced” section earlier in the chapter.) When the buyer of the property sells it to someone else and the taxpayer agrees to let the new buyer assume the original buyer’s installment obligation, the taxpayer has not disposed of the installment obligation. This is true even if the new buyer pays the taxpayer a higher rate of interest than the original buyer.

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Death of the Seller The transfer of an installment obligation (other than to a buyer) as a result of the seller’s death is not a disposition. The recipient of the debt obligation reports the installment payments in the same manner as the decedent would have if they had lived to receive the payments. The recipient does not receive a step-up in basis in the installment obligation. Example 28. In 2009, Patricia sold her business to her daughter, Peggy, on installment. When Patricia died, her son, Larry, inherited the installment note. Larry reports the interest and principal payments he receives each year in the same manner that Patricia would have if she had not passed away. However, if an installment obligation is canceled, becomes unenforceable, or is transferred to the buyer because of the death of the holder of the obligation, then it is a disposition. A transfer of the note under these conditions is considered to occur upon the earlier of the following events.58 1. The executor’s assent to the distribution of the note under state statute 2. The cancellation of the note by the executors 3. When the note becomes unenforceable 4. Termination of the administration of the estate for federal income tax purposes The estate must calculate its gain or loss on the disposition based on the note’s FMV. If the deceased holder and the buyer were related, the installment obligation’s FMV is considered to be no less than its full face value. Example 29. Use the same facts as Example 28, except Peggy inherited the note. Because Peggy was both related to the decedent and the obligor of the note, the FMV of the note is equal to the remaining principal due under the agreement. Accordingly, Patricia’s estate must report the remaining unreported gain from the sale on its income tax return for the year the note is actually transferred to Peggy, the year the note is canceled by the executors, or the year the note becomes unenforceable.

59 REPOSSESSION59

If the taxpayer repossesses the property after making an installment sale, the taxpayer must calculate the following. • The gain (or loss) on the repossession • The basis in the repossessed property The rules for repossessions of personal property differ from those for real property. In addition, special rules apply if the taxpayer repossesses property that was their main home before the sale.60 The repossession rules apply regardless of whether title to the property transfers to the buyer. It does not matter how the taxpayer repossesses the property, whether the taxpayer forecloses or the buyer voluntarily surrenders the property to the taxpayer. However, the property is not considered repossessed when the buyer puts the property up for sale and the taxpayer repurchases it.

58. Ltr. Rul. 8552007 (Sep. 18, 1985). 59. IRS Pub. 537, Installment Sales. 60. See Treas. Reg. §1.1038-2 for further information.

B48 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 For the repossession rules to apply, the repossession must at least partially satisfy the buyer’s installment obligation to the taxpayer. The discharged obligation must be secured by the property the taxpayer repossesses. This requirement is met if the property is auctioned off after the taxpayer forecloses and the taxpayer then applies the installment obligation to the bid price at the auction.

FMV OF REPOSSESSED PROPERTY The repossessed property’s FMV is a question of fact to be established in each case. If the taxpayer bids for the property at a lawful public auction or judicial sale, its FMV is presumed to be the price it sells for, unless there is clear and convincing evidence to the contrary.

PERSONAL PROPERTY If the taxpayer repossesses personal property, they may have a gain or a loss on the repossession. In some cases, the taxpayer also may have a bad debt. The gain or loss on the repossession is calculated using the following formula.

FMV of property at time of repossession + FMV of additional property received at time of repossession − Total basis in the installment obligation − Repossession expenses Gain or loss on reposession

How the taxpayer calculates the basis in the installment obligation depends on whether the taxpayer reported the original sale on the installment method. The method the taxpayer used to report the original sale also affects the character of the gain or loss on the repossession.

Installment Method Not Used to Report Original Sale If the taxpayer did not use the installment method to report the original sale, the basis of the installment obligation is the value of the obligation used to calculate the gain or loss in the year of the sale less the principal payments received prior to repossession. Accordingly, the following formula may be used to calculate the gain or loss on the repossession.

FMV of property at time of repossession + FMV of additional property received at time of repossession − Value of the obligation used to calculate gain or loss in the year of the sale + All principal payment received prior to repossession − Repossession expenses Gain or loss on repossession

A gain on an installment obligation is taxed as ordinary income. If the repossession results in a loss, the loss is considered a bad debt. The manner in which the taxpayer deducts the bad debt depends on whether the taxpayer sold business or nonbusiness property in the original sale.

Note. See IRS Pub. 550, Investment Income and Expenses, for information on nonbusiness bad debts. See IRS Pub. 535, Business Expenses, for information on business bad debts.

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Example 30. Tommy sold his custom 1965 Volkswagen van to Marian for $89,000 in 2012. On his 2012 return, Tommy elected out of the installment method. He reported the $10,000 cash he received and the $79,000 face value of the installment note as if he received the full $89,000 in 2012. Tommy received $9,000 principal payments plus interest in each year from 2013 to 2015. In 2016, the cost of Marian’s medical bills made it impossible for her to continue making the required payments, so she stopped payment on the note. Tommy repossessed the van. Unfortunately, because Marian’s glaucoma had interfered with her ability to drive, the van was only worth $20,000 when Tommy took it back. As part of the negotiated settlement, Marian also gave Tommy her porcelain doll collection, which had an FMV of $25,000 at the time of the settlement. Tommy paid $2,000 in attorney’s fees to negotiate the settlement. Tommy’s loss on the repossession was calculated as follows. He reported the nonbusiness bad debt on his 2016 return as a as a short-term capital loss.

FMV of property at time of repossession $20,000 Plus: FMV of additional property received at time of repossession 25,000 Less: value of the obligation used to calculate gain or loss in the year of the sale (79,000) Plus: all principal payment received prior to repossession ($9,000 × 3) 27,000 Less: repossession expenses (2,000) Loss realized on repossession ($ 9,000)

Installment Method Used to Report Original Sale If the taxpayer used the installment method to report the original sale, the basis in the installment obligation is the unpaid balance multiplied by the difference between 100% and the gross profit percentage. Accordingly, the gain or loss may be calculated using the following formula.

FMV of property at time of repossession + FMV of additional property received at time of repossession − Unpaid balance on the obligation × (100% − gross profit percentage) − Repossession expenses Gain or loss on reposession

The gain or loss on the repossession is of the same character (capital or ordinary) as the gain on the original sale. Example 31. Use the same facts as Example 30, except Tommy did not elect out of the installment method. On his 2012 return, he calculated his gross profit percentage to be 25%. The unpaid balance on the installment agreement at the time of the repossession was $52,000 ($79,000 – ($9,000 × 3)). Tommy’s 2016 gain is calculated as follows.

FMV of property at time of repossession $20,000 Plus: FMV of additional property received at time of repossession 25,000 Less: Unpaid balance on the obligation of $52,000 × (100% − 25% gross profit percentage) (39,000) Less: repossession expenses (2,000) Gain realized on repossession $ 4,000

B50 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 REAL PROPERTY The rules for the repossession of real property allow the taxpayer to keep essentially the same adjusted basis in the repossessed property that the taxpayer had before the original sale. The taxpayer can recover this entire adjusted basis when they resell the property. In effect, this cancels out the tax treatment that applied to the taxpayer on the original sale and puts the taxpayer in the same tax position they were in before that sale. As a result, the total payments the taxpayer received from the buyer on the original sale are considered income to the taxpayer. The taxpayer must report, as gain on the repossession, any part of the payments not yet included in income. These payments are amounts the taxpayer previously treated as a return of the adjusted basis and excluded from income. However, the total gain the taxpayer reports is limited, as explained later. The rules concerning basis and gain on repossessed real property apply regardless of whether the taxpayer reported the sale on the installment method. However, they only apply if all of the following conditions are met. 1. The repossession must occur to protect the taxpayer’s security rights in the property. 2. The installment obligation satisfied by the repossession must have been received in the original sale. 3. The taxpayer cannot pay any additional consideration to the buyer to get the property back unless either of the following situations applies. a. The reacquisition and payment of the additional consideration were provided for in the original contract of sale. b. The buyer defaulted, or default is imminent. Additional consideration includes money and other property the taxpayer pays or transfers to the buyer. For example, additional consideration is paid when the taxpayer reacquires the property subject to a debt that arose after the original sale. If any of the three conditions above are not met, then the taxpayer must use the rules applicable to personal property instead of real property.

Gain on Repossession The gain on repossession of real property is the difference between the following amounts. • The total payments received, or considered received, on the sale • The total gain already reported as income Taxable gain is limited to the gross profit on the original sale minus the sum of the following amounts. • The gain on the sale the taxpayer reported as income before the repossession • The repossession costs The limit on taxable gain does not apply if the selling price is indefinite and cannot be determined at the time of repossession. For example, a selling price stated as a percentage of the profits realized from the buyer’s development of the property is an indefinite selling price. If the taxpayer reported the sale on the installment method, the taxable gain on repossession is ordinary income or capital gain, the same as the gain on the original sale. However, if the taxpayer did not report the sale on the installment method, the gain is ordinary income.

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Example 32. Gloria sold a tract of land in January 2014 for $25,000. She received a $5,000 down payment, plus a $20,000 mortgage secured by the property and payable at the rate of $4,000 annually plus 5% interest. The payments began on January 1, 2015. The adjusted basis in the property was $19,000, and she reported the transaction as an installment sale. The selling expenses were $1,000. On her 2014 return, she calculated the gross profit as follows.

Selling price $25,000 Less: adjusted basis (19,000) Less: selling expenses (1,000) Gross profit $ 5,000

The gross profit percentage is 20% ($5,000 gross profit ÷ $25,000 contract price). In 2014, Gloria included $1,000 in income (20% × $5,000 down payment). In 2015, she reported a profit of $800 (20% × $4,000 annual installment). In 2016, the buyer defaulted and Gloria repossessed the property. She paid $500 in legal fees to get the property back. Gloria included $2,700 as taxable gain from the repossession on her 2016 return. Her original profit limited her taxable gain, which was calculated as follows.

Total payments received before repossession ($5,000 + $4,000) $9,000 Less: gain already reported as income ($1,000 + $800) (1,800) Gain on repossession $7,200 Gross profit on original sale $5,000 Less: gain already reported as income ($1,000 + $800) (1,800) Less: costs of repossession (500) Limit on taxable gain on repossession $2,700

The lesser of the limit on gain on repossession or the taxable gain is $2,700.

Basis in Repossessed Property The basis in the repossessed property is determined as of the date of repossession. It is the sum of the following amounts. • The adjusted basis in the installment obligation (i.e., the unpaid balance on the obligation × (100% – gross profit percentage) • The repossession costs • The taxable gain on the repossession Example 33. Use the same facts as Example 32. The unpaid balance of the installment obligation (the $20,000 note) was $16,000 at the time of repossession ($20,000 – 4,000 payment in 2015). The gross profit percentage on the original sale was 20%. Gloria’s adjusted basis in the note was $12,800 ($16,000 × (100% – 20%)) at the time of the repossession. She calculated the basis in the repossessed property as follows.

Adjusted basis in the installment obligation $12,800 Plus: repossession costs 500 Plus: taxable gain on the repossession 2,700 Basis in repossessed real property $16,000

B52 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 Holding Period for Resales If the taxpayer resells the repossessed property, the resale may result in a capital gain or loss. The holding period includes the period the taxpayer owned the property before the original sale plus the period after the repossession. It does not include the period the buyer owned the property. If the buyer made improvements to the reacquired property, the holding period for these improvements begins on the day after the date of repossession.

Bad Debt If the taxpayer repossesses real property under these rules, the taxpayer cannot take a bad debt deduction for any part of the buyer’s installment obligation. This is true regardless of whether the obligation is fully satisfied by the repossession. If the taxpayer took a bad debt deduction before the tax year of repossession, the taxpayer is considered to have recovered the bad debt when they repossessed the property. The taxpayer must report the bad debt deduction taken in the earlier year as income in the year of repossession. However, if any part of the earlier deduction did not reduce the tax, the taxpayer does not have to report that portion as income. The taxpayer increases the adjusted basis in the installment obligation by the amount the taxpayer reports as income from recovering the bad debt.

61 INTEREST ON DEFERRED TAX 61

Generally, the taxpayer must pay interest on the deferred tax related to any obligation that arises during a tax year from the disposition of property under the installment method if both of the following apply. • The property had a sales price over $150,000. In determining the sales price, all sales that are part of the same transaction are treated as a single sale. • The total balance of all nondealer installment obligations arising during, and outstanding at the close of, the tax year is more than $5 million. The taxpayer must continue to pay this interest in subsequent years if installment obligations that originally required interest to be paid are still outstanding at the close of a tax year. This interest rule does not apply to dispositions of the following types of property. • Farm property • Personal-use property by an individual • Personal property sold before 1989 • Real property sold before 1988

Note. For more information about the interest on deferred tax and how to report the interest on tax returns, see IRS Pub. 537.

61. IRS Pub. 537, Installment Sales.

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SELF-CANCELING INSTALLMENT NOTES

A self-canceling installment note (SCIN) instantly cancels all future payments due when the holder of the note dies.62 One purpose of a SCIN is to reduce the taxpayer’s taxable estate without incurring gift taxes during the taxpayer’s lifetime. A SCIN may also be part of a business succession plan. Example 34. Jean has no children and no other family members who have an interest or ability to operate her business. Jean wants to retire, but she does not want to sell her tax practice to anyone incompetent or unethical. The only potential buyer that she trusts is her assistant, Tate. Jean would give Tate the business outright, but she needs the income for support during her lifetime. Therefore, Jean sells the business at FMV to Tate on an installment contract that provides her the requisite annual income. However, because Tate is her chosen successor, the terms of the note provide that any balance on the installment contract will be forgiven upon her death. Because the business was purchased at FMV, Jean does not have to file a gift tax return. Furthermore, the business is no longer part of her estate, so any future growth in its value will not be reflected in her estate’s taxable value. The note has no value upon her death, so it is also not included in her estate. CCA 201330033 outlines the IRS’s position on SCINs. Based on that advisory, the preceding Example 34 provides the “cleanest” fact pattern for passing IRS scrutiny. 1. The parties are not related, which makes it more likely to be an arms-length transaction. 2. The cash flow from the note is appropriate to the situation because it is based on Jean’s needs; therefore, there was a good reason, other than estate tax savings, to enter into the transaction. 3. The self-canceling feature will contribute to the business’s odds of survival. Based on these factors, it is easy to conclude that the transaction is a bona-fide sale and that tax avoidance is not its primary purpose. However, this type of situation is rare. The typical SCIN transactions involve related parties and multiple entities, such as revocable and irrevocable trusts. These complex transactions often employ many other features meant to preserve the tax benefits in the event of IRS scrutiny. Such intricacies are beyond the scope of this material.

Note. For excellent background information on SCINs and a prelude to understanding the current climate, see “Self-Canceling Installment Notes (SCINs) – IRS Guidance and Pending Tax Court Case; CCA 201330033 and Estate of William Davidson” by Steve R. Akers. This article can be found at uofi.tax/17b1x1 [www.bessemertrust.com/portal/binary/com.epicentric.contentmanagement.servlet.ContentDeliveryServlet/ Advisor/Presentation/Print%20PDFs/Self-Canceling%20Installment%20Notes%20CCA%20 201330033 _10.18.13_FINAL.pdf].

62. CCA 201330033 (Feb. 24, 2012).

B54 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 The courts, not the IRS, have the ultimate authority to determine which fact patterns satisfy the requirements of the applicable tax laws and which do not. There have been a number of court cases involving SCINs. Two high-profile cases were recently settled — Estate of Woelbing v. Comm’r63 and Estate of Davidson v. Comm’r.64 In these cases, the plaintiffs filed petitions with the Tax Court after the IRS assessed deficiencies. The IRS’s position was based on the following arguments. 1. The notes had no value at the time of the transactions; therefore, gift tax was due on the transfers. 2. The sales were not bona-fide arm’s-length transactions; therefore, the transferred assets should be included in the taxable estate. Many interested parties hoped that the courts would weigh in on key issues, such as the following. 1. Which of the following measures are appropriate to use in determining the FMV of the note?65 a. The rules applicable to installment debt instruments (the willing-buyer, willing-seller standard in Treas. Reg. §25.2512-8) b. The rules applicable to annuities under IRC §7520 2. What is the effectiveness of certain provisions, such as the “value adjustment clause,” which were included in the SCIN documents to protect the transactions from being nullified by the IRS and the courts?66 Unfortunately, the recent cases were settled out of court, leaving observers to continue speculating on the issues. The Woelbing case settlement involved no additional gift or estate tax liabilities. However, compromises may have been reached in a related situation;67 therefore, any conclusions drawn from the settlement are speculative. 68

Note. For the Estate of Marion Woelbing case, a stipulated decision was entered on Mar. 28, 2016, indicating that no additional gift tax is due related to the SCIN transaction in this and the related Estate of Donald Woelbing case. However, this case did not address estate tax. The statute of limitations was still open for the decedent’s estate tax at the time of the settlement. Accordingly, the SCIN issues may have been part of undisclosed negotiations between the IRS and the decedent’s estate regarding unassessed estate taxes.68

63. Estate of Donald Woelbing v. Comm’r, Tax Court Docket No. 30261-13 (Petition filed Dec. 26, 2013; stipulated decision Mar. 25, 2016). [www.ustaxcourt.gov/UstcDockInq/DocumentViewer.aspx?IndexID=6812800]. Accessed on Apr 25, 2017. 64. Estate of William Davidson v. Comm’r, Tax Court Docket No. 13748-13 (Petition filed Jun. 14, 2013; stipulated decision Jul. 6, 2015). [www.ustaxcourt.gov/UstcDockInq/DocumentViewer.aspx?IndexID=6610435]. Accessed on Apr 25, 2017. 65. Ron Aucutt’s “Top Ten” Estate Planning and Estate Tax Developments of 2015. Aucutt, Ronald. Jan. 4, 2016. McGuireWoods LLP. [www.mcguirewoods.com/Client-Resources/Alerts/2015/12/Ron-Aucutt-Top-Ten-Estate-Planning-Tax-Developments-2015.aspx] Accessed on Apr. 25, 2017; Tax Cases Going Into 2016 Cause Concern for Estate Planners. Beddingfield, Matthew. Jan. 12, 2016. Bloomberg BNA. [www.bna.com/tax-cases-going-n57982066220/] Accessed on Apr. 24, 2017. 66. Ron Aucutt’s “Top Ten” Estate Planning and Estate Tax Developments of 2015. Aucutt, Ronald. Jan. 4, 2016. McGuireWoods LLP. [www.mcguirewoods.com/Client-Resources/Alerts/2015/12/Ron-Aucutt-Top-Ten-Estate-Planning-Tax-Developments-2015.aspx] Accessed on Apr. 25, 2017; IRS Grabs $388 Million From Billionaire Davidson Estate. Ebeling, Ashlea. July 8, 2015. Forbes. [www.forbes.com/sites/ashleaebeling/2015/07/08/irs-grabs-388-million-from-billionaire-davidson-estate/#50193ebd7de7] Accessed on Apr 25, 2017. 67. Estate of Marion Woelbing v. Comm’r, Tax Court Docket No. 30260-13. See Settlement of Woelbing Cases (Involving Sale to Grantor Trust with Defined Value Feature). Akers, Steve. Apr. 2016. Bessemer Trust. [www.bessemertrust.com/portal/binary/com.epicentric. contentmanagement.servlet.ContentDeliveryServlet/Advisor/Presentation/Print%20PDFs/Woelbing%20Settlement%20Summary %2004%2004%2016.pdf] Accessed on Apr. 25, 2017. 68. Expert Analysis: IRS Settlement With Carmex Owners Is Surprising. Aucutt, Ronald D. Apr. 14, 2016. Law 360. [www.law360.com/articles/ 783013?scroll=1] Accessed on Apr. 25, 2017.

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The Davidson case, in contrast, was settled for $338 million, which covered estate and gift tax liabilities. While the settlement does not disclose how the valuation issues were decided, it does provide a warning to practitioners on the riskiness of using SCINs as part of “cutting-edge” estate planning strategies.

GIFT TAX69 The transfer of property by gift is subject to gift tax.70 A transfer involves a gift if the transferor receives less than adequate consideration in exchange for the property.71 The gifted portion of a transfer is the amount by which the FMV of the property given exceeds the FMV of the consideration received. Example 35. Aaron gave Margret a Triumph motorcycle in exchange for an antique teddy bear. The FMV of the Triumph was $20,000. The FMV of the teddy bear was $1,000. Aaron gave Margret a gift of $19,000. In general, a transaction in which property is exchanged for a promissory note is not treated as a gift if the value of the property transferred is substantially equal to the value of the note.72 The FMV of a note is presumed to be the amount of unpaid principal, plus accrued interest.73 However, the note’s face value and time period over which payments are due must be reasonable in light of the circumstances. A note’s FMV is worth less than its unpaid principal plus interest in the following circumstances. 1. The interest rate, maturity date, or other factors cause it to be worth less. 2. The full face value of the note is not collectible (because of the insolvency of the liable parties or for other reasons). 3. The FMV of the property pledged as security is insufficient to satisfy the debt. Example 36. Elvis gave his mother a Cadillac in exchange for an unsecured note payable. The FMV of the Cadillac was $20,000. The note payable was for $20,000. However, under the terms of the note, the principal was due in 500 years and the interest rate was 0%. Elvis gave his mother a gift of $20,000. In Estate of Costanza v. Comm’r,74 the appellate court set the standard for related party SCINs: “a SCIN signed by family members is presumed to be a gift and not a bona fide transaction.” However, the appellate court also stated that this presumption may be rebutted by affirmative evidence that at the time of the transaction there was a real expectation of repayment and intent to enforce the collection of the indebtedness.

69. CCA 201330033 (Feb. 24, 2012). 70. IRC §2501. 71. IRC §2512(b). 72. Treas. Reg. §25.2512-8. 73. Treas. Reg. §25.2512-4. 74. Estate of Costanza v. Comm’r, 320 F.3d 595 (6th Cir. 2003), rev’g TC Memo 2001-128.

B56 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 ESTATE TAX75 The FMV of a decedent’s gross estate is subject to tax. An estate includes the FMV of all property owned by the decedent at the time of their death, to the extent of the decedent’s ownership interest in the property.76 An estate also includes the value of transferred property in the following circumstances.77 1. The enjoyment of the property was under the decedent’s control at the time of their death (in a grantor trust or otherwise). “Under the decedent’s control” includes situations in which the control was shared with another party or parties. 2. During the 3-year period ending on the date of the decedent’s death, the decedent surrendered the property or the rights to control the property for less than adequate consideration. Example 37. On his deathbed, Carl gave his mansion to Priscilla in exchange for a SCIN. The mansion was included in his estate because he clearly made the transfer in anticipation of his death without any intention that the SCIN would require any payments from Priscilla. If a SCIN is not a valid debt instrument, the decedent may be considered to have retained enough control over the assets to include them in the decedent’s estate. One significant factor in determining if a SCIN is a valid debt instrument is the debtor’s ability to repay the note.

INCOME TAX There are particular income tax consequences to canceling a note when the debt is between related parties. In such case, the holder of the note must recognize income equal to the difference between the greater of the FMV or the face value of the note and the holder’s basis in the obligation.78 This also applies when the holder of the note is an estate.79 The estate’s basis in the note is not stepped up because the unpaid principal is income in respect of the decedent (IRD); the estate’s basis is equal to the decedent’s basis.80 The IRS’s position is that the IRD related to the canceled note principal is reported on the estate’s initial income tax return.81 This position was upheld by the 8th Circuit Court in Estate of Frane v. Comm’r82 in 1993. 83

Observation. It may be argued that the position taken by the dissenting justices in Estate of Frane v. Comm’r83 is the most legally sound. In that dissent, the judge recharacterizes the transaction as a contingent payment sale. If a SCIN arrangement is a contingent payment sale, the life span of the decedent determines the selling price of the property. There is no debt canceled and there is no IRD to recognize. Practitioners taking such a stance are advised to disclose that the position is contrary to IRS published guidance.

75. CCA 201330033 (Feb. 24, 2012). 76. IRC §2033. 77. IRC §2038. 78. IRC §§453B(a) and (f). 79. IRC §§691(a)(2), (4), and (5). 80. IRC §691(a)(4). 81. Rev. Rul. 86-72, 1986-1 CB 253. 82. Estate of Robert E. Frane v. Comm’r, 998 F.2d 567 (1993). 83. Estate of Frane v. Comm’r, 98 TC 341 (1992).

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It is unclear what the income tax consequences are of a SCIN’s cancellation feature for the purchaser of the property. Exploring the following questions is outside the scope of this material, but the issues should be researched by anyone representing a client who has received property via a SCIN arrangement. 1. What is the purchaser’s basis in the property? It may be equal to the principal payments actually made if SCINs are considered contingent payment instruments under Treas. Regs. §§1.483-4 and 1.1275-4(c)(5). 2. Are there cancellation-of-indebtedness issues under IRC §108(e)? 84

Note. In Estate Planning Issues With Intra-Family Loans and Notes,84 authors Akers and Hayes recommend the following resources for further exploration of the IRC §108(e) topic. • Raby & Raby, Self-Canceling Installment Notes and Private Annuities, 2001 Tax Notes Today 115- 54 (2001), which takes the position that IRC §108(e) applies • Jerome M. Hesch & Elliott Manning, Beyond the Basic Freeze: Further Uses of Deferred Payment Sales, 34 Univ. Miami Heckerling Inst. on Est. Pl., ¶1601.3.F (2000), which argues that IRC §108(e) does not apply • Jerome M. Hesch, The SCINs Game Continues, 2001 Tax Notes Today 136-96 (2001), which also argues that §108(e) does not apply

84. Estate Planning Issues With Intra-Family Loans and Notes. Akers, Steve, R. and Hayes, Philip J. [www.americanbar.org/content/dam/aba/ publishing/rpte_ereport/2014/1_february/te_akers.authcheckdam.pdf] Accessed on Apr. 25, 2017.

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TEST RATES FOR UNSTATED INTEREST AND ORIGINAL ISSUE DISCOUNT85 An installment sale contract may provide that each deferred payment on the sale includes interest or that there will be an interest payment in addition to the principal payment. Interest provided under the contract is referred to as stated interest. If an installment sale contract does not provide for adequate stated interest, part of the stated principal amount of the contract may be recharacterized as interest. When IRC §483 applies to the contract, this interest is called unstated interest. When IRC §1274 applies to the contract, this interest is called original issue discount (OID). Whether either of these sections applies to a particular installment sale contract depends on several factors, including the total selling price and the type of property sold. An installment sale contract does not provide for adequate stated interest if the stated interest rate is lower than the test rate. (Both of these Code sections and the test rate are discussed later.) To determine whether IRC §§1274 or 483 applies to an installment sale contract, all sales or exchanges that are part of the same transaction (or related transactions) are treated as a single sale or exchange. In addition, all contracts arising from the same transaction (or a series of related transactions) are treated as a single contract. The total consideration due under an installment sale contract is determined at the time of the sale or exchange. Any payment (other than a debt instrument) is taken into account at its FMV. When either IRC §§1274 or 483 applies to the installment sale contract, the seller must treat part of the installment sale price as interest, even though interest is not called for in the sales agreement. If either section applies, the taxpayer must reduce the stated selling price of the property and increase the interest income by this unstated interest.

Note. The buyer reduces their basis in the assets by the unstated interest or OID. Their interest expense includes the unstated interest and/or OID. These rules do not apply to personal-use property.

IRC §§483 and 1274 IRC §§483 and 1274 both require that when the stated interest rate in an installment agreement is not adequate, the seller and the buyer must recharacterize a portion of the contract principal as interest. The reason it is important to know which Code section applies is because unstated interest (IRC §483) is included in income based on the taxpayer’s method of accounting and OID (IRC §1274) is included in income over the term of the contract. The following example demonstrates how the interest is taxed under each of these Code sections. Example 38. Rocky has an installment contract that calls for one payment of $500,000 five years following the agreement date. The agreement states that the interest rate is 0%. If the AFR is 2%, the present value of the contract is $452,865.86 Accordingly, the imputed interest over the life of the contract is $47,135 ($500,000 – $452,865). If the contract falls under IRC §483 and Rocky uses the cash basis of accounting, he will include the $47,135 interest in income in the year the payment is received. If the contract falls under IRC §1274, he must recognize the interest income each year as it accrues regardless of his method of accounting.

85. IRS Pub. 537, Installment Sales. 86. Calculated using Present Value Calculator. Financial Mentor. [financialmentor.com/calculator/ present-value-calculator] Accessed on Apr. 3, 2017.

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OID includable in income each year is based on the constant yield method described in IRC §1272. (This computation is beyond the scope of this chapter.) In some cases, the OID on an installment sale contract may also include all or part of the stated interest, especially if the stated interest is not paid at least annually. Each Code provision exempts a number of transactions. Before determining whether the interest rate is adequate, it is important to ensure the transaction does not qualify for one of the exceptions applicable to both Code sections. Both IRC §§483 and 1274 exclude debt instruments related to sales and exchanges under the following circumstances. • All payments are due within six months after the date of the sale. • The buyer assumes an existing debt on the exchanged property unless the terms or conditions of the debt instrument are modified in a manner that constitutes a deemed exchange under Treas. Reg. §1.1001-3. • Either the debt instrument issued or the exchanged property is publicly traded. • The sale or exchange involves all of the substantial rights to a patent, or an undivided interest in property that includes part or all substantial rights to a patent, or if any amount is contingent on the productivity, use, or disposition of the property transferred.87 • An annuity contract described in IRC §1275(a)(1)(B) and Treas. Reg. §1.1275-1(j) is issued as part of the exchange. • The property is transferred between spouses or incident to a divorce.88 • A demand loan that is a below-market loan described in IRC §7872(c)(1) (e.g., gift loans and corporation- shareholder loans) is issued as part of the exchange. • A below-market loan described in IRC §7872(c)(1) (which applies only to the seller) is issued in connection with the sale or exchange of personal-use property. The exchanged property is personal-use property in the hands of the buyer.89 If both IRC §§483 and 1274 apply to a transaction, then the rules of IRC §1274 apply.90 Thus, practitioners should first review the exceptions for IRC §1274. Generally, IRC §1274 applies to a debt instrument issued for the sale or exchange of property when both of the following conditions exist. 1. Any payment is due more than six months after the date of the sale or exchange. 2. The note does not provide for adequate stated interest.

87. See IRS Pub. 544, Sales and Other Dispositions of Assets. 88. See IRC §1041. 89. IRC §1275(b). 90. IRC §483(d)(1).

B60 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook 1 However, a number of exceptions apply in addition to those previously covered that apply to both Code sections. The first exception is for cash method debt instruments issued as part of property exchanges that do not involve new tangible personal property subject to depreciation.91 A cash method debt instrument is any debt instrument given as payment for a sale or exchange if the debt’s stated principal is $4,083,80092 (in 2017) or less and the following conditions apply. (This stated principal amount is indexed annually for inflation.93) 1. The lender does not use an accrual method of accounting and is not a dealer in the type of property sold or exchanged. 2. Both the borrower and the lender jointly elect to account for interest under the cash method of accounting. 3. IRC §1274 would apply except for the election in (2) above. IRC §1274 also does not apply to an installment sale contract that is a cash method debt instrument arising from the following types of sales and exchanges. 1. Total payments are $250,000 or less 2. Sale or exchange of the taxpayer’s main home 3. Farms sold or exchanged for $1 million or less by an individual, an estate, a testamentary trust, an IRC §1244(c) small business corporation, or a domestic partnership that meets requirements similar to those of IRC §1244(c)(3) 4. Certain land transfers between related persons (discussed later) If an installment contract lacks adequate stated interest and meets one of the preceding IRC §1274 exceptions, the rules of IRC §483 must be used. However, there are additional exceptions to the application of IRC §483. IRC §483 does not apply to an installment sale contract that arises from the following transactions. 1. A sale or exchange for which no payments are due more than one year after the date of the sale or exchange 2. A sale or exchange for $3,000 or less

Note. If the debt is subject to the IRC §483 rules and is also subject to the below-market loan rules, the below-market loan rules apply. Below-market loans include gift loans, compensation-related loans, and corporation-shareholder loans. For more information, see the 2017 University of Illinois Federal Tax Workbook, Volume A, Chapter 1: Investments.

91. IRC §1274A(b) defines the excluded property as “other than new section 38 property within the meaning of section 48(b), as in effect on the day before the date of enactment of the Revenue Reconciliation Act of 1990…” 92. Rev. Rul. 2016-30, 2016-52 IRB 876. 93. IRC §1274A(d)(2)(A).

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Adequate Stated Interest Test Rate In general, an installment sale contract provides for adequate stated interest if the stated interest rate (based on an appropriate compounding period) is at least equal to the test rate of interest. The test rate of interest for a contract is the “3-month rate.” The 3-month rate is the lower of the following AFRs based on the appropriate compounding period. (This 3-month rate is not the same as the 3-month rate used to calculate imputed interest.) 1. The lowest AFR in effect during the 3-month period ending with the first month in which there is a binding written contract that substantially provides the terms under which the sale or exchange is ultimately completed. 2. The lowest AFR in effect during the 3-month period ending with the month in which the sale or exchange occurs.

Note. For more information about AFRs, see the 2017 University of Illinois Federal Tax Workbook, Vol u me A, Chapter 1: Investments. AFRs are published monthly by the IRS and can be found at uofi.tax/17b1x2 [apps.irs.gov/app/picklist/list/federalRates.html].

Example 39. On June 1, 2016, Archie entered into a binding written contract to sell his tavern. The contract called for the transfer of the property on contract for deed to the buyer on March 1, 2017. To determine if the contract for deed included adequate stated interest, his CPA used the lowest appropriate 3-month rate for April, May, and June of 2016 and January, February, and March of 2017. For 2017, if the sale or exchange involves seller financing of $5,717,40094 or less, the test rate of interest cannot be more than 9%, compounded semiannually. However, if the sale or exchange is over $5,717,400 or for new IRC §38 property, the test rate of interest is 100% of the AFR. For information on new IRC §38 property, see IRC §48(b), as in effect before the enactment of Public Law 101-508.

Test Rate for Land Transfers Between Related Persons For land transfers between related persons, the test rate used to determine if the interest rate is adequate cannot exceed 6%, compounded semiannually. Related persons for this purpose include an individual and the members of the individual’s family and their spouses. Members of an individual’s family include the individual’s spouse, brothers and sisters (whole or half), ancestors, and lineal descendants. The IRC §483 rules apply to debt instruments issued in a land sale between related persons to the extent the sum of the following amounts is $500,000 or less. • The stated principal of the debt instrument issued in the sale or exchange • The total stated principal of any other debt instruments for prior land sales between these individuals during the calendar year The IRC §1274 rules, if otherwise applicable, apply to debt instruments issued in a sale of land between related parties to the extent the stated principal amount exceeds $500,000. IRC §1274 is also used instead of IRC §483 if any party to the sale is a nonresident alien.

94. Rev. Rul. 2016-30, 2016-52 IRB 876.

B62 2017 Volume B — Chapter 1: Installment Sales Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook Chapter 2: Individual Taxpayer Issues 2 Crowdfunding and the Sharing Economy...... B65 Self-Certification Procedures ...... B108 Types of Crowdfunding...... B65 Effect of Self-Certification ...... B109 Sharing Economy...... B68 Model Letter...... B109 Information Reporting Compliance...... B79 Daily Fantasy Sports...... B111 Self-Directed IRAs...... B84 Treatment as Earnings from Games of Skill...... B111 Prohibited Transactions...... B84 Treatment as Gambling Winnings...... B112 Investing...... B90 Summary ...... B113 Unrelated Business Taxable Income ...... B98 Legal Fees...... B114 Summary ...... B106 Unlawful Discrimination...... B114 Waiver of 60-Day Rollover Period...... B107 Whistleblower Claims ...... B116 Waiver...... B108

About the Authors Carolyn Schimpler, CPA, is Assistant Director, Tax Materials, at the University of Illinois Tax School. She joined Tax School in 2008, after holding a variety of positions in public accounting and private industry. She graduated with honors from Governors State University in 1988 and passed the CPA examination later that year. Carolyn serves as editor of the annual Federal Tax Workbook. She is a member of the Illinois CPA society. Kenneth Wright has a law degree and a Master of Laws in Taxation from the University of Florida. He has been in private practice and has taught continuing education courses for the University of Missouri, the IRS, the AICPA, and the American Bar Association among others. Ken has served as Vice Chair of the Taxpayer Advocacy Panel, a Federal Advisory Group to the IRS, and was the first non-IRS recipient of the National Taxpayer Advocate Award for his work with the IRS on cancellation of indebtedness income and individual bankruptcy tax issues.

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Chapter Summary

Crowdfunding campaigns can be donation-, reward-, equity-, or loan-based. When contributions are considered gifts, there often are no tax consequences either for the contributor or recipient. While reward- based campaigns do not have immediate tax consequences for contributors, recipients of contributions can have taxable income, particularly when the activity constitutes a business enterprise. Cash contributions to equity-based campaigns are usually nontaxable transactions. The interest element of loan-based campaigns usually has tax consequences. The sharing economy includes activities like ridesharing, lessors of lodging (e.g., Airbnb), sale of parking spaces, event ticket resellers, and online sellers. Relevant tax issues include IRS reporting, self- employment, tips, personal/business use allocations, passive activity limitations, and capital gain/ordinary income characterization. The tax treatment of daily fantasy sports (DFS) depends on whether these activities are considered gambling or games of skill. Professional gambling is considered self-employment. However, achieving this tax treatment for DFS is difficult. Self-directed IRAs differ from other IRAs because they permit IRA beneficiaries to control investment decisions. This section explores the two most common problems with self-directed IRAs — beneficiaries engaging in prohibited transactions and IRA investments that result in taxation of unrelated business income. Distributions from a qualified retirement plan or an IRA are excluded from income if they are transferred to another eligible retirement plan within 60 days of the distribution. The IRS can grant a hardship exception to the 60-day rollover requirement for events beyond the reasonable control of the beneficiary. To apply for a hardship exception, the taxpayer must request a letter ruling from the IRS and pay a $10,000 user fee. Alternatively, automatic approval of a waiver to the 60-day requirement is granted when a rollover is not timely because of an error on the part of a financial institution and self-certification procedures are followed. A self-certification is not a waiver by the IRS of the 60-day requirement. During the course of a subsequent examination, the IRS may consider whether the taxpayer meets the requirements for the waiver. Legal expenses may be deductible as an itemized deduction if incurred for producing or collecting taxable income, determining tax liability, keeping the taxpayer’s job, tax advice related to divorce, and collecting taxable alimony. Legal fees incurred in obtaining taxable payments in connection with claims of “unlawful discrimination” as defined in IRC §62(a) and whistleblower claims are deductible as an adjustment to income instead of as an itemized deduction.

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CROWDFUNDING AND THE SHARING ECONOMY

Crowdfunding and the sharing economy arose with the advent of online transactions and the use of technology in 2 commerce. The widespread use of the Internet, smart phones, and apps permits individuals to engage in commercial and noncommercial transactions through peer-to-peer networks or, most commonly, through intermediaries such as Airbnb and Uber. Crowdfunding, such as Go Fund Me, is the practice of soliciting online contributions by a campaign organizer for a project. Crowdfunding uses social media and other websites to bring campaign organizers and investors (or contributors) together.1 The sharing economy involves direct transactions between two individuals, in which a supplier makes goods or services available to a consumer.2 As originally envisioned, the sharing economy permitted individuals to share or rent items (e.g., tools) that would otherwise sit idle. That model of the sharing economy did not become widespread. Over the years, the sharing economy shifted into the model of large commercial intermediaries managing the transactions between suppliers and consumers and withholding a portion of the consideration paid by the consumer to the supplier.3 One significant issue with crowdfunding and the sharing economy is the lack of guidance concerning the tax consequences of persons who engage in such transactions. To address this need, the IRS recently created a webpage entitled the Sharing Economy Tax Center.4 However, it does little other than provide brief descriptions of possible tax responsibilities and links to various pages containing existing IRS forms or publications. It also discusses such topics as self-employment (SE) taxes, filing requirements, etc.

TYPES OF CROWDFUNDING There are four types of crowdfunding campaigns.5 1. Donation-based 2. Reward-based 3. Equity-based 4. Loan-based

Donation-Based Donation-based campaigns are organized around life events. A campaign could be to help pay medical expenses, help rebuild a home after a disaster, or fund a honeymoon or “bucket list” adventure. Charitable organizations may also use donation-based campaigns to raise money for particular projects or to support their general operating costs. In donation-based campaigns, the contributor receives nothing of value in exchange for the contribution. It is essentially a gift, as discussed next.

1. Crowdfunding. Investopedia. [www.investopedia.com/terms/c/crowdfunding.asp] Accessed on Mar. 20, 2017. 2. Sharing Economy. Investopedia. [www.investopedia.com/terms/s/sharing-economy.asp] Accessed on Mar. 17, 2017. 3. The Rise of the Sharing Economy. Mar. 9, 2013. The Economist. [www.economist.com/news/leaders/21573104-internet-everything-hire- rise-sharing-economy] Accessed on Mar. 17, 2017. 4. Sharing Economy Tax Center. Jan. 12, 2017. IRS. [www.irs.gov/businesses/small-businesses-self-employed/sharing-economy-tax-center] Accessed on Jan. 24, 2017. 5. The 4 Types of Crowdfunding. Apr. 27, 2014. CrowdFundingLegalHub.com [crowdfundinglegalhub.com/2014/04/27/test-3/] Accessed on Mar. 17, 2017.

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Tax Issues. IRC §102 excludes gifts from gross income. The Supreme Court, citing prior cases, described a gift for income tax purposes as proceeding from a “detached and disinterested generosity” and “out of affection, respect, admiration, charity or like impulses.”6 Furthermore, there can be no moral or legal obligation to make the gift or an anticipation of economic benefit. However, if there is an an economic benefit, a gift may still exist to the extent the value of the transfer exceeds the economic benefit received. Contributions made to donation-based campaigns are gifts for federal tax purposes when donors receive no consideration for their contribution. To avoid gift tax consequences, a donor’s annual contribution to a single donee is limited to the current year’s gift tax exclusion amount ($14,000 for 20177). Although many taxpayers feel entitled to an income tax deduction for contributions to a “worthy” cause, gifts to individuals are not deductible as charitable contributions, regardless of the reason. Crowdfunding gifts made to a §501(c)(3) exempt organization may be deductible by the donor subject to the usual substantiation rules. Some crowdfunding sites specifically state on their webpages and on donor receipts that the organization is a charity. If no information on the receipt substantiates the charitable contribution, the donor should contact the organization. The site’s receipt may suffice for income tax purposes but not in the event of any single contribution of $250 or more. These require a contemporaneous written acknowledgment from the donee organization.8 The donor should contact the organization directly to obtain the acknowledgment. As mentioned earlier, money received as a gift is excludable from the gross income of the recipient. A recipient of the gift may use it for its intended purpose, such as to help a family who suffered a casualty loss to their home or who had catastrophic medical expenses. However, the recipient cannot simultaneously take an income tax deduction for the same expenses. Deductions for casualty losses and medical expenses must be reduced by the amount of any reimbursement.9 In the absence of a statutory exclusion, however, a deduction should be permitted because IRC §265, which disallows deductions attributable to tax-exempt income, does not apply to deductible expenses paid from unrestricted gifts.10

Note. For a detailed discussion of the tax rules that apply to gifts, see the 2013 University of Illinois Federal Tax Workbook, Volume B, Chapter 3: Advanced Individual Issues. This can be found at uofi.tax/arc [taxschool.illinois.edu/taxbookarchive].

Reward-Based Reward-based campaigns are designed for business-to-consumer fund raising. Reward-based campaigns offer donors something in exchange for their contributions. This can be as little as a “thank you,” or a T-shirt or hat. However, the “reward” is most often the ability of the donor to obtain a product from the campaign organizer at a discounted price. Reward-based campaigns generally require minimum contributions to obtain rewards and may have tiered rewards depending upon the level of contribution. Occasionally, those who contribute earlier are entitled to priority over later contributors. Although the campaign may advertise a minimum contribution goal, most retain funds received regardless of whether that goal is achieved.

6. Comm’r v. Duberstein, 363 U.S. 278 (1960). 7. Rev. Proc. 2016-55, 2016-45 IRB 707. 8. IRS Pub. 1771, Charitable Contributions. 9. IRC §§165(a) and 213(a). 10. GCM 34506 (May 26, 1971).

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Example 1. Silver Stream Kayak is developing an innovative concept: a kayak that will fold and store easily. In an effort to raise capital, Silver Stream offers 50% off retail pricing for the first 1,000 contributors who give $200 or more. 2 These initial qualified contributors are potentially receiving a reward for their contribution in the form of a discount. Tax Issues. By their very nature, reward-based campaigns provide something in exchange for contributions. The question is whether the donor receives value in exchange for the money given. If the donor receives value, then reward-based campaigns are essentially sales of goods. From the donor’s perspective, it is the purchase of a product. If nothing was received in exchange for the contribution, it is a gift. The organizer of reward-based campaigns must address the issues of gross income, SE tax, and possibly sales and other tax issues. Are amounts received considered gross income? Most reward-based campaigns claim to offer the product to contributors at a discount from the “retail” price. Because the reward still has significant value, all contributions are includable in gross income. A question may arise regarding whether a noncharitable organizer has gross income if the value of the reward is substantially less than the contribution amount. Unlike charitable contributions, there is no de minimis rule allowing the value of token gifts in exchange for contributions to be ignored. If the reward-based campaign organizer can prove that the value given is less than the value contributed, then the difference is arguably a gift and excludable from income. When the reward-based campaign organizer is an individual in the trade or business of selling a product, the income is subject to SE tax. Usually, these campaigns are not isolated sales of a single item; often, they involve selling hundreds or thousands of items.

Note. The same situation exists for a U.S. citizen or resident who regularly sells items on eBay.

The campaign organizer reports the gross income from the reward-based campaign and deducts allowable expenses on a properly filed tax return. If the reward-based campaign launches a first-time product of a newly formed business, expenses for setting up the campaign may be treated as startup expenses under IRC §195. These expenses must be capitalized and amortized.

Equity-Based Equity-based campaigns raise capital for a business start-up or established business. Investors receive some form of equity interest in the business. These types of campaigns are private placement offerings that are exempt from registration with the Securities and Exchange Commission (SEC), but which can be offered only to accredited investors. A formula based on a combination of annual income and net worth is used to determine who qualifies as an accredited investor and their applicable annual investment limits. Because of these requirements and the nature of the campaigns, access by interested businesses is subject to stricter control and review by the fund-raising portal. 11

Note. See the SEC’s website for more information on crowdfunding private placement offerings and accredited investors.11

11. Regulation Crowdfunding: A Small Entity Compliance Guide for Issuers. May 13, 2016. SEC. [www.sec.gov/info/smallbus/secg/ rccomplianceguide-051316.htm] Accessed on Jan. 22, 2017.

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Tax Issues. Cash contributed to a corporation in exchange for stock, as occurs in equity-based campaigns, is not taxable to the corporation under IRC §118 or to the stock recipient under IRC §351 if only cash is transferred. Similar rules apply under IRC §721 to cash and property transfers to partnerships in exchange for partnership interests.

Loan-Based Loan-based campaigns involve lending money to businesses and individuals. Most loan-based campaigns require interest to be paid to the lenders, although a few do not because they involve micro-financing and other low income and third-world financing projects. Tax Issues. Similar to equity-based campaigns, loan-based campaigns fall within existing tax models. The lender has interest income, and the borrower has interest expense. Deductibility of the expense depends on the borrower’s entity type and use of the loan proceeds. If the loan is not repaid, the lender has a short-term capital loss unless the lender can establish that the lending activity rose to the level of a trade or business. In that case, the loss is an ordinary deduction. Interest income is included in net earnings from self-employment. Loan-based campaigns used for microloans (small, short-term loans) or to otherwise help disadvantaged individuals, in which the lender receives no interest from the borrower, have no tax consequences for either the lender or the borrower except to the extent interest is actually paid. If no interest is paid, it is doubtful that interest would be imputed. Gift loans under IRC §7872 are exempt from imputed interest rules as long as the outstanding balance on any day does not exceed $10,000.12 Gift loans in excess of $10,000 but less than $100,000 are subject to imputed interest only to the extent of the borrower’s net investment income for the year.13 This situation is unlikely with these types of loans. In addition, if the loan is to a non-U.S. entity or person, the imputed interest rules do not apply.14

SHARING ECONOMY Ridesharing Ridesharing is a service that allows individuals to arrange one-time individual or shared rides on short notice through smartphone-enabled apps. Well-known ridesharing services include Uber, Lyft, and Sidecar. These organizations do not directly provide the service. Rather, they are transportation network companies (TNCs) through which transactions between service providers (drivers) and customers are arranged and paid. TNCs offer individuals the ability to make extra money by using their personally owned vehicles to provide paid taxi services. Drivers can work when and as often as they choose. Customers use a smartphone app to request and pay for a ride. The TNC locates and dispatches an available driver and notifies the customer of the driver’s details. TNCs rely on GPS to guide the driver to the customer and generally permit the customer to follow the driver’s progress. Drivers may receive tip income. Lyft’s app allows the rider to add a tip.15 In the past, Uber maintained an official no- tipping policy such that the fee for a ride is all that could be paid to the driver. That policy appears to be changing, and drivers are now permitted to have signs or other indicators in their vehicles stating that tips are appreciated. The TNC charges the driver a commission on each fare as well as other expenses. Drivers can print statements from their accounts showing all their activity as well as a summary statement. Uber, for example, indicates on the summary statement those expenses charged against the driver’s account that should be deductible for income tax purposes. The statement also reflects the number of miles the driver drove with passengers in the vehicle.16 Other mileage, such as trips for fuel and to and from passenger pickups and drop-offs, may also be deductible. A sample Uber statement follows.

12. IRC §7872(c). 13. IRC §7872(d). 14. Temp. Treas. Reg. §1.7872-5T(b)(10). 15. How to Tip Your Driver. Lyft. [help.lyft.com/hc/en-us/articles/213583978-How-to-Tip-Your-Driver] Accessed on Mar. 17, 2017. 16. UBER Tax Filing Information. Jan. 25, 2016. I Drive With Uber. [www.idrivewithuber.com/uber-tax-filing-information] Accessed on Feb. 24, 2017.

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NOT AN OFFICIAL 1099 FORM UBER 2 2016 TAX SUMMARY JOHN DOE Many of the items below may be deductible; please consult with a tax expert for more guidance.

1099-K breakdown: Gross fares (Uber fee is included) 1 $36,000 1099-MISC breakdown: Sales tax 500 Incentive payment $ 400 Black car fund 100 Referrals 500 Airport fee 100 Join and support 100 Split fair fee 100 Miscellaneous 200 Safe rides fee 200 Total $ 1,200 Miscellaneous 300 Total $37,300 Other items: Device subscription $ 40 Uber fee 10,800 Fuel card charges 200 On-trip mileage 2 30,000 miles

1 Gross fares are calculated as a base + time + distance (this includes the Uber fee). 2 On-trip mileage only. Additional mileage may be deductible. Items in bold may be deductible. Check with a tax professional to learn more.

Tax Issues. Rideshare drivers who are paid more than $600 of referral fees, bonuses, and other income not directly attributable to customer rides receive a Form 1099-MISC, Miscellaneous Income, for those amounts only. Uber and other TNCs also issue Forms 1099-K, Payment Card and Third Party Network Transactions, for customer credit card charges. Uber issues a Form 1099-K regardless of whether a driver reaches the required reporting threshold. Other TNCs do so only when the Form 1099-K transaction threshold is met (discussed later).17 TNC drivers are treated as independent contractors. This is a controversial issue and challenges have been raised in a few states, although there is not yet a definitive ruling.18 As independent contractors, drivers are required to file Schedule C, Profit or Loss From Business, and pay SE tax. They are also entitled to deduct expenses as adjustments to gross income. Many of a driver’s expenses are those of any taxpayer using a vehicle in a trade or business, such as standard mileage or actual vehicle costs, repairs, tolls, and parking. Although the driver’s statement from the TNC shows total trip miles, this only includes miles from the beginning to end of the fare and does not include mileage to and from the fare, refueling, car washes, and similar travel. Drivers are entitled to deduct expenses charged by the TNC, including the TNC’s fee, which can be considerable. Other deductions may include the following. • Cell phone use (or rent if rented from the TNC) • Cell phone mounts and chargers • Candy, water, and other amenities for passengers • Music apps

17. Lyft vs. Uber: Lyft Doesn’t Actually Report Most Driver Income to the IRS. Leff, Gary. May 24, 2016. Miles and Points Consulting LLC. [viewfromthewing.boardingarea.com/2016/05/24/lyft-vs-uber-lyft-doesnt-actually-report-driver-income-irs/] Accessed on Mar. 17, 2017. 18. Sharing is Caring: Are Uber, Lyft Drivers Independent Contractors? Frazier, Ryan B. Oct. 14, 2016. HR Hero Line. [www.hrhero.com/hl/ articles/2016/10/14/sharing-is-caring-are-uber-lyft-drivers-independent-contractors-2] Accessed on Feb. 24, 2017.

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• Air freshener • Allocable share of personal property taxes and car loan interest • Phone chargers for passengers • Cost of any required additional insurance Any personal use of the vehicle or cell phone requires an allocation of some expenses between personal and business use. If vehicle expenses are calculated using actual costs and depreciation, the recordkeeping burden can increase significantly. The luxury automobile limitation must also be addressed.19 For these reasons, it seems most drivers prefer using the standard mileage rate. TNCs do not withhold federal income tax for independent-contractor drivers. Therefore, drivers may need to make quarterly estimated tax payments.

Observation. First-time drivers may be shocked when they find out what their tax liability is, especially if they are not familiar with SE tax. Consequently, they may not make sufficient estimated tax payments.

Airbnb Airbnb, similar to Uber, provides peer-to-peer services — in this case between short-term lessors and lessees of overnight lodging. The original intent was to permit individuals who had extra space in their residences to earn money by renting the space. In exchange for staying in a private residence that lacks hotel amenities, the renters pay less than they would if they stayed at a hotel. While this model still describes the majority of Airbnb hosts (as lessors are called), some individuals who own overnight-lodging properties use Airbnb as a way to skirt state and local laws governing hotels and to avoid occupancy and other taxes normally imposed on hotel rooms. Airbnb now has agreements in place with many states and localities under which it collects and remits required taxes.20 Tax Issues. Most Airbnb hosts rent space in residences as that term is defined in IRC §280A. This limits the taxpayer’s ability to deduct expenses for rentals of properties that the taxpayer also uses for personal purposes. The first step in preparing the return for an Airbnb host (or similar provider) is determining which rules apply. The following points help determine whether expenses are deductible. 1. If the total number of rental days is less than 15, rents are excluded from gross income and no deductions other than mortgage interest and real estate taxes are permitted.21 2. If the rental space is in the same residence in which the host lives and the number of rental days is greater than 14, the residential rental limitations of §280A apply. • Taxes and mortgage interest otherwise allowable are deductible. • Other expenses are apportioned between rental and nonrental periods of the year and between the portion of the residence rented and the portion used for personal purposes. • Ordering rules for expenses require taxes and mortgage interest to be deducted first against rental income, and then other expenses are deducted against any remaining rental income. • Deductions cannot exceed income. Any unused deductions carry over to be used against future income but remain subject to the income limitation.

19. IRC §280F. 20. In What Areas is Occupancy Tax Collection and Remittance by Airbnb Available? Airbnb, Inc. [www.airbnb.com/help/article/653/in-what- areas-is-occupancy-tax-collection-and-remittance-by-airbnb-available] Accessed on Feb. 24, 2017. 21. IRC §280A(g).

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3. If the rental property is in a different location from the host’s residence and the property is not used for personal purposes for more than the lesser of 14 days or 10% of the time it is rented at fair market value,22 it is not subject to §280A. All expenses are deductible subject to the passive activity loss limitations of IRC §469. 2 4. The services or amenities the host provides help determine whether rentals should be reported on Schedule E, Supplemental Income and Loss, or Schedule C, Profit or Loss From Business. This is discussed later under “Significant Services and SE Tax.” Income. It is likely that many Airbnb hosts who have minimal rentals fail to report their income from Airbnb rentals because they receive no information return from Airbnb if their gross receipts are less than the filing threshold for Form 1099-K. They may assume their rentals are not taxable or they intentionally do not report the income.

Caution. Airbnb retains a digital record of all rentals, whether the income is reported on information returns or not. It is possible that the IRS could choose at some point to subpoena rental records and match them against returns.

Airbnb complies with the reporting requirements for Forms 1099-K. Hosts can access their information returns and the underlying details from the transaction history in their accounts.23 Airbnb charges a service fee to both the host and the guest on each reservation.24 These charges vary depending on the specifics of the reservation. If the host does not receive a Form 1099-K, the host’s Airbnb gross income is the net remittance the host receives, and the host service fees are not deductible. However, if the rentals are reported on Form 1099-K, the full amount of charges must be reported25 and the host service fees are deducted separately (the guest service fee does not appear on the Form 1099-K). If a guest cancels a reservation after a host receives the rental, the full rental amount is reported on Form 1099-K and should be included in the host’s income. The host can then deduct any refund.26 Deductions. Hosts are entitled to deduct all the ordinary and necessary expenses of the rental property. If there is any personal use of the property beyond the lesser of 14 days or 10% of the number of days it is rented, expenses must be prorated between personal and rental use.27 In addition, if the host is subject to §280A (discussed earlier), expenses can be deducted only to the extent of income.28 29

Note. See IRS Pub. 527, Residential Rental Property, for a detailed description of available deductions, including the §280A limitations. The Airbnb website also has a publication on taxation of rental income prepared for it by Ernst & Young LLP, which can be downloaded.29

22. IRC §280A(d)(1). 23. Should I Expect to Receive a Tax Form from Airbnb? Airbnb, Inc. [www.airbnb.com/help/article/414/should-i-expect-to-receive-a-tax-form- from-airbnb] Accessed on Mar. 21, 2017. 24. What are Host Service Fees? Airbnb, Inc. [www.airbnb.com/help/article/63/what-are-host-service-fees] Accessed on Mar. 17, 2017. 25. Instructions for Form 1099-K. 26. Airbnb: General Guidance on the Taxation of Rental Income. Ernst and Young, LLP. [https://assets.airbnb.com/eyguidance/us.pdf] Accessed on Mar. 9, 2017. 27. IRC §280A(d). 28. IRC §280A(c)(5). 29. Airbnb: General Guidance on the Taxation of Rental Income. Ernst and Young, LLP. [https://assets.airbnb.com/eyguidance/us.pdf] Accessed on Mar. 9, 2017.

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In allocating expenses between personal and rental use, two methods are available: the IRS method and the Tax Court method. Under the IRS method (as reflected in Worksheet 5-1 of IRS Pub. 527), the total number of rental days is divided by the sum of the rental days and the actual number of days of personal use (rather than the total days in the year). This fraction is then applied to all expenses related to the rental, including mortgage interest and taxes.30 The Tax Court method involves creating two fractions, one for allocating mortgage interest and taxes and the other for allocating all other expenses.31 1. For mortgage interest and taxes, the allocation percentage is determined by dividing the total number of rental days by the total days in the year. 2. For all other expenses, the allocation percentage is determined by dividing the total number of rental days by the sum of the rental days and the number of days of personal use (rather than the days in the year). The following example illustrates the difference in results between the two methods.

30. Treas. Reg. §1.280A-3(d). 31. See, e.g., Bolton v. Comm’r, 694 F.2d 556 (9th Cir. 1982), aff’g 77 TC 104 (1981).

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Example 2. Wade and Chelsea, who file jointly, own a lakeside home they rent at a fair rental price for 75 days during 2017. They use the home for personal purposes on 35 other days during the tax year and rent it to a friend at a discount for 10 days (which they also treat as personal use32). Thus, the home is used for some purpose on 120 days during the tax year. 2 Under the IRS method, the rental allocation fraction for all expenses cannot exceed 62.5% (75 rental days ÷ 120 total days of use). The following table shows the 2017 income and expenses for the lakeside home and the calculation of allowable expenses using the IRS method.

IRS Method

Gross rental receipts 75 days at $225 (fair rental) per day $16,875 10 days at $100 per day 1,000 Less: advertising and realtor fees (2,200) Gross rental income $15,675 $15,675 Mortgage interest and taxes Mortgage interest ($15,000 × 62.5%) $ 9,375 Real estate taxes ($2,800 × 62.5%) 1,750 Total allowable interest and taxes $11,125 (11,125) Remaining income for other expenses $ 4,550 Other expenses Insurance ($900 × 62.5%) $ 563 Utilities ($2,400 × 62.5%) 1,500 Repairs ($8,000 × 62.5%) 5,000 Marina charges ($2,600 × 62.5%) 1,625 Homeowners association fees ($3,000 × 62.5%) 1,875 Total other expenses $10,563 $10,563 Allowable other expenses (lesser of $4,550 or $10,563) (4,550) Carryover to next year $ 6,013 Remaining income for depreciation $ 0 Depreciation ($2,000 × 62.5%) 1,250 Allowable depreciation 0 Total depreciation carryover to next year $ 1,250 1,250 Total carryover to next year $ 7,263 Mortgage interest that may be deductible on Schedule A ($15,000 − $9,375) $ 5,625 Real estate taxes that may be deductible on Schedule A ($2,800 − $1,750) 1,050 Total allowable Schedule A deductions $ 6,675

32. IRC §280A(d)(2)(C).

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Under the Tax Court method, the rental allocation fraction for mortgage interest and taxes is 20.5%, because it uses the total number of days in the year as the denominator (75 rental days ÷ 365 = 20.5%). For the other expenses and depreciation, the IRS allocation fraction (62.5%) is used.

Tax Court Method

Gross rental receipts 75 days at $225 (fair rental) per day $16,875 10 days at $100 per day 1,000 Less: advertising and realtor fees (2,200) Gross rental income $15,675 $15,675 Mortgage interest and taxes Mortgage interest ($15,000 × 20.5%) $ 3,075 Real estate taxes ($2,800 × 20.5%) 574 Total allowable interest and taxes $ 3,649 (3,649) Remaining income for other expenses $12,026 Other expenses Insurance ($900 × 62.5%) $ 563 Utilities ($2,400 × 62.5%) 1,500 Repairs ($8,000 × 62.5%) 5,000 Marina charges ($2,600 × 62.5%) 1,625 Homeowners association fees ($3,000 × 62.5%) 1,875 Total other expenses $10,563 $10,563 Allowable other expenses (lesser of $12,026 or $10,563) (10,563) Carryover to next year $ 0 Remaining income for depreciation ($12,026 − $10,563) $ 1,463 Depreciation ($2,000 × 62.5%) $ 1,250 Less: allowable depreciation (lesser of $1,250 or $1,463) (1,250) Total carryover to next year ($1,250 − $1,250) $ 0 Mortgage interest that may be deductible on Schedule A ($15,000 − $3,075) $11,925 Real estate taxes that may be deductible on Schedule A ($2,800 − $574) 2,226 Total allowable Schedule A deductions $14,151

Which allocation method should be used depends on each taxpayer’s circumstances. When a bedroom in a residence is used exclusively for guests and the host uses the residence for personal purposes for the entire year, there is no difference in results between the two methods. This is because the denominator will be the total days in the year for all expenses for both methods. The methods differ only when there are days in the year during which there is neither rental nor personal use. In deciding which allocation method to use, other factors affecting a taxpayer’s return must be considered, such as the following. • Whether the taxpayer can benefit from itemized deductions • Whether the taxpayer may reasonably be expected to benefit from disallowed deduction carryovers • Whether the taxpayer has suspended passive activity losses that could be used against net rental income Tax Reporting. There seems to be some confusion over whether to report Airbnb rentals on Schedule E or Schedule C. Another item that causes confusion is the 7-day rule for rental activities under the passive activity limitations. In addition, many Airbnb hosts may not understand under what circumstances their income is subject to SE tax.

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Schedule E is used to report real estate rental activities. Rental activities are not subject to SE tax when there is a net profit. If the rental activity results in a loss, it is treated as a passive activity. The loss can be deducted in accordance with passive activity limitations. As discussed in the next section, however, Airbnb rentals can become SE income for hosts who provide significant services to their guests. 2 Significant Services and SE Tax. IRC §1402(a)(1) excludes real estate rental income from net SE earnings. Treas. Reg. §1.1402(a)-4 provides an exception for rentals in which the taxpayer provides significant services to the tenant in addition to furnishing the rental property itself. 33 Generally, services are considered rendered to the occupant if they are primarily for his convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only. The supplying of maid service, for example, constitutes such service; whereas the furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, the collection of trash, and so forth, are not considered as services rendered to the occupant. It is common for hosts to provide amenities to guests in addition to a sleeping room. The basic amenities include linens, blankets, towels, and perhaps toiletries, but many hosts go beyond the basics in their efforts to please guests and to earn good reviews.34 As the level of guest amenities rises, there is a possibility that the host may cross the line between providing services attributable to the property and instead provide services to the guest.

Observation. Some Internet chatrooms indicate that all an Airbnb guest expects is a clean place with the basics, such as soap, towels, sufficient toilet paper, and an overall comfortable place to stay. Other chatrooms encourage competition among hosts to increase rankings and positive reviews. Guest expectations may drive more and more hosts to provide additional amenities beyond those associated with the room itself. This could include such services as local guides; welcome gifts such as wine, fruit baskets, or candy; sleeping masks; toiletries; hairdryers; umbrellas; and breakfast items. One host even provides free airport, bus, or train pickup and drop-off.

Although published authority in this area is sparse, one 1973 case stands out.35 David Johnson owned and operated a marina and fishing camp as a sole proprietor. He had income from rentals of boat sheds and a net profit from the fishing camp. The following are services Johnson provided to boat owners who rented space in the boat sheds. • Providing gas and oils • Selling of sundry items at his store • Making arrangements for others to repair the boat owners’ boats and motors • Recharging of batteries • Loaning of boat paddles, cushions, and other gear useful in the operation of boats • Providing fishing tips • Checking daily for overdue boats and reporting the overdue boats to the local conservation department Johnson received payment for gas, oil, fishing tackle, and items sold to boat owners. The other services he provided at no cost. The IRS assessed an SE tax deficiency because it treated Johnson as providing significant services to the boat owners who rented space in his shed.

33. Treas. Reg. §1.1402(a)-4. 34. DIY Hosting Tips: Unforgettable Amenities Made Easy. Aug. 15, 2014. Airbnb, Inc. [blog.airbnb.com/amenities-diy-hosting-tips] Accessed on Mar. 12, 2017. 35. Johnson v. Comm’r, 60 TC 829 (1973).

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The Tax Court cited social security benefit cases in which rentals that included the provision of significant services to the tenant constituted earned income for purposes of reducing a retiree’s benefits. Those cases held that the IRC §1402(a)(1) exception from SE tax for rentals should be narrowly restricted to payments for occupancy only. Any service not clearly required to maintain the property in condition for occupancy should be considered work performed for the tenant. The Tax Court ruled that the same narrow construction should be applied for SE tax purposes so there would be symmetry between the social security eligibility provisions and the corresponding Code provisions regarding SE income. The court then determined that the gratuitous services provided by Johnson to the boat shed renters were not those usually or customarily provided in connection with the rental of space in a boat shed. Therefore, they constituted significant services and subjected his rental income to SE tax. In Bobo v. Comm’r,36 the Tax Court again addressed the issue of when services are significant. The Bobos owned a 46- space mobile home park of which most spaces were occupied by owners of their mobile homes and eight spaces were occupied by tenants of mobile homes owned by the Bobos. They provided gas, water, sewer, metered electrical connections, garbage collection, and washers and dryers owned by a third party concessionaire. The washers and dryers were required by state law and the Bobos received a commission from the concessionaire. The mobile home park grounds were paved with concrete and asphalt so that no landscaping maintenance was required. Mr. Bobo was disabled and received Social Security payments. Mrs. Bobo occasionally visited the park, but overall operation was handled by a resident manager who collected rents, cleaned the laundry facilities, rented mobile homes when tenants moved out, and swept leaves. The manager worked approximately three hours per week. No additional services were provided to the tenants of the eight mobile homes and no recreational facilities or public telephones were provided to the park. The IRS assessed a SE tax deficiency on the basis that the Bobos were providing significant services to the tenants and that the rent therefore constituted net earnings from self-employment. Citing a non-tax social security case dealing with the issue of whether significant services were provided to tenants,37 the Tax Court noted there are two factors that must be analyzed. 1. Whether services are required for purposes of maintaining a space in a condition for occupancy 2. Whether additional services are of such a substantial nature that the compensation for those services could be said to constitute a material part of the tenant’s rent payment The Tax Court found that all of the services other than the washers and dryers constituted services provided solely for purposes of occupancy. Supplying washers and dryers and the cleaning of that space was a service for the tenants, not for occupancy, and the fact that it was operated through a third party concessionaire was irrelevant. The Tax Court concluded, however, that the service was not substantial enough that a material part of the rent payments could be said to be for the washers and dryers rather than occupancy. It was not separately stated, billed, and paid for, but was merely an incidental and minor service to occupants who paid rent primarily for space.

36. Bobo v. Comm’r, 70 TC 706 (1978), acq. AOD/CC 1983-030 (Sep. 19, 1983). 37. Delano v. Celebrezze, 347 F.2d 159 (9th Cir. 1965).

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Although the Tax Court used the terms “substantial” and “material,” those terms must be interpreted in light of a narrow interpretation applicable to the rental real estate exclusion from the definition of earned income for SE tax purposes. Under that rationale, Airbnb hosts who provide amenities beyond those necessary for occupancy may be providing significant services that subject their rental income to SE tax. There is currently no guidance about which or 2 how many guest amenities create a risk that the income will be considered self-employment. As in Johnson’s case, any amenities that go beyond those necessary to provide the rental space itself to a guest create a potential for SE tax liability. In the Delano case cited by the Tax Court in Bobo, the Ninth Circuit reversed a Social Security Council denial of retirement benefits to Delano because he should have been treated as having Social Security retirement earnings as a result of performing significant services for tenants of apartments. The court said the following about the role of significant services.38 The Council also erred in holding that non-excluded services were gratuitously performed because the leases did not obligate the owners to perform them. Appellant had no intention of conferring a gratuity. The services were rendered as a part of appellant’s total effort to satisfy his tenants and thus assure the profitable operation of the business. They were a portion of the total package of rights and services which was extended to the tenants and for which the tenants were willing to pay, and the record indicates that their availability played a part in maintaining full occupancy of the apartments. Passive Activity Limitations. A passive activity is defined in IRC §469(c)(1) as any trade or business in which the taxpayer does not materially participate. IRC §469(c)(2) adds that any rental activity is a passive activity. For this reason, rental activities are referred to as “per se” passive activities. This means they are passive activities simply because they are rentals, and material participation is therefore irrelevant in their classification. There are instances under the regulations, however, when rental activities are recharacterized as trades or businesses. By treating the rental activity as a trade or business, a taxpayer can make the activity nonpassive through material participation. Temp. Treas. Reg. §1.469-1T states that if the average period the property is rented by customers is seven days or less, then for passive activity purposes, the rental is treated as a trade or business and not as a passive activity.39 This recharacterization rule often leads individuals to think property rented an average of seven days or less must be reported on Schedule C. This is not the case. The recharacterization applies only for purposes of applying the passive activity rules under §469. In fact, the regulations specifically say the following.40 Neither the provisions of section 469(a)(1) . . . nor the characterization of items of income or deduction as passive activity gross income . . . or passive activity deductions . . . affects the treatment of any item of income or gain under any provision of the Internal Revenue Code other than section 469. Unless a host has a loss from Airbnb rentals, the 7-day rule is not an issue. If the host has a loss and the average period of customer rental is seven days or less, the host must materially participate or the loss becomes a suspended passive activity loss. As such, the loss can be used only against future passive activity income or upon disposition of the entire activity.

Note. If the taxpayer’s average period of customer rental is seven days or less and there is a loss from the rentals, the $25,000 special allowance under §469(i) is not applicable because the rental is treated as a trade or business and not as a rental real estate activity.

Note. For a detailed explanation of material participation, limitations on passive activity losses, and the $25,000 special allowance, see the 2014 University of Illinois Federal Tax Workbook, Volume B, Chapter 4: Passive Activities. This can be found at uofi.tax/arc [taxschool.illinois.edu/taxbookarchive].

38. Ibid. 39. Temp. Treas. Reg. §1.469-1T(e)(3)(ii)(A). 40. Temp. Treas. Reg. §1.469-1T(d)(1).

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Renting Parking Spaces In residential areas surrounding sporting venues, it is common for homeowners to offer parking spaces for rent in their driveways and yards. Mobile apps enable drivers to find private parking spaces for rent, either from commercial parking lots or individuals, nonprofits, or other businesses with surplus parking spaces available. MonkeyParking is an app that was started in San Francisco, which enabled individuals to offer public parking spaces on city streets. The city of San Francisco and other cities enacted ordinances against this practice because the individuals renting out the spaces did not actually “own” them. The app is still available for renting privately owned spaces.41 Tax Issues. Renting privately owned parking spaces constitutes real estate rental, and payments are therefore ordinary income. Unless the lessor is providing significant services, such as security or carwashes, the income is not subject to SE tax. 42

Note. Some municipalities have realized there is a potential for city revenue and now require homeowners to obtain permits or licenses to be able to rent residential parking spaces.42

In Roy v. Comm’r,43 the Tax Court ruled that the yard area surrounding a residence is part of the residence for purposes of the residential rental limitations of §280A. IRC §280A (discussed earlier) permits a homeowner who rents parking spaces for fewer than 15 days (e.g., during a college football season) to exclude the income legally.

Event Ticket Resellers Ticket brokers (or scalpers) may use automated computer programs or other means to obtain many of the best tickets for sporting or entertainment events, intending to sell them at a premium. Ticket brokers are in the business of reselling tickets and are responsible for paying taxes on their net income.

Note. Some ticket purchasing sites often require the completion of a CAPTCHA (Completely Automated Public Turing test to tell Computers and Humans Apart) to prevent or minimize the automated purchase of large ticket quantities.

Tax Issues. Many individuals resell tickets that they cannot use, or resell them with the intention of making a profit. As a practical matter, many of these individuals may not realize they have taxable income, or they simply choose to ignore it. Sale of Unused Tickets. Tickets purchased for personal use are capital assets under IRC §1221. Tickets sold at a gain generate a capital gain. Usually, the gain is short-term and taxed as ordinary income. Losses on the sale of personal- use assets are not deductible, even as an offset to capital gain. Sale of Appreciated Tickets. When tickets for an event rapidly appreciate, the ticket owner may decide to sell the tickets to make a profit. If the ticket owner purchased tickets with the intent to use them but later sold the tickets because of the high secondary market price, the result is generally the same as for selling unused tickets.

41. Kicked Out of San Francisco, Monkey Parking App Plans a Fresh Start in Santa Monica. Maddaus, Gene. Sep. 18, 2014. LA Weekly. [www.laweekly.com/news/kicked-out-of-san-francisco-monkeyparking-app-plans-a-fresh-start-in-santa-monica-5080436] Accessed on Mar. 17, 2017. 42. See, e.g., San Bruno Orders Homeowners to Stop Renting Out Driveway. Barnard, Cornell. Sep. 30, 2015. ABC, Inc. [http://abc7news.com/ traffic/san-bruno-orders-homeowners-to-stop-renting-out-driveway/1011078/] Accessed on Mar. 17, 2017; How to Make $250 a Month Renting Out Your Driveway or Parking Space. Pope, Kristen. Jun. 27, 2015. The Penny Hoarder. [www.thepennyhoarder.com/jobs-making- money/side-gigs/rent-your-driveway-parking-apps] Accessed on Mar. 17, 2017; Parking Space Rental Tax is Now Law! Fix, David. Mar. 2013. AOA. [www.aoausa.com/magazine/?p=1053] Accessed on Mar. 10, 2017. 43. Roy v. Comm’r, TC Memo 1998-125 (Mar. 31, 1998).

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Purchased with Intent to Resell. If the purchaser’s intent is to resell tickets at a profit, the issue becomes whether the reseller is a ticket dealer. In making this determination, the factors of profit motive, continuity, and regularity are considered. Selling a number of tickets at a profit over a period of months may meet these requirements. Unlike the first two types of resellers described above, a ticket purchaser who intends to resell tickets at a profit and who 2 continues this activity is likely to come under IRS scrutiny. Many resellers use StubHub or other online facilitators to sell their tickets. These facilitators are payment settlement entities (PSEs). The PSEs issue Forms 1099-K to high-volume resellers who reach the $20,000 or 200 transactions threshold (discussed later), and the IRS matches these information returns with the taxpayer’s tax return. Tax Reporting. Individual resellers of tickets report the gain on Schedule D, Capital Gains and Losses. The ticket dealer reports their income and expenses on Schedule C, and their income is subject to SE tax. Online Selling For some, eBay may seem like an online garage sale. Even for an occasional disposition of personal property, the seller technically has gross income from which basis is subtracted to arrive at a gain or loss. A gain is either a long- or short-term capital gain. Losses on personal-use assets are not deductible and cannot offset capital gain. Tax Issues. When an individual goes beyond selling a few personal items and intentionally buys merchandise for resale on eBay, the IRS may determine that the individual is in a trade or business because the Form 1099-K discloses income. In that situation, the goods become inventory and the seller is entitled to a deduction for the cost of goods in determining gain or loss. INFORMATION REPORTING COMPLIANCE Form 1099-K Online contributions to crowdfunding sites, payments to Uber and Lyft drivers, merchant sales on Amazon, and transactions on eBay, Etsy, and other e-commerce websites are made with credit or debit cards. The entities that collect the payment, or the third party handling the credit card charges are PSEs that may be required under IRC §6050W to file Form 1099-K (reproduced below).

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For the calendar year, the PSE is required to issue Form 1099-K if both of the following are satisfied.44 1. The gross amount of total reportable payment transactions exceeds $20,000. 2. The total number of such transactions exceeds 200. When a Form 1099-K is issued to a taxpayer and that taxpayer fails to report the transactions on their tax return, the IRS issues a CP2000 notice, proposing a deficiency based on the gross proceeds shown on the Form 1099-K.45 If the transactions involve selling products — such as on eBay, Etsy, or a reward-based crowdfunding campaign — the IRS may assess SE tax in addition to income tax. The burden falls on the individual to respond to the IRS.

Note. Campaign organizers should be careful when establishing a campaign on a crowdfunding website. The campaign should be in the name and tax identification number (TIN) of the individual for whose benefit it is organized. Any Form 1099-K will then be issued to that individual.

Caution. Although the IRS might abate a SE tax deficiency if the individual had only a few casual sales, the IRS may demand that the individual prove their basis in the sold assets. (See “Proving Basis” section later in this chapter.)

Caution. Although amounts reported on a Form 1099-K should not also be reported on a Form 1099- MISC, this does occur at times. Taxpayers must reconcile Forms 1099-K and Forms 1099-MISC to gross receipts to avoid double reporting. For example, Uber issues a Form 1099-MISC for certain driver nonfare benefits in addition to issuing a Form 1099-K for all credit card charges. As mentioned earlier, Uber issues Forms 1099-K to all drivers, not just to those who have reached the threshold. Other e-commerce sites issue Forms 1099-K only to drivers who reach the threshold.

Reporting Transactions on Form 1099-K.46 Form 1099-K reports the amount of credit card transactions processed by a PSE for a participating payee (any person accepting credit card payments). Because the participating payee must provide their TIN to the e-commerce site, multiple accounts with the same TIN are aggregated to determine whether the threshold is reached.47 Accounts on different sites, such as eBay and Etsy, are not aggregated unless the individual uses the same PSE, such as PayPal, to receive payments from both. Box 1a of Form 1099-K reports the gross amount of credit card charges. No reduction should be made for fees, refunds, chargebacks, sales taxes, or other costs and refunded amounts. The full amount of the Form 1099-K should be reported on a tax return except that cashback is given to the customer making the charge; therefore, it is not includable in gross receipts and is not deductible as a business expense. Taxpayers must therefore have detailed records to permit reconciliation of their actual business receipts and expenses to the Form 1099-K. Box 1b reports transactions not actually accomplished via a card terminal. This includes charges made online.

44. IRC §6050W(e). 45. See Understanding Your CP2000 Notice. IRS. [www.irs.gov/individuals/understanding-your-cp2000-notice] Accessed on Feb. 10, 2017. 46. Instructions for Form 1099-K. 47. See, e.g., Does Paypal Combine Business EIN Payments & Personal Account SSN $ to Meet 1099 IRS Threshold? PayPal Community Help Forum. [www.paypal-community.com/t5/About-Payments-Archive/Does-Paypal-combine-Business-EIN-payments-amp-Personal- account/m-p/1013811]. Accessed on Mar. 10, 2017.

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Box 2 is for the payee’s merchant category code (MCC). It is important that the MCC correctly describe the payee’s business.48 The IRS uses data accumulated on various industries throughout the years to determine the approximate mix of cash and card transactions those industries typically have. By comparing a business’s income tax return with its Forms 1099-K, the IRS can assess whether the business appears to be properly reporting its cash receipts. If the MCC 2 is incorrect, the payee should contact the PSE to request a corrected Form 1099-K. Example 3. Assume IRS statistics show that convenience store gross receipts should be approximately 60% credit and debit cards and 40% cash. The income tax return of PDQ, a chain of convenience stores, shows a ratio of 75% card transactions and 25% cash. PDQ may be subject to IRS inquiries because the statistics indicate that the business may not be reporting all of its cash receipts. Box 3 of the Form 1099-K shows the total number of payment transactions processed through the payment card or third party network. Box 4 shows the federal income tax withheld. Boxes 5a–5l shows the gross amount paid each month. The total of the monthly amounts should equal the amount reported in box 1a. Boxes 6–8 provide space for reporting to two different states. Several states require PSEs to file copies of Forms 1099-K with them and may require income tax withholding for permitted payees in their states. Reconciliation. When reconciling gross receipts to Forms 1099-K, transactions not attributable to the business should be eliminated and documented. Such transactions include the following. • Transactions from more than one person on a shared terminal • Transactions made before a purchaser buys a business or after a seller sells a business that are still reported under the purchaser’s or seller’s TIN • Changes in business structure not reflected in the records of the PSE • Cashback to customers • Using a single card terminal for more than one line of business of the same person

Proving Basis Some taxpayers could face an unanticipated problem even for nonbusiness sales of items through Internet portals. It is a general rule of tax law that a taxpayer unable to prove their basis in property sold can be required to use a zero basis.49 It may be difficult for a taxpayer to prove basis in property sold when the property was purchased many years ago and the taxpayer did not retain receipts for the personal assets. However, a taxpayer in that situation may be able to salvage some basis. For business purposes, the loss of records through casualty or other unavoidable means does not relieve the taxpayer from the requirement to substantiate deductions. Even when the taxpayer’s records are lost by the IRS during an audit, the taxpayer still is required to substantiate claimed deductions.50 When the taxpayer’s records are lost or destroyed, the taxpayer may be able to use an alternative method to substantiate the deductions. In rare cases, the sole evidence may be the taxpayer’s uncontradicted and credible testimony. This is referred to in general as the Cohan rule.

48. MCCs can be found in Rev. Proc. 2004-43, 2004-2 CB 124. 49. See, e.g., Namyst v. Comm’r, 435 F.3d 910 (8th Cir. 2006). 50. See, e.g., Cook v. Comm’r, TC Memo 1991-590 (Dec 2, 1991).

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The Cohan rule comes from a 1930 case.51 That case established a rule of “indulgence” for deductions, which are otherwise subject to strict rules. Under the Cohan rule, when a taxpayer is unquestionably entitled to a deduction but the amount is not adequately substantiated, the court may make an allowance based on an estimate. The court must be convinced of both of the following. 1. The taxpayer actually incurred the expense. 2. There is some basis upon which to estimate the allowance. The Cohan rule cannot be used if the taxpayer has access to evidence to support deductions but fails to produce that evidence or if there is no evidence at all to support entitlement to the deductions. In addition, under IRC §274(d), the Cohan rule does not apply to travel, entertainment, gifts, and listed property expenses. Although the Cohan rule is pro-taxpayer, the taxpayer also bears a heavy burden of proof. In practical terms, a taxpayer trying to establish entitlement to deductions under the Cohan rule is usually allowed to claim estimated expenses that are significantly less than those originally claimed on the return. The Cohan rule is not only used in court. It can be used in audits and appeals as well, although a taxpayer will probably be less successful with this approach at the audit level, especially given that most audits are correspondence examinations involving CP2000 notices. It may be necessary for a taxpayer to go through the appeals process or even file a petition in Tax Court. Although the Cohan rule is usually considered in connection with business expenses, courts have applied it in other contexts. This includes estimating asset basis, as shown by Marcus v. Comm’r.52 Following the death of her stepfather in 1980, Maria Marcus inherited a one-third interest in her mother’s real estate in Italy. The mother died in 1970 and left the stepfather the equivalent of a life estate in the mother’s property. Maria and her two sisters, both of whom lived in Europe, disagreed over the handling of the property. They resolved the matter by entering into an agreement in 1980, under which the other two sisters would give Maria one-third of the proceeds from any liquidation of the real estate. In 1990, Maria received $38,000 from the sale of some of the real estate but did not include it on her 1990 income tax return. The IRS assessed a deficiency based on the inclusion of the entire $38,000 in gross income. The Tax Court concluded that Maria received the $38,000 with respect to inherited property, the basis of which is its fair market value (FMV) on the mother’s date of death in 1970. Maria, however, had no idea of its value on that date or at any subsequent time. Under IRC §102, she claimed an exclusion for the entire $38,000 as an inheritance. She testified that her sister in Italy told her the property had decreased in value between 1970 and 1990. The Tax Court, noting that Maria would have shared in any post-1970 appreciation and depreciation in the property’s value, cited the Cohan rule in awarding her $25,000 of basis (a number simply chosen by the judge). The use of the Cohan rule is very dependent on the facts and circumstances of each individual case. Consequently, no threshold exists that, once satisfied, automatically entitles a taxpayer to estimate deductions under the Cohan rule. To the extent there is a commonality in the cases, it is the taxpayer’s credibility in the eyes of the court and the efforts of the taxpayer to establish evidence substantiating deductions. Keeping in mind the requirement for credibility, the following is a discussion of some of the means that a taxpayer may use to produce evidence of basis. • Testimony of the taxpayer. If no other documentation is available, the court may accept the taxpayer’s credible testimony to substantiate a deduction as it did in Maria Marcus’s case. Because this is self-serving testimony, however, the court will closely scrutinize the details of the taxpayer’s testimony and the demeanor of the taxpayer on the witness stand. As a witness, the taxpayer must appear open and candid. The more details a taxpayer can provide concerning deductions, the more credible the testimony. Testimony should not be vague or contradictory. Although it is rare for deductions to be allowed solely on the basis of the taxpayer’s testimony, credible testimony greatly strengthens a case in which secondary evidence is otherwise weak.

51. Cohan v. Comm’r, 39 F.2d 540 (2nd Cir. 1930). 52. Marcus v. Comm’r, TC Memo 1996-190 (Apr. 22, 1996).

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• Third-party testimony. Testimony by third parties is subject to the same credibility standard as testimony by the taxpayer. The testimony must make it apparent that the third party was sufficiently involved in a transaction for which the taxpayer claimed a deduction, such that the third party can offer testimony as to specific details of the transaction. Vague, generalized testimony by a third party is not very helpful. 2 Testimony by a related party is subject to a higher standard of credibility because of the obvious lack of arm’s-length dealing. • Third-party sources. Third parties can sometimes provide secondary evidence of basis. Taxpayers attempting to use the Cohan rule must make a diligent effort to obtain whatever third-party evidence might be available to corroborate claims of deductions. If there is a reason why those third-party records cannot be produced, the taxpayer should be prepared to show the court that they made the effort and explain why it was not successful. Failure to produce obvious third-party records without a good reason is damaging to a case. • Checks and credit card statements. Canceled checks, bank statements, check registers, and credit card statements when coupled with credible testimony may constitute acceptable secondary evidence of purchase prices of assets. • Online accounts. A taxpayer may be able to retrieve records of purchases through accounts with online vendors. • Search engines. The Internet is a repository of an incredible amount of information, much of which apparently is never deleted. It may be possible to find what a particular item or one similar to it cost when purchased new even if the item was purchased many years ago. If inherited property was sold, as in Maria Marcus’s case, efforts should be made to find evidence of its FMV on the applicable date of death. Gifted property may be more problematic because of carryover basis. IRC §1015(a) states the general rule that the donee of gifted property takes the same basis the property had in the hands of the donor. It then goes on to say the following. If the facts necessary to determine the basis in the hands of the donor or the last preceding owner are unknown to the donee, the Secretary shall, if possible, obtain such facts from such donor or last preceding owner, or any other person cognizant thereof. If the Secretary finds it impossible to obtain such facts, the basis in the hands of such donor or last preceding owner shall be the fair market value of such property as found by the Secretary as of the date or approximate date at which, according to the best information that the Secretary is able to obtain, such property was acquired by such donor or last preceding owner. Although there are surprisingly few cases dealing with this provision,53 the following principles apply to its application. • Although the taxpayer generally has the burden of proof, the IRS cannot arbitrarily give the taxpayer a zero basis for purposes of determining gain on a disposition of gifted property unless the IRS can show it has no way of determining the property’s carryover basis or its FMV. • In the absence of proof by the taxpayer, courts are likely to sustain the IRS if its determination of FMV is at all reasonable. • If neither the IRS nor the taxpayer can submit reasonable evidence of basis, it is treated as zero.

53. See the dissent of Judge Bruce in James E. Caldwell & Company v. Comm’r, 24 TC 597 (1955), reversed and remanded, 234 F.2d 660 (6th Cir. 1956) for a good discussion of this provision. The 6th Circuit reversed the Tax Court based on Judge Bruce’s dissenting opinion.

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SELF-DIRECTED IRAs

Self-directed IRAs permit IRA beneficiaries to control investment decisions. In many cases, when beneficiaries choose a self-directed IRA, they are simply seeking alternatives to more traditional investments. The extent to which custodians54 allow beneficiaries to direct investments varies widely. With most IRA trustees and custodians, even a self-directed IRA is limited to traditional types of investments such as publicly traded equities and bonds and cash accounts. Generally, few self-directed IRA custodians allow the beneficiary to truly self-direct investment decisions by investing in whatever nontraditional assets are not specifically prohibited. However, it is easy to locate custodians on the Internet who permit many forms of nontraditional investments, the most popular of which appears to be real estate. Additionally, in the last decade, self-directed IRAs or 401(k) accounts increasingly have been used as a means for beneficiaries to finance a business without taking a taxable distribution. These accounts are commonly referred to as rollovers as business startups (ROBS). Little guidance exists regarding the use of self-directed IRAs and nontraditional investments. The IRS expressed concern about ROBS55 and instituted a means of identifying the use of self-directed IRAs and traditional retirement plans to ascertain whether nontraditional investments are permitted (discussed later). The two most common problems with self-directed IRAs are beneficiaries engaging in prohibited transactions and IRA investments that result in taxation of unrelated business income. Both of these issues are discussed in this section.

PROHIBITED TRANSACTIONS IRC §4975 prohibits certain transactions between plans and disqualified persons. Although §4975 does not specifically include the beneficiary of an IRA as a disqualified person, this apparently was an oversight in drafting the law because the legislative history clearly shows they were intended to be covered. Consequently, the IRS, the Department of Labor (DOL), and the courts consistently apply §4975 to beneficiaries of IRAs. A prohibited transaction is defined in §§4975(c)(1)(A)–(F) as any direct or indirect: A. Sale, exchange, or lease of any property between a plan and a disqualified person; B. Lending of money or other extension of credit between a plan and a disqualified person; C. Furnishing of goods, services, or facilities between a plan and a disqualified person; D. Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan; E. Act by a disqualified person who is a fiduciary whereby the person deals with the income or assets of a plan in the person’s own interest or for the person’s own account; or F. Receipt of any consideration for their own personal account by any disqualified person who is a fiduciary from any party dealing with the plan in connection with a transaction involving the income or assets of the plan (referred to in the Internal Revenue Manual as kickbacks56).

54. The term “custodian” in this chapter includes both trustees and custodians. 55. Guidelines Regarding Rollovers as Business Start-ups. Julianelle, Michael. Oct. 1, 2008. Department of the Treasury. [www.irs.gov/pub/irs- tege/robs_guidelines.pdf] Accessed on Jan. 28, 2017. 56. IRM 4.72.11.3.6 (Dec. 17, 2015).

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Under §4975(d), certain transactions are specifically excluded from the definition of prohibited transactions. The exceptions include loans from a plan to beneficiaries, payment of reasonable compensation to disqualified persons for services rendered to the plan, and reimbursement of expenses incurred in the performance of duties with the plan. Most of these exceptions are intended for qualified plans under IRC §401(a) and do not apply to IRAs. 2

Disqualified Person A disqualified person is defined under §§4975(e)(2)(A)–(I) as a person who is one of the following. A. A fiduciary B. A person providing services to the plan C. An employer, any of whose employees are covered by the plan D. An employee organization, any of whose members are covered by the plan E. An owner, direct or indirect, of 50% or more of one of the following, which is an employer or employee organization described in C or D i. The combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation ii. The capital interest or the profits interest of a partnership iii. The beneficial interest of a trust or an unincorporated enterprise F. A member of the family of any individual described in A, B, C, or E G. A corporation, partnership, or trust or estate, of which, or in which, 50% or more of one of the following is owned directly or indirectly or held by persons described in A–E above i. The combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation ii. The capital interest or the profits interest of a partnership iii. The beneficial interest of such trust or estate H. An officer, director (or individual having similar responsibilities), a 10% or more shareholder, or a highly compensated employee (earning 10% or more of the yearly wages of an employer) of a person described in C, D, E, or G I. A 10% or more (in capital or profits) partner or joint venturer of a person described in C, D, E, or G Family members for the purpose of determining disqualified persons include an individual’s spouse, ancestors, lineal descendants, and any spouse of a lineal descendant.57 Family members do not include siblings or spouses of ancestors. For purposes of ownership in corporations, partnerships, and trusts, certain attribution rules of IRC §267(c) apply. A fiduciary is any person who exercises any discretionary authority or control over the management of a plan or its assets, or has discretionary authority or responsibility in its administration.58 The beneficiary of a self-directed IRA is always considered a fiduciary for purposes of §4975. It is common for courts and the IRS to find that an IRA beneficiary participated in a prohibited transaction by violating their fiduciary duty.

57. IRC §4975(e)(6). 58. IRC §4975(e)(3).

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Consequences of Prohibited Transaction Under §4975, any disqualified person other than the IRA’s beneficiary who engages in a prohibited transaction with an IRA is subject to an excise tax of 15% of the amount involved in the prohibited transaction for each year (or part of a year) that the transaction continues. In addition, any person on whom the 15% tax is imposed is subject to an additional tax of 100% of the amount involved if the prohibited transaction is not corrected by the earlier of: • The date the IRS mails a notice of deficiency with respect to the 15% tax; or • The date on which the 15% tax is assessed. In the case of an IRA, if the beneficiary engages in a prohibited transaction, IRC §408(e)(2)(A) provides that the account ceases to be an IRA as of the first day of the tax year in which the prohibited transaction occurs. This applies to the entire account, not just to the amount involved in the prohibited transaction. If this occurs, the beneficiary is not subject to any of the excise taxes under §4975. Any other disqualified person engaging in a prohibited transaction with the IRA is subject to the excise tax provisions. This can be an especially harsh treatment. In a 1988 technical advice memorandum (TAM),59 an individual borrowed $50,000 from a profit-sharing plan of a corporation in which the individual was a one-sixth shareholder and gave the plan a promissory note. The individual also participated in a money purchase plan sponsored by the same employer. Both plans terminated in 1983. The individual received the following distributions on December 28, 1983.

Profit Sharing Money Purchase Total Cash $382,568 $49,112 $431,680 Note balance 41,185 0 41,185 Total $423,753 $49,112 $472,865

On January 30, 1984, the individual rolled over the cash and note to an IRA and treated it as a tax-free rollover. The IRS ruled that the transfer of the individual’s promissory note to the IRA was a prohibited transaction because the continuation of the note in the IRA effectively constituted a loan from the IRA to the individual. Under IRC §408, the IRA ceased being an IRA as of January 1, 1984. This meant the rollover was to an account that was not an IRA, and the transfer was not eligible for rollover treatment. As a result, the entire $472,865 was includable in the gross income of the individual.

Observation. This result is unlikely to happen today because qualified plan administrators usually treat any unpaid plan loan as a distribution if not repaid at the time an individual terminates participation in the plan.

Although there are instances in which the IRS waived the excise tax under §4975, no instances have been found in which the IRS waived the disqualification under §408.

Planning Tip. Only the account in which the prohibited transaction occurred is deemed distributed. When an IRA is invested in different assets, it may be wise to consider establishing a separate IRA for each investment if there is any possibility of a prohibited transaction.

59. TAM 8849001 (Aug. 30, 1988).

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Prohibited Transaction Exemptions Although §4975 is part of the Internal Revenue Code, the DOL has exclusive authority under §4975(c) to grant exemptions from the prohibited transaction rules. The DOL rulings are known as prohibited transaction exemptions (PTEs). The DOL issues PTEs upon request for such things as cash sales of stock to beneficiaries to enable a 2 corporation to elect subchapter S and cash sales of real estate from an IRA to the beneficiary. The DOL also issues advisory opinions for prospective transactions (similar to private letter rulings) if there is concern that a transaction might be prohibited. Notices of proposed PTEs are frequently published in the Federal Register for a period of public comment before final issuance.60 The most common PTEs for IRAs address transfers of property between an IRA and the beneficiary either as a sale or to fund a required minimum distribution (RMD) to the beneficiary. For example, one PTE permitted the beneficiary of an IRA to purchase shares of a closely held corporation that was a disqualified person so the corporation could elect S status.61

Examples of Prohibited Transactions There is a developing body of judicial and administrative guidance illustrating how IRAs are affected by prohibited transactions. The most important lesson is that, although self-directed IRAs are perfectly legitimate, the rules are complicated and the consequences of violations can be severe. Courts are quick to look beyond the form of transactions to the substance in determining whether there is any direct or indirect prohibited transaction.

Note. Individuals contemplating nontraditional investments for their self-directed IRAs should consider seeking guidance from a professional who is knowledgeable about ERISA (Employee Retirement Income Security Act of 1974).

Extending Credit. Shareholders of closely held corporations are frequently required to guarantee loans to their corporation. This is not allowed when a self-directed IRA owns the corporation. In Peek, et al. v. Comm’r,62 two individuals established traditional IRAs in 2001. They formed FP Company and directed their new IRAs to use rolled-over cash to purchase 100% of FP Company’s newly issued stock. They used FP Company to acquire the assets of AFS Corporation. The individuals personally guaranteed loans of FP Company that arose out of the asset purchase. In 2003 and 2004, they rolled over the FP Company stock from their traditional IRAs to Roth IRAs, including the value of the stock in their income. In 2006, after the FP Company stock’s value had significantly appreciated, they directed their Roth IRAs to sell all the FP stock. Their personal guaranties on the loans of FP Company continued until the stock sale in 2006. The IRS challenged their transactions, and the Tax Court held that the taxpayers’ personal guaranties of the FP Company loan were prohibited transactions. As a result, the taxpayers’ IRAs ceased to be qualified IRAs in 2001 when the original loan guarantees were made. When the Roth IRAs were established in 2003 and 2004, they ceased to be qualified Roth IRAs when funded with FP Company stock because the prohibited transactions continued with those accounts. Consequently, the gains realized in 2006 and 2007 from the sales of FP stock were includable in the taxpayers’ income because the accounts holding the stock at that time were not Roth IRAs.

Note. If a taxpayer nonfraudulently omits more than 25% of gross income, IRC §6501(e)(1)(A) provides a 6- year statute of limitations for assessment of a deficiency. The 6-year statute had probably expired in this case.

60. See 29 CFR 2570 Prohibited Transaction Exemption Procedures Employee Benefit Plans. Department of Labor. [www.dol.gov/agencies/ ebsa/employers-and-advisers/guidance/exemptions/class/pte-procedures] Accessed on Jan. 10, 2017. 61. DOL Authorization 08-09E, Craig E. Pines IRA Application E00598 (Oct. 29, 2008). 62. Peek, et al. v. Comm’r, 140 TC 216 (2013).

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Note. For more information about the Peek case, see the 2013 University of Illinois Federal Tax Workbook, Volume B, Chapter 5: Rulings and Cases. This can be found at uofi.tax/arc [taxschool.illinois.edu/ taxbookarchive].

In a 2016 case,63 James Thiessen and his wife left their employment, and Mr. Thiessen looked for a metal fabrication business to buy. A broker from a business brokerage firm advised Mr. Thiessen that he could roll over his 401(k) from the former employer into a self-directed IRA and use it to buy a metal fabrication business listed with the brokerage firm. Mr. Thiessen worked with the broker, the CPA of a friend who had recently used his IRA for a ROBS, and a lawyer in structuring the purchase. The broker’s firm recommended that the acquisition of an existing business be structured to include a loan from the seller because the seller would have an interest in helping the buyer in the future. Both Mr. Thiessen and his wife rolled their 401(k)s into self-directed IRAs and used $432,000 to buy the stock of the newly formed corporation. The corporation then purchased the assets of a metal fabrication business using $342,000 of the IRA money, a $60,000 deposit from Mr. Thiessen’s personal funds, and a $200,000 promissory note to the seller. The Thiessens personally guaranteed the note. The IRS challenged the transactions. The Tax Court, citing Peek, found the note guarantee to be a prohibited transaction. As a result, the entire $432,000 balance in the IRAs was deemed to be distributed. Unlike Peek, the 6-year statute of limitations was applicable because the Thiessens did not disclose income that exceeded 25% of the gross income reported on their return.

Note. For more information about the Thiessen case, see the 2016 University of Illinois Federal Tax Workbook, Volume B, Chapter 6: Rulings and Cases.

Use of Plan Assets. Rollins v. Comm’r64 involves a prohibited transaction of 401(k) plan assets under §4975(c)(1)(D). The result in this case would have been the same had it been a self-directed IRA because both IRAs and qualified plans are subject to the same prohibited transaction rules.65 Joseph Rollins was a CPA and registered investment advisor. He held various certifications in financial planning and investment management. He was a certified employee benefits specialist, a certified financial planner, and a chartered financial consultant. Mr. Rollins’ professional corporation had a 401(k) plan of which he was both trustee and administrator. He was also the sole shareholder and CEO of a separate corporation that offered financial counseling. The professional corporation and the counseling corporation entered into an agreement, which Mr. Rollins signed for both entities. Under the contract, the counseling corporation made all investment decisions on behalf of the professional corporation’s 401(k) plan. The 401(k) plan established various loans to three different corporations in which Mr. Rollins held minority interests. Rollins was an officer in each of those three corporations and signed the promissory notes to the 401(k) plan on behalf of the borrowing corporations. The notes all bore interest rates above market rate, and all the loans were repaid with interest.

63. Thiessen v. Comm’r, 146 TC No. 7 (2016). 64. Rollins v. Comm’r, TC Memo 2004-260 (Nov. 15, 2004). 65. See DOL Advisory Opinion 88-18A (Dec. 23, 1988) in which the DOL warned that a loan from a self-directed IRA to a corporation, 48% of the stock of which was owned by the participant who also served as an employee and member of the board of directors, could result in a prohibited transaction. The opinion stated that the participant’s interest in the corporation could affect his judgment as a fiduciary and constitute a use of plan assets to benefit a disqualified person or an act of self-dealing.

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Because of his use of plan assets, the IRS determined that Mr. Rollins was a disqualified person under §4975(c)(1)(D) and that he breached his fiduciary duty under §4975(c)(1)(E). It assessed an excise tax against him as provided under §4975. (The deemed distribution rule is not applicable to 401(k)s and other qualified plans.) 2 Mr. Rollins argued that each loan was a sound investment, the plan earned interest above the market rate, the loans were fully secured, and they were repaid. Although he acknowledged that he was a disqualified person, he contended that none of the borrowers were disqualified persons, the loans were not transacted between the plan and him, and that he did not benefit from the loans. However, the Tax Court held that Mr. Rollins had benefited from the use of plan assets in violation of §4975(c)(1)(D). In reaching its decision, the court extensively reviewed the legislative history of §4975 and concluded that Congress intended to replace what had been an unworkable arm’s-length standard with an outright ban on any direct or indirect benefit by a disqualified person from the use of plan assets. It cited an example in the legislative history of a prohibited transaction in which the plan’s assets were used to manipulate the price of a security to the advantage of a disqualified person. The court found that Mr. Rollins could have derived a benefit as a significant part owner in each of the borrowing corporations because those corporations secured financing without having to deal with independent lenders. This may have enhanced the value of his ownership in those corporations. It is also possible that he derived no benefit. Because no determination could be made from the evidence in the record, it was Mr. Rollins’ burden to prove by a preponderance of the evidence that the loans did not constitute a use of the plan’s income or assets for his own benefit. He failed to prove this. Citing prior cases, the court further stated that the prudence of an investment and the fact that the plan benefited is not a defense to a prohibited transaction. Conflict of Interest. The owner of a self-directed IRA is a disqualified person both as the beneficiary and as a fiduciary. IRC §§4975(c)(1)(E) and (F) apply specifically to fiduciaries. IRC §4975(c)(1)(E) prohibits a disqualified person from dealing with plan income or assets in their own interest or on their own account. IRC §4975(c)(1)(F) prohibits a disqualified person from receiving consideration for their own personal account from a party dealing with income or assets of a plan. Although these Code sections are separate prohibited transactions, the regulations treat them as together barring fiduciaries from engaging in a transaction that creates a conflict of interest between the fiduciary and the IRA. Treas. Reg. §54.4975-6(a)(5)(i) states the following. The prohibitions of sections 4975(c)(1)(E) and (F) supplement the other prohibitions of section 4975(c)(1) by imposing on disqualified persons who are fiduciaries a duty of undivided loyalty to the plans for which they act. These prohibitions are imposed upon fiduciaries to deter them from exercising the authority, control, or responsibility which makes such persons fiduciaries when they have interests which may conflict with the interests of the plans for which they act. In such cases, the fiduciaries have interests in the transactions which may affect the exercise of their best judgment as fiduciaries. In a DOL advisory opinion,66 Mr. Adler wanted to have his IRA purchase a 39.4% interest in a limited partnership in which he held a 6.5% interest and was the general partner. The partnership investments were managed by Bernard L. Madoff Investment Securities, which required a $1 million minimum capital investment for its services. The partnership met the minimum capital requirement, but the IRA by itself had only $500,000 and could not meet the requirement. The DOL ruled that the IRA’s purchase would not be a prohibited transaction as a sale or exchange between the IRA and a disqualified person because the combined partnership interests of Mr. Adler and the IRA would be less than 50%.

66. DOL Advisory Opinion 2000-10A (Jul. 27, 2000).

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The opinion went on to warn, however, that Mr. Adler was also a fiduciary of his IRA and could not cause the IRA to enter into a transaction that, by its nature, could result in a conflict of interest between the IRA and the fiduciary or a person in which the fiduciary has an interest. If a conflict subsequently develops, the fiduciary must take steps to eliminate it. The opinion further stated that, “[T]he fiduciary must not rely upon and cannot be otherwise dependent upon the participation of the IRA in order for the fiduciary (or persons in which the fiduciary has an interest) to undertake or to continue his or her share of the investment.” The DOL stated that these were questions of a factual nature upon which it would not issue an opinion.67 Other examples of possible fiduciary conflicts of interest include the following. • A taxpayer’s purchase of stock through his IRA from an employee stock ownership plan (ESOP) was determined to be a prohibited transaction. It appeared that the transaction was not in the best interest of the IRA but was instead to provide money for the ESOP to pay off a loan and for the taxpayer to gain a larger interest in a bank’s stock.68 • Corporation B owned 35% of the shares of Corporation A. The taxpayer was president of Corporation B and a director of Corporation A. The IRS ruled that a purchase of 5% of Corporation A stock by the taxpayer’s IRA would not be a prohibited sale or exchange between disqualified persons because the combined ownership of the taxpayer and the IRA in Corporation A was less than 50%. There would be a prohibited transaction in his capacity as a fiduciary, however, if he benefited directly or indirectly from the purchase. This could occur if the IRA’s stock acquisition ensured his reelection as a director of Corporation A or benefited him in his position as president of Corporation B.69

INVESTING Except for statutory restrictions against collectibles70 and life insurance contracts,71 no assets are prohibited IRA investments. However, there may be indirect limits such as an IRA’s general ineligibility to be an S corporation shareholder.72 Consequently, investments held in a self-directed IRA can be invested in real estate, foreign property, limited partnerships, closely held C corporations, and just about anything else. The only limitation is whether a custodian is willing to accept a particular asset as an IRA investment. An investment choice can also be influenced by whether it is subject to income tax on unrelated business taxable income (UBTI). An IRA can invest in any type of real estate or instrument associated with real estate such as unimproved, rental, and commercial property; trust deeds; limited partnerships, LLCs, and corporations holding real estate; tax liens; and real estate investment trusts.

Rollovers as Business Startups (ROBS) Under the court’s ruling in Swanson v. Comm’r,73 self-directed IRAs are permitted to fund ROBS. In January 1985, Mr. Swanson, the sole shareholder of an S corporation, Tool Company, organized a domestic international sales corporation (DISC). He also created a self-directed IRA (IRA #1) for his benefit. Mr. Swanson was director and president of the DISC. On the same day that IRA #1 was established, it received 2,500 shares of the DISC’s stock and became the DISC’s sole shareholder.

67. For the same reason, the IRS will not issue a ruling. See Ltr. Rul. 8009091 (Dec. 7, 1979). 68. CCA 200945040 (Sep. 24, 2008). 69. Ltr. Rul. 8009091 (Dec. 7, 1979). 70. IRC §408(m). 71. IRC §408(a)(3). 72. Taproot Administrative Services, Inc. v. Comm’r, 679 F.3d 1109 (9th Cir. 2012); Rev. Rul. 92-73, 1992-2 CB 224. 73. Swanson v. Comm’r, 106 TC 76 (1996).

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For the years 1985 to 1988, Tool Company paid commissions to the DISC on Tool Company’s sale of export property. During those years, Mr. Swanson, as president of the DISC, directed the DISC to pay dividends to IRA #1. The dividends totaled $593,602 during those four years. Tool Company stopped paying commissions to the DISC after December 31, 1988, because Swanson no longer considered such payments advantageous from a tax 2 planning perspective. In 1989, Mr. Swanson directed the trustee of his IRA to transfer $5,000 to a new self-directed IRA (IRA #2). At the same time, he created a foreign sales corporation (FSC). IRA #2 received 2,500 shares and became the sole shareholder of the FSC. In 1990, the FSC paid a $28,000 dividend to IRA #2. The IRS issued notices of deficiency to Mr. Swanson and his wife alleging that prohibited transactions occurred within each IRA and, because of those transactions, each IRA ceased to be an IRA under §408(e)(2)(A). The alleged prohibited transactions included the following. 1. The sale of stock by the DISC and the FSC to the respective IRAs 2. The payment of dividends by these companies to their IRA shareholders The IRS ultimately conceded the case at the administrative level and Swanson and his wife sued for attorney fees. The Tax Court, in awarding litigation costs to the taxpayers under IRC §7430, held that the IRS’s position regarding prohibited transactions was not substantially justified. The court concluded that when the initial issuance of DISC (and FSC) stock to the IRA occurred, the issuing company was not yet a disqualified person because the newly issued stock was not owned by anyone at the time of the sale. Thus, the sale of stock to the IRA was not a sale or exchange of property between a plan (the IRA) and a disqualified person within the meaning of §4975(c)(1)(A). The payment of dividends by the DISC (or FSC) to the IRA was further held not to be the use of IRA assets for the benefit of a disqualified person within the meaning of §4975(c)(1)(D) because the dividends did not become IRA assets until they were paid. Finally, the court ruled that the actions of arranging for IRA ownership of DISC (and FSC) stock and for the subsequent payment of dividends by the DISC (and FSC) to the IRA, considered together, did not constitute an act whereby a fiduciary directly or indirectly deals with income or assets of a plan in their own interest or for their own account within the meaning of §4975(c)(1)(E). The court noted that the IRS had not alleged that the taxpayer ever dealt with the corpus of the IRA for his own benefit, saying that the only benefit Mr. Swanson received related solely to his status as a participant in the IRAs. This benefit is one to which a disqualified person is specifically entitled under §4975(d)(9). Ellis v. Comm’r74 provides guidance on how a ROBS should not be structured. In 2005, Terry Ellis rolled his qualified plan into a self-directed IRA. He then formed CST LLC (which elected C corporation status), in which the IRA owned 98% of the membership interests and an unrelated party (not identified) owned the remaining 2%. The IRA paid a total of $319,500 to CST in exchange for its membership interest. CST’s business was used car sales. Under CST’s operating agreement, Mr. Ellis was general manager and entitled to guaranteed payments for services as such. CST paid Mr. Ellis a salary of $29,000 in 2006. Also in 2005, Mr. Ellis formed CDJ LLC, a partnership consisting of Mr. Ellis, his wife, and their children. CDJ purchased real estate. Beginning January 1, 2006, CST rented the real estate and paid CDJ a total of $21,800 during 2006.

74. Ellis v. Comm’r, TC Memo 2013-245 (Oct. 29, 2013), aff’d 787 F.3d 1213 (8th Cir. 2015).

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The IRS assessed deficiencies for both 2005 and 2006, alleging the following were prohibited transactions in one of those two years. 1. Formation of CST LLC in 2005 using IRA funds 2. Payment of compensation to Mr. Ellis by CST 3. Mr. Ellis’s causing CST to enter into the lease with CDJ The Tax Court found that forming CST did not constitute a prohibited transaction under Swanson. The court concluded, however, that payment of compensation to Mr. Ellis in 2005 constituted a prohibited transaction under §4975(c)(1)(E). As a fiduciary of his IRA and as general manager of CST, he indirectly dealt with the IRA assets in his own interest because he controlled both sides of the transaction. In addition, he transferred IRA assets to himself indirectly because nearly all the capital of CST consisted of IRA plan contributions that were used to fund his compensation. The Tax Court affirmed a deficiency of nearly $136,000 plus $27,000 in accuracy-related penalties for the 2005 tax year. Because the court found one prohibited transaction, it was not necessary for it to address the lease with CDJ. Had the court done so, it is likely the lease would have constituted a prohibited transaction under §4975(c)(1)(A) because CDJ was a disqualified person under §4975(e)(2)(G).

Note. Interestingly, Mr. Ellis argued that §4975(d)(10) exempted his compensation from being classified as a prohibited transaction. Under that Code section, the payment of reasonable compensation by a plan to a disqualified person is allowed for services rendered to the plan. The court noted that Mr. Ellis provided services to CST, not to the plan, and therefore did not qualify for the exception.

Custodians who permit self-directed IRAs to form ROBS generally advise individuals that they must pay themselves salaries from the business profits. If the IRA purchases an existing business, there may be immediate business profits from which to pay salaries. Often, however, ROBS are used to form new businesses.

Observation. Sales of franchises as ROBS are heavily promoted on the Internet. It is unlikely that a brand- new business will generate enough immediate profit to pay a salary. The danger is that the beneficiary may be tempted to use IRA money contributed to the corporation as capital to fund a salary.

Roth IRAs and ROBS. Most custodians of self-directed IRAs do not permit the use of Roth IRAs for ROBS. Because of the abusive use of Roth IRAs, IRS Notice 2004-8 identified as “listed transactions” certain arrangements that involve holding business interests.75 The IRS notice applies only to transactions that are substantially similar to those described in it. These listed transactions typically involve an individual who creates a Roth IRA and minimally funds it with a contribution sufficient to enable the Roth IRA to become the sole shareholder of a newly formed C corporation. The Roth corporation then enters into some form of management contract with an existing business or businesses owned by the beneficiary. The Roth corporation receives management fees and, in turn, distributes significant dividends to the Roth IRA. The IRS identified these as tax avoidance transactions intended to circumvent the annual contribution limitation applicable to Roth IRAs. Taxpayers must indicate their participation in listed transactions on their income tax returns or they may be subject to large penalties. The IRS notice does not completely prohibit the use of Roth IRAs for ROBS.

75. IRS Notice 2004-8, 2004-1 CB 333.

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Real Estate Real estate is a common investment for self-directed IRAs. Real estate investments include rental houses, “flip” properties, rehabs, farms, and derivatives of real estate, such as property tax certificates and loans. 2

Observation. Many questions posted on self-directed IRA chat boards deal with investing in rehab properties through a self-directed IRA. These investments are permitted. There are, however, potentially serious limitations from a practical perspective because of how some IRA beneficiaries want to structure these transactions.

Furnishing services is a prohibited transaction under §4975(c)(1)(C). When a self-directed IRA invests in real estate that is going to be rehabbed, neither the IRA beneficiary nor any other disqualified person should perform any services in rehabbing the property. For example, if the beneficiary owns 50% or more of a construction company (including ownership attribution from related parties), the company cannot rehab the property. No authority exists to indicate that providing services is a prohibited transaction only when the disqualified person is compensated for the services. Therefore, custodians typically indicate that a beneficiary cannot perform services, even without compensation.

Observation. Although some websites indicate the rehab services may be performed as long as the disqualified person receives absolutely no compensation, this is only a supposition derived indirectly from several PTE exemptions issued by the DOL regarding unrelated issues.

When an IRA makes successive investments in rehab properties, is it in the trade or business of rehabbing properties? If the activity rises to the level of a trade or business, then income from the business is subject to the tax on UBTI. Being subject to UBTI defeats the whole purpose of using the self-directed IRA because income is subject to taxation when earned by the IRA and then a second time upon distribution. A similar income tax on unrelated debt-financed income can arise if the IRA borrows money to finance real estate. If a rehab encounters unexpected problems that increase the cost of rehabbing beyond the financial resources of the IRA, such as asbestos or lead-based paint elimination, the IRA may experience serious losses unless the beneficiary can make additional contributions from another IRA or retirement plan, or contribute within their annual limit to cover the loss.

Note. See the section on “Unrelated Business Taxable Income” later in this chapter for more information about the impact of self-directed IRAs investing in real estate.

Because neither the beneficiary nor any disqualified person is generally permitted to have personal possession of any IRA assets, all expenses relating to the rehab must be handled directly by the custodian or possibly by an unrelated third party, such as an accountant, who agrees to do so for a fee. It is not clear, however, how such a third-party arrangement might work, because neither the IRS nor the DOL has issued a ruling on this.

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Partnering. It is common to find self-directed IRA custodians or chat boards on the Internet recommending that a beneficiary partner with their IRA as a means of acquiring real estate investments.76 This can be accomplished through co-ownership as tenants in common or as members of an LLC. As mentioned earlier, a fiduciary engages in a prohibited transaction if they depend upon the IRA’s participation in order for the fiduciary or persons in whom the fiduciary has an interest to undertake or to continue their share of an investment. Both the DOL and the IRS have said they will not issue rulings in this area due to its factual nature. If a beneficiary and their self-directed IRA partner to acquire real estate as tenants in common, the following problems might arise. • The IRS could treat the partnering as a prohibited transaction that enabled the beneficiary as fiduciary to undertake the investment. According to the Tax Court in the Rollins case (discussed earlier), the burden of disproving a prohibited transaction is on the beneficiary. This might require, for example, that the beneficiary prove that both they and the IRA had sufficient individual assets to purchase the entire property. • If outside financing is required, it must be nonrecourse to both parties. If it is nonrecourse only to the IRA and not the beneficiary, this would amount to an indirect extension of credit to the IRA, which is a prohibited transaction. • If each party borrows funds, they must either have separate loans or a single loan carefully structured to limit each party’s liability under the loan to their proportionate interest in the real estate. Otherwise, there may be an extension of credit between them. • A lender will want a lien on the property to secure borrowings. The extent of the lien must be limited to a party’s proportionate interest as a tenant in common so that in the event of default only that party’s interest would be foreclosed. A lien on the entire property for the individual debt of either party would be an extension of credit. • In a tenancy in common, each party is entitled to the benefit and use of the entire property but only to the extent of their share of the property’s value. Each is also liable for payment of their share of expenses. If either party is unable to pay their share of expenses, the other party cannot do so for them because this would constitute a prohibited transaction. • Commingling is not allowed. Each party’s share of income and expenses must be credited to and paid from their separate accounts. • If the separate interest of either party is foreclosed, it will likely be acquired by the lender because of the difficulty of selling an undivided fractional interest in real estate. However, the lender then becomes a tenant in common with the remaining party and can sue to have the property partitioned. In most cases, this means the property will be sold at public auction and the proceeds divided between the lender and the remaining owner in proportion to their interests. This may result in the higher value for partition of the whole property versus the lower value of a fractional interest being treated as an indirect extension of credit between the parties.

76. See, e.g., Partnering with Your Own Self Directed IRA to Purchase Land. Bigger Pockets. [www.biggerpockets.com/forums/50/topics/ 349964-partnering-with-your-own-self-directed-ira-to-purchase-land] Accessed on Feb. 22, 2017; 5 Ways to Partner Your Self-Directed IRA. The Entrust Group. [www.theentrustgroup.com/blog/5-ways-to-partner-your-self-directed-ira] Accessed on Feb. 22, 2017.

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If the parties are instead members of an LLC that will acquire the property, the following problems may arise. • Based on the Swanson case (discussed earlier), the parties would have to make simultaneous transfers of assets in exchange for their initial membership interests to avoid having a sale or exchange between 2 disqualified persons (the members and the LLC) that would be a prohibited transaction. • The IRS could treat the partnering as a prohibited transaction in which the LLC enabled the fiduciary to undertake the investment. • Neither member can guarantee any debt incurred by the LLC. • No authority exists on whether subsequent capital contributions can be made to the LLC once it becomes a disqualified person. If any contributions are made, they must be in proportion to the members’ interests. Disproportionate contributions might be viewed as an indirect extension of credit by the member making them. • Interim distributions of LLC profits to the members should be permitted, although there is no authority addressing this. • The redemption of a member’s interest by the LLC would be a sale or exchange. Therefore, the redemption is a prohibited transaction. • No authority exists on whether distributions in liquidation of the members’ interests would be treated as an exchange between disqualified persons that constitutes a prohibited transaction. Swanson (discussed earlier) emphasized that the entity came into being with the issuance of shares to the IRA and was therefore not a disqualified person until after that occurred. It is possible that a similar rationale might be applied to a distribution terminating the disqualified person’s existence. • In-kind distributions of nonfungible assets should be in proportion to the members’ interests and as tenants in common, if necessary. • The beneficiary-fiduciary controls all aspects of the LLC, creating the potential for conflict of interest and a prohibited transaction. Problems with these arrangements can also affect bankruptcy filings. Generally, an individual who files bankruptcy can claim as exempt property up to $1 million of an IRA. A bankruptcy court77 ruled that an individual’s self- directed IRA was not exempt because the taxpayer had partnered with his IRA in forming an LLC to buy unimproved land for development. The court found that he had violated §§4975(c)(1)(D) or 4975(c)(1)(E) because acquisition and development of the property significantly enhanced the value of adjoining property already owned by the individual.78

Caution. Even when a transaction is likely permissible under the prohibited transaction rules, caution should be exercised. In one advisory opinion,78 the DOL opined that a loan from a self-directed IRA to a corporation, where 48% of the stock was owned by the participant who also served as an employee and member of the board of directors, could result in a prohibited transaction. According to the DOL, the participant’s interest in the corporation could affect his judgment as a fiduciary and constitute a use of plan assets to benefit a disqualified person or an act of self-dealing under the prohibited transaction rules. This is true even though there might not be any current violation.

77. In Re Kellerman, 531 BR 219 (E.D. Ark. 2015). 78. DOL Advisory Opinion 88-18A (Dec. 23, 1988).

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Required Minimum Distribution Issues. RMDs must begin by April 1 of the year after the beneficiary reaches age 70½. The RMD is a fractional portion of the IRA’s value determined as of December 31 of the previous year. With traditional IRA investments, this is generally not an issue. The assets are valued using an objective standard that is easily divisible for purposes of making an in-kind distribution if desired. An IRA holding real estate faces issues related to RMDs. The first issue concerns how to determine the fair market value (FMV) as of the previous year. This may necessitate an appraisal of the property. A question arises about how often to reappraise the property, and the requirement varies among custodians. Another issue is that real estate is not easily divisible like shares of stock. It is possible to transfer a fractional ownership interest in real estate by using a tenancy in common, which permits different owners to have unequal fractional interests in property. The problem with this arrangement concerns how to ensure that the proper RMD is distributed. Typically, lack of marketability valuation discounts apply to fractional real estate interests, which can expose the beneficiary to the 50% excise tax for failure to take sufficient distributions. Example 4. An IRA contains real estate with a $100,000 FMV. The RMD is based on the owner’s actuarial life expectancy of 20 years and is therefore $5,000 ($100,000 ÷ 20). A distribution to the IRA beneficiary of an undivided one-twentieth interest as a tenant in common in the property appears to accomplish the $5,000 distribution. However, if an appropriate marketability discount is 20%, the value of the one-twentieth interest is only $4,000, not $5,000. In this situation, the RMD amount is less than required.79 Unfortunately, there is no definitive means to determine the appropriate lack-of-marketability discount for any particular situation. Because of the complexities of making fractional distributions of real estate under the RMD rules, custodians may require the beneficiary to take a single distribution of the entire property or require the IRA to sell the property in order to fund distributions (if there are insufficient liquid assets for distributions). If the property itself is distributed in a single transaction, this results in the beneficiary having “phantom” income because the full FMV of the property is includable in the beneficiary’s gross income as ordinary income with no cash distributed. The beneficiary then has a basis in the property equal to its FMV. If the IRA is a Roth IRA and the distribution is qualified, there is no phantom income. There is, however, a DOL PTE80 approving distribution of real estate owned by an IRA to the IRA’s beneficiary in satisfaction of the RMD. An undivided half interest was distributed on the last banking day of the year and the remaining undivided half interest distributed on the first banking day of the following year. The short span of time between the distributions presented minimal opportunity for a conflict of interest between the beneficiary (a disqualified person) and the IRA. Two separate appraisals were obtained from qualified appraisers. Both appraisals determined the same FMV, although one was discounted due to lack of marketability. The DOL approved the PTE on the following basis. • The transaction was necessary to satisfy the RMD requirements. • The conflict of interest risk was minimal. • The terms and conditions were at least as favorable to the IRA as they would have been in an arm’s-length transaction between unrelated parties. • The property’s FMV was determined by independent qualified appraisers. • The IRA would not pay costs associated with the transaction. The DOL also required the property’s FMV to be determined without the lack-of-marketability discount.

79. IRC §4974. 80. DOL PTE 2005-17 (Dec. 28, 2005).

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Checkbook IRAs Custodian fees and the custodians’ delay in processing payment for assets the beneficiary wants the IRA to purchase is a common complaint of self-directed IRA beneficiaries. In response, several websites promote checkbook IRAs. These arrangements provide an IRA beneficiary with indirect access to IRA money. The IRA forms an LLC of which 2 it is the sole member. The beneficiary is appointed manager of the LLC under the operating agreement and establishes a checking account over which the beneficiary-manager has signature authority and which is funded by money from the IRA. The beneficiary-manager can then write checks directly to pay expenses or acquire assets for the LLC.

Observation. Neither the IRS nor the DOL has addressed checkbook IRAs. This absence of guidance may seem to legitimize checkbook IRAs. More conservative commentators and custodians view checkbook IRAs as problematic. While the assets of an entity owned by a self-directed IRA are generally considered separate from the outside interest owned by the IRA (stock or membership interest), it is apparent from Ellis and developing case law that courts do not hesitate to pierce the veil of entity ownership to find indirect use of IRA assets by a beneficiary. What beneficiaries cannot do directly, they also cannot do indirectly.

Borrowing Although some banks may make loans to self-directed IRAs, this is uncommon and can cause difficulty. In order for an IRA to borrow money, the debt must be nonrecourse. Only property that serves as collateral is available to satisfy the debt if the IRA defaults. The lender cannot go after other assets of the IRA. Lenders may require a high equity-to- loan ratio to protect them. The IRA beneficiary or any disqualified person cannot personally guarantee or in any other manner back the loan. Banks that sell their loan portfolios are unlikely to make a loan to an IRA because the loan is not marketable. Beneficiaries may need to use a smaller bank that holds its own loan portfolios and is familiar enough with the beneficiary to enter into a nonrecourse loan with the IRA.

Observation. In perusing applicable Internet chat boards, this inability to find a willing lender appears to be a serious handicap to leveraged IRA investments.

IRS Scrutiny It appears that the proliferation of self-directed IRA investment schemes has attracted the interest of the IRS. An increasing number of taxpayers are going to court to settle disputes with the IRS about IRAs and prohibited transactions. Changes made by the IRS in response to self-directed IRA investment schemes include the following. • Form 1065, Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., includes a question (part II, question I2) about whether the partner is an IRA or other retirement plan. • Form 5498, IRA Contribution Information, (boxes 15a and 15b) asks specifically for the FMV of nontraded business and other IRA assets that do not have a readily available FMV. Additionally, a 2015 Government Accounting Office (GAO) report81 focused on the use of IRAs for nontraditional investments and their potential for enabling taxpayers to accumulate large amounts in their IRAs through investments in closely held businesses. The GAO expressed concern about the increasing potential for self-directed IRAs to be involved in prohibited transactions and noted the inability of the IRS to easily identify situations where that might occur. The GAO noted the additional information required on Form 5498 and urged the IRS to digitize that information to help it identify situations requiring attention. The GAO also questioned whether the existing 3-year statute of limitations gives the IRS enough time to find prohibited transaction violations and whether Congress should be asked to enact a longer limitations period.

81. 2015 Annual Report: Additional Opportunities to Reduce Fragmentation, Overlap, and Duplication and Achieve Other Financial Benefits. April 2015. Government Accounting Office. [www.gao.gov/assets/670/669613.pdf] Accessed on Feb. 9, 2017.

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UNRELATED BUSINESS TAXABLE INCOME Although earnings in an IRA or a qualified plan generally are exempt from current taxation, under IRC §§511–514, an income tax is imposed on unrelated business taxable income (UBTI). UBTI includes income from a trade or business regularly carried on by an IRA that is not substantially related to the IRA’s tax-exempt purpose. The fact that an IRA is intended to produce profits or appreciation in assets in order to fund a beneficiary’s retirement benefit is expressly excluded under §513(a) as being substantially related to its tax-exempt purpose. In general, the UBTI rules apply to both qualified plans and IRAs in the same manner. Because the taxes imposed by §511 are those imposed by Chapter 1 of the Internal Revenue Code, all the provisions of Chapter 1 are applicable to the assessment and collection of the UBTI. Tax-exempt organizations are therefore also required to pay estimated taxes according to the provisions of IRC §6654 and are subject to the same penalties as nonexempt entities. The term “trade or business” has the same meaning as it has in IRC §162(a), relating to trade or business expenses.82 Unfortunately, it is not always easy to determine whether an activity is a trade or business, especially for self-directed IRAs investing in real estate.

Trade or Business The standard by which an activity is deemed to be a trade or business originated in a court case on gambling. In Comm’r v. Groetzinger,83 Mr. Groetzinger devoted 60 to 80 hours per week to pari-mutuel wagering on dog races with the hope of earning a living from the activity. He had no other employment and gambled solely for his own account. In 1978, he had gross winnings of $70,000 on wagers of $72,082, for a $2,082 net gambling loss. His other income during the year was $6,500 from interest, dividends, capital gains, and salary earned before his job was terminated in February 1978. On his 1978 income tax return, Mr. Groetzinger reported as income only the $6,500 received from nongambling sources. He did not report any gambling winnings or deduct any gambling losses. The IRS assessed a deficiency against him for minimum tax purposes because, under the income tax law in effect in 1978, gambling losses were a tax preference and were not deductible for minimum tax purposes. Mr. Groetzinger successfully asserted in the Tax Court that he was in the trade or business of gambling so that the gambling losses should be deductible in determining adjusted gross income for both regular and minimum tax purposes. The IRS appealed to the Supreme Court. The IRS contended that Mr. Groetzinger could not be in a trade or business, because he made wagers only for his own account and did not have any customers or goods or services that he sold to others. The Court rejected this argument. They ruled that although sporadic activities, hobbies, or amusement diversions do not qualify as a business, if a taxpayer’s gambling activity occurs full-time, in good faith, and with regularity for the production of income for a livelihood, it is a trade or business. In this case, given the time and effort expended by Mr. Groetzinger and his clear intent to derive profits, the Court concluded he was in a trade or business. Application of the Groetzinger standard is inherently factual. There is no bright-line test. Generally, a single venture into a for-profit activity for a limited period does not rise to the level of a trade or business. In Batok v. Comm’r,84 a retired automobile mechanic stained and engraved glass as a hobby. He was hired for one month to help install office windows. He received $4,000, and it was reported on a Form 1099-MISC, Miscellaneous Income. The taxpayer did not include this amount on his tax return, and the IRS assessed income and self-employment (SE) tax deficiencies. The Tax Court held that the activity was not a trade or business. Although it was engaged in for profit, it was neither continuous nor regular. The taxpayer had never installed windows prior to or after that time.

82. Treas. Reg. §1.513-1(b). 83. Comm’r v. Groetzinger, 480 U.S. 23 (1987). 84. Batok v. Comm’r, TC Memo 1992-727 (Dec. 28, 1992).

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IRA as Real Estate Dealer As discussed later in the section on unrelated debt-financed income (UDFI), rental real estate income earned by a self- directed IRA is not subject to the tax on UBTI except to the extent it is debt-financed. Some individuals, however, use their self-directed IRAs to buy and rehab properties, sell them, then purchase new properties. Others may perform 2 only minimal repairs before “flipping” the properties. The issue in such instances is whether the IRA is in the trade or business of dealing in real estate and therefore liable for tax on UBTI derived from the trade or business. Generally, rental real estate is a trade or business for income tax purposes. Like other trades or businesses, dispositions are reported on Form 4797, Sales of Business Property, and not on Schedule D, Capital Gains and Losses. Rental real estate income is not generally subject to SE tax because it is excluded from the definition of net earnings from self- employment under IRC §1402(a)(1) unless: • The lessor provides significant services,85 • The lessor is a dealer in real estate,86 or • The rent is derived from a material participation crop share arrangement.87 IRAs are not subject to SE tax. The proper analysis for whether an IRA is in a real estate trade or business for UBTI purposes is therefore based on whether a sale of property by the IRA should be treated as the sale of a capital asset or as one used by the IRA in its nonrental trade or business. IRC §1221(a) defines a capital asset as “property held by the taxpayer (whether or not connected with his trade or business).”88 However, IRC §1221(a)(1) specifically excludes from the definition “stock in trade of the taxpayer or other property of a kind which would properly be included in the inventory of the taxpayer if on hand at the close of the taxable year, or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.” The Supreme Court held that the word “primarily” as used in §1221(a)(1) means “of first importance” or “principally.”89 In doing so, it rejected a lower court interpretation that a purpose was primary if it was “substantial.” In another case, the Court held that the term “capital asset” is to be interpreted narrowly in keeping with congressional intent that it apply to cases of realization of appreciation in value accrued over a substantial period.90 In connection with real estate dealers, the issue is whether property was held for sale to customers in the taxpayer’s trade or business. This requires two separate factual analyses: whether property was held primarily for sale and whether the sale was in the taxpayer’s trade or business.91 The second factor distinguishes the sale of investment property from sale of property as a trade or business.92 91 92

85. Treas. Reg. §1.1402(a)-4(c). 86. Treas. Reg. §1.1402(a)-4(a). 87. Treas. Reg. §1.1402(a)-4(b). 88. IRC §1221(a). 89. Malat v. Riddell, 383 U.S. 569 (1966). 90. Comm’r v. Gillette Motor Transport, Inc., 364 U.S. 130 (1960). 91. Buono, et al. v. Comm’r, 74 TC 187 (1980), acq. 1981-2 CB 1. 92. Malat v. Riddell, 383 U.S. 569 (1966).

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Generally, courts consider the following factors when determining whether a taxpayer is a dealer in real estate.93 • The nature and purpose of buying the property — A taxpayer’s original purpose for acquiring property is important, but the alleged purpose must be supported by credible facts. Although even investment property may be acquired with the intent to sell it, investment property is generally held for long-term market appreciation. Shorter holding periods, frequent sales, and efforts by a taxpayer to increase the value of property are facts that may rebut a claim of acquiring property for investment purposes. • The length of time the taxpayer owned the property — Short-term holding periods do not support acquisition for investment purposes. “Short-term” and “long-term” are subjective terms based on the facts of each case and have no relationship to short- or long-term capital gain holding periods. Although an isolated short-term holding period may be disregarded if due to unusual facts, evidence of a pattern of short-term holding periods weighs against investment purposes. • The continuity of sales activity over a period of time — A trade or business is viewed as an activity continuing over a period of time. This is in keeping with the “regularity” requirement in the Groetzinger definition of trade or business (discussed earlier). Although important, the overriding intent of the taxpayer or circumstances can overcome this factor. For example, in Estate of Simpson,94 taxpayers inherited 400 acres of Kentucky farmland in 1930 but were unable to sell it as a single parcel for an acceptable price. Therefore, from 1936 through 1955, they periodically subdivided parts of the farm, laid out lots, installed sewers and streets, made water and utilities available, and appointed one of the heirs as full-time agent in handling the property. The Tax Court held they were not in a trade or business because all activities were conducted solely for purposes of liquidating an estate. • The number and frequency of sales — This is generally considered one of the most important factors, as it is characteristic of a trade or business and is inconsistent with holding property for long-term appreciation in value. • The extent to which the taxpayer developed the property, solicited customers, and advertised — Investment property increases in value by virtue of overall appreciation in the marketplace. When value is derived, instead, from efforts by the taxpayer to improve the property’s marketability, it may be indicative of a trade or business but does not by itself establish that fact. Other factors, such as number and frequency of sales are also relevant. Courts tend to ignore such things as platting property with no physical improvements.95 As demonstrated by Estate of Simpson,96 even substantial development is disregarded when necessity dictates development as the only feasible means of selling investment property. Solicitation and advertising, while mentioned in many cases, is subject to too many variables to be significant. It may not be necessary in a seller’s market, or investment property may require widespread advertising and the use of brokers to obtain the best price. • The ratio of sales to other sources of income — The greater the proportion of a taxpayer’s income from sales of real estate is to other sources of income, the greater the likelihood real estate will be treated as a trade or business. This is especially true when combined with other factors, such as continuity and frequency. Even when real estate sales constituted 100% of a partnership’s income, however, the Tax Court found that two sales in four years of undeveloped properties were of insufficient frequency to be from a trade or business.97

93. McCullen v. Comm’r, TC Memo 1997-280 (Jun. 19, 1997). 94. Estate of Simpson, et al. v Comm’r, TC Memo 1962-71 (Mar. 30, 1962). 95. Buono, et al. v. Comm’r, 74 TC 187 (1980), acq. 1981-2 CB 1. 96. Estate of Simpson, et al. v Comm’r, TC Memo 1962-71 (Mar. 30, 1962). 97. Phelan v. Comm’r, TC Memo 2004-206 (Sep. 15, 2004).

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No authority exists to address whether a self-directed IRA or qualified plan has UBTI from real estate dealings. The IRS’s current interest in self-directed IRAs with nontraditional investments calls for speculation as to how the preceding factors may apply to an IRA rehabbing or flipping real estate. The following is a theoretical discussion of how these factors might be applied to a self-directed IRA. 2 • Purpose in acquiring — The facts probably make it evident whether the IRA’s real estate was acquired as rental or investment property or instead as rehab or flip property, especially if the real estate activity was engaged in over a period of time. If the property is being rehabbed or flipped, the beneficiary engages in efforts to improve the property for sale when the improvements are completed or engages in active marketing efforts soon after acquisition. • Length of ownership — This is a significant factor because the most important characteristic of investment property is that it is held for market appreciation. Although this is a subjective facts-and-circumstances determination, it is likely that evidence of attempts to sell property — especially if the IRA improved it — within a few years of acquisition does not favor the determination that the IRA held the property for investment in the absence of special circumstances justifying a shorter holding period. • Continuity — The Groetzinger definition of trade or business requires regularity in the carrying on of an activity. Sporadic activities do not come within its scope. To determine whether an activity is undertaken with continuity and regularity, the question must be asked: Can a pattern of ongoing sales activity be detected over a period of time? The fact that a self-directed IRA may be selling rehabbed or flipped properties on an irregular basis is a matter of timing, not pattern. Furthermore, rehabbing and marketing efforts — not just the sales — are part of the activity being evaluated. In this sense, the use of the word “sporadic” in Groetzinger is misleading. In Levinson v. Comm’r,98 for example, Mr. Levinson was the proprietor of a retail store selling electronic goods and collectibles but also created and patented inventions in his spare time. One of his patents was for a microwave cookware container. He later received an award against a company for patent infringement. The award included a license agreement for use of the patent, under which he received significant sums over a period of time. The IRS assessed a deficiency for SE tax. The Tax Court held that Mr. Levinson was not in a trade or business because he did not develop or design inventions on a continuous or regular basis. It accepted his testimony that his inventions were a result of sudden inspirations that were unpredictable and irregular. Therefore, according to the court, his activities were sporadic. • Number and frequency of sales — Unless a self-directed IRA has the resources to engage simultaneously in multiple real estate activities, this is likely to be a relatively insignificant factor. • Development and marketing — Rehabbing involves development by the IRA, and both rehabbing and flipping generally require active marketing efforts. These activities are inconsistent with holding property for investment. • Sources of income — This is a significant factor, because it is likely that the IRA’s income is derived entirely from its real estate activity. Although it is true that a self-directed IRA could have rental or investment properties in addition to properties acquired for rehabbing or flipping, this does not appear to be common. If a beneficiary has more than one IRA, the IRAs cannot be aggregated for purposes of determining sources of income because each IRA is a separate taxpayer for purposes of filing Form 990-T, Exempt Organization Business Income Tax Return.

98. Levinson v. Comm’r, TC Memo 1999-212 (Jun. 29, 1999).

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IRA is Partner in a Partnership If an IRA is a partner in a partnership and the partnership is engaged in a trade or business, the IRA’s UBTI must include its share of the partnership’s gross income, regardless of whether the income is distributed. There is no distinction between limited and general partners. The same rule applies to LLCs classified as partnerships. In seeking higher returns on IRA investments, brokers of IRA custodians may recommend a master limited partnership (MLP) as an investment for self-directed IRAs. The consequences of this investment may not be beneficial. Distributive shares of income from MLPs are UBTI. When the MLP’s Form 1065, Schedule K-1, is properly prepared, UBTI is shown in box 20 (“other information”) with a “V” code indicating UBTI. Even when box 20 contains no entry, if box 1 (“ordinary business income (loss)”) has a positive entry, this amount constitutes unrelated business income or loss.

Caution. Although the partnership Schedule K-1 should be sent to the IRA custodian, it is common for the IRA beneficiary to receive it and not be aware of the reporting requirements. Tax return preparers who are aware of a client with a self-directed IRA invested in an MLP or nontraditional investment should advise the client to file returns for the IRA if required. This applies even when there are losses, such as from oil and gas publicly traded partnerships (PTPs). It is important to track suspended loss carryovers.

If income taxes are from a client’s IRA containing an MLP investment, it is important to ascertain whether the custodian filed a Form 990-T and obtain a copy. The tax preparer should make sure the IRA properly took into account any loss carryovers that may have arisen in prior years.

IRA Receives Rent from Realty and Personal Property When computing UBTI, rents from real property and from certain personal property leased with real property (and the deductions pertaining to them) are excluded. However, rents attributable to the personal property must be incidental to the total amount of rents received or accrued under the lease (determined when the personal property is first placed in service by the lessee). It is generally not “incidental” when rents attributable to personal property exceed 10% of the total rents from all property leased. In general, rents from personal property are UBTI.99 Both the rent from the real property and the personal property are taxable if determining the amount of the rents depends on the income or profits derived by any person from the leased property (other than an amount based on a fixed percentage of gross receipts or sales).100 The point of this rule appears to be that the sharing of net profit is the equivalent of a business partnership in which the real property is the tax exempt entity’s contribution to the business operation (analogous to a material participation crop share arrangement).

IRA Invests in Farmland In some parts of the country, farmland is an increasingly popular self-directed IRA investment. If the IRA actively farms the land, even through an agent, the activity is an unrelated trade or business. Therefore, the farmland must be rented while it is held in the IRA to avoid UBTI. If there is no unrelated debt-financed income (UDFI, discussed later), the rental income is not UBTI. Cash leases of farmland alone are not a problem for UBTI purposes. However, farmland is commonly rented on a crop share basis. Crop share arrangements can be complicated for income tax purposes. When they are structured in one way, the income derived is rent; when they are structured in another way, it is trade or business income. The distinction between the two is not clear.

99. IRC §512(b)(3). 100. IRC §512(b)(3)(B)(ii).

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Several court cases and private letter rulings address the issue of whether a crop share arrangement is excluded from UBTI as rental income. Three prominent cases are included in the following discussion.101 The analysis focuses on whether the arrangement amounts to sharing net profit from the crop production. If the arrangement does so, it is a trade or business. 2 All three cases contain similar facts. Charitable trusts owned farmland they rented under written crop share leases. They all referred to the transaction as a lease, and the parties were referred to as landlord and tenant. In each case, the landlord furnished the land and the tenant furnished machinery, equipment, and labor. The landlord generally maintained the property. The tenant farmed the land in a businesslike manner. Crops were divided 50-50 between the parties and each paid half the cost of seed, herbicides, insecticides, and fertilizers. In some of the cases, the parties also shared the costs of soil tests, limestone, and electricity for drying crops. In all three cases, the charitable trusts were represented on the farms by third-party farm managers with whom the tenants were required to confer concerning such things as planting, crop rotation, cultivation, participation in farm programs, and harvesting. These leasing activities might constitute a material participation crop share for SE tax purposes under §1402(a)(1), depending on the actual degree of the farm managers’ involvement. It appears as though the IRS used SE cases in support of its position that the rent was UBTI. The circuit court expressly rejected such arguments, saying that the issue for unrelated business tax purposes is whether the arrangement between the landlord and the tenant is that they shared net profit acting as a partnership, or that the arrangement is a lease in which they shared gross profit. The trusts have UBTI only when sharing net profit. In all three cases, the courts concluded that the landlord and tenant shared gross profit. In support of their conclusions, the courts cited the following factors. • The parties’ written leases were consistent with their creation of a landlord-tenant relationship. • The details of the leases reflected arrangements commonly accepted as being leases in the local area and under state law. • None of the farm managers participated sufficiently in the day-to-day activities of the operations to rise to the level of creating a partnership. • In the event of a loss, the landlord was not required to make contributions to cover it as would be the case in a partnership, and no losses were carried over from one year to another. • It is common for nonfarm commercial leases to contain some form of cost sharing. • In the Tax Court case, it was important that the lease contained a provision making the tenant liable for all accidents attributable to its farming the land (in a joint venture, both parties are liable).

Deductions In computing the unrelated business income tax of an exempt organization, deductions are allowed for expenses, depreciation, and similar items that are deductible by a commercial enterprise in computing its income tax. The deductions must have a proximate and primary relationship to carrying on the unrelated business. When expenses relate to both the exempt functions and the conduct of an unrelated business, an allocation is required between the two activities.

101. U.S. v. Myra Foundation, 382 F.2d 107 (8th Cir. 1967); Harlan E. Moore Charitable Trust v. U.S., 9 F.3d 623 (7th Cir. 1993); Emily Oblinger Trust v. Comm’r, 100 TC 114 (1993).

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Exclusions The following income items and any deductions directly connected with them are excluded from UBTI.102 • Dividends • Interest • Annuities • Royalties • Rents from real property, including personal property leased with the real property unless the determination of the amount of rent depends on the income or profits derived by any person from the leased property (other than an amount based on a fixed percentage of gross receipts or sales) • Gains and losses from the sale or other disposition of property other than stock in trade inventory

Unrelated Debt-Financed Income When a self-directed IRA borrows funds to purchase real estate, it is subject to the rules for UDFI. A percentage of the IRA’s (or other tax-exempt entity’s) UDFI is taxed as UBTI. IRC §514 covers UDFI. It defines debt-financed property as any income- or gain-producing property (other than exempt types) on which there is acquisition indebtedness at any time during the tax year or during the preceding 12 months, if the property is disposed of during the year. It does not include debt-financed property used for certain purposes, such as in the entity’s exempt function or unrelated business. It also does not include income taxable as UBTI.103 The percentage of gross income from the debt-financed property included in UBTI is the same percentage (but not more than 100%) as the average acquisition indebtedness for the tax year is of the average amount of the adjusted basis of the property during the period it is held in the tax year.104 UDFI is represented by the following formula.

Average acquisition indebtedness UDFI = ------ Gross income Average adjusted basis

The average adjusted basis is the average of the adjusted basis of the property on the first and last days of the tax year. The fact that the entity is tax-exempt does not eliminate the requirement that, for purposes of determining average adjusted basis, depreciation adjustments must be made for prior years.105 Example 5. Warren’s self-directed IRA owns an office building that is debt-financed property. The building produced $10,000 of gross rental income in 2016. The average adjusted basis of the building during 2016 was $100,000, and the average acquisition indebtedness for the building was $50,000. Accordingly, the debt/basis percentage was 50% ($50,000 ÷ $100,000). Therefore, the UDFI for the building was $5,000 (50% × $10,000).106

102. IRC §512(b). 103. IRC §514(b)(1). 104. Treas. Reg. §1.514(a)-1(a)(1). 105. Treas. Reg. §1.514(a)-1(a)(2). 106. This example is adapted from IRS Pub. 598, Tax on Unrelated Business Income of Exempt Organizations.

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Acquisition indebtedness is the unpaid amount of any indebtedness:107 • Incurred in acquiring or improving the property; • Incurred before the acquisition or improvement, provided the indebtedness would not have been incurred but 2 for the acquisition or improvement; or • Incurred after the acquisition or improvement, provided:  The indebtedness would not have been incurred but for the acquisition or improvement, and  The incurring of indebtedness was reasonably foreseeable at the time of acquisition or improvement. Extension, renewal, or refinancing of a pre-existing indebtedness is not treated as the creation of a new indebtedness. The same percentage used in computing UDFI is used to determine the percentage of deductions allowed on the property. The percentage is not used, however, for a capital loss deduction resulting from the carryover of unused losses in prior tax years. Debt incurred by qualified retirement plans (but not IRAs) to finance real estate investments, with certain exceptions, is not included in the definition of acquisition indebtedness. Thus, income or gain received from such investments in real property is not debt-financed income and is not subject to the tax on UBTI.108

Compliance and Reporting If an IRA has UBTI, this can create difficulties, such as the following. • The custodian must file a Form 990-T for the IRA. If the custodian refuses to prepare the Form 990-T, the beneficiary must do so. • Any amounts owed on the Form 990-T must be paid with IRA funds and not by the beneficiary.109 • If the IRA invests in an MLP, Forms 990-T must be filed for early years even though MLPs typically have deductions in those years that offset income or create losses. This is necessary to track loss carryforwards in order to offset future income or gain from disposition of the MLP interest. • Late-filed Forms 990-T with a balance due incur normal late filing and payment penalties and interest. Any IRA or qualified plan subject to tax on UBTI is taxed as a trust. UBTI should be reported on Form 990-T if an organization’s gross income from unrelated business is $1,000 or more. The first $1,000 of UBTI is known as the specific deduction and is not subject to tax. The $1,000 deduction is not allowed in calculating the net operating loss (NOL) for purposes both of the NOL deduction and of UBTI. Each separate IRA is treated as a separate taxpayer for purposes of the tax on UBTI and is therefore entitled to its own $1,000 specific deduction.110

Planning Tip. Individuals wanting to invest self-directed IRAs in MLPs or other UBTI-generating activities should evaluate the potential trade-off of avoiding taxation on UBTI against the increased administrative costs from creating separate IRAs for each investment in order to leverage specific deductions.

107. IRC §514(c)(1). 108. IRC §514(c)(9). 109. Ltr. Rul. 8830061 (May 4, 1988). 110. Instructions for Form 990-T.

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Generally, Form 990-T is filed by the 15th day of the fifth month after the end of the tax year. However, an IRA or an employees’ trust must file Form 990-T by the 15th day of the fourth month following the end of its tax year. An exempt corporation may file for an automatic 6-month extension. Extensions are requested by filing Form 8868, Application for Automatic Extension of Time To File an Exempt Organization Return.111

Note. At the time this workbook went to press, Form 990-T was not eligible for electronic filing.

Any tax-exempt organization that expects its tax on UBTI to be $500 or more is required to make estimated tax payments, due by the 15th day of the 4th, 6th, 9th, and 12th months of the organization’s tax year. Form 990-W (Worksheet), Estimated Tax on Unrelated Business Taxable Income for Tax-Exempt Organizations, is used to calculate the estimated tax payments.112

SUMMARY The following is a summary of important points in this section. • Practitioners may not be aware a client has a self-directed IRA invested in a ROBS. • Both the IRS and the DOL have jurisdiction over prohibited transactions but only the DOL can issue PTEs. • Sales of franchises as ROBS are heavily promoted on the Internet but they can lead to individuals unknowingly engaging in prohibited transactions. • The IRS and courts look at the substance of transactions involving self-directed IRAs and are not hesitant to find direct or indirect prohibited transactions. • Lack of guidance from the IRS does not mean that arrangements presently permitted by some self-directed IRA custodians, such as checkbook IRAs, do not constitute prohibited transactions. • The burden of proof is generally on the taxpayer to establish that a prohibited transaction did not occur. • The IRS has information available through Schedules K-1 and Forms 5498 enabling them to identify taxpayers who may have ROBS. There is no guarantee the IRS will not launch an examination program focusing on self-directed IRAs and ROBS. • Self-directed IRAs engaging in a trade or business are taxed on their UBTI in the same manner as trusts. • The definition of trade or business is the same as for other purposes of the Code and include an IRA’s distributive share of trade or business income from a partnership. • UBTI from a partnership is required to be shown on line 20 of the partnership K-1 with a “V” code. However, if there is no entry there, any partnership trade or business income reported on line 1 should be treated as UBTI. • If an IRA investment is financed through borrowing, such as stock purchased on margin, income or gain from the investment that is treated as UDFI is taxed in the same manner as UBTI. • The IRA custodian is responsible for filing Form 990-T and paying any tax due from the IRA’s funds. However, the beneficiary assumes this responsibility if the custodian fails to perform these duties. • IRAs and qualified plans with UBTI are required to file Form 990-T by the 15th day of the fourth month following the end of the tax year, unlike Form 990-T for exempt organizations, which is not due until the 15th day of the fifth month.

111. Ibid. 112. Ibid.

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113 WAIVER OF 60-DAY ROLLOVER PERIOD113

A rollover is a nontaxable distribution from one retirement account to another. Any amount distributed from a 2 qualified retirement plan or an IRA is excluded from income if it is transferred to an eligible plan within 60 days of the date that the taxpayer received the distribution.114 If the taxpayer receives a distribution and does not roll it over, it is generally taxable. In addition, the taxpayer may also be subject to an additional 10% tax unless they qualify for an exception.115 The following chart shows which rollover transactions are allowed between one type of retirement account and another.116

113. Rev. Proc. 2016-47, 2016-37 IRB 346. 114. IRC §§402(c)(3) and 408(d)(3). 115. IRC §72(t); Retirement Topics—Exceptions to Tax on Early Distributions. Jan. 30, 2017. IRS. [www.irs.gov/retirement-plans/plan- participant-employee/retirement-topics-tax-on-early-distributions] Accessed on May 8, 2017. 116. Rollover Chart. IRS. [www.irs.gov/pub/irs-tege/rollover_chart.pdf] Accessed on May 8, 2017.

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WAIVER The IRS can grant a hardship exception to the 60-day rollover requirement when the failure to waive the requirement would be “against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the individual subject to such requirement.”117 To apply for a hardship exception, the taxpayer must request a letter ruling following the procedures established in Rev. Proc. 2003-16. A $10,000 user fee must accompany every request for a letter ruling to waive the 60-day rollover requirement.118 Rev. Proc. 2003-16 also provides for automatic approval of a waiver to the 60-day requirement in certain circumstances in which a rollover is not timely because of an error on the part of a financial institution. No letter ruling request to the IRS is required in this case. Instead, the self-certification procedures described in the next section can be used.

SELF-CERTIFICATION PROCEDURES Under Rev. Proc. 2016-47, effective August 24, 2016, taxpayers can make a written self-certification to a plan administrator or an IRA trustee if they meet the following conditions. 1. The rollover contribution meets all the other requirements for a valid rollover except the 60-day requirement.119 2. The distribution came from an IRA established by the taxpayer or from a retirement plan the taxpayer participated in.120 3. The IRS did not previously deny the taxpayer’s waiver request regarding a rollover of all or part of the distribution to which a contribution relates. 4. The taxpayer was unable to complete a rollover before the 60-day deadline because of one or more of the following reasons. • The financial institution receiving the contribution or making the distribution to which the contribution relates committed an error. • The distribution was made by check, and the taxpayer misplaced or never cashed the check. • The taxpayer deposited the distribution into an account that the taxpayer mistakenly thought was an eligible retirement plan and the distribution remained in that account. • The taxpayer’s principal residence was severely damaged. • A member of the taxpayer’s family died. • The taxpayer or a family member was seriously ill. • The taxpayer was incarcerated. • A foreign country imposed restrictions. • A postal error occurred. • The distribution was made because of a levy to collect prior taxes under IRC §6331 and the levy proceeds were returned to the taxpayer. • The party making the distribution delayed providing information that the receiving plan or IRA required to complete the rollover despite the taxpayer’s reasonable efforts to obtain the information.

117. IRC §§402(c)(3)(B) and 408(d)(3)(I). 118. Retirement Plans FAQs relating to Waivers of the 60-Day Rollover Requirement. Mar. 02, 2017. IRS. [www.irs.gov/retirement-plans/ retirement-plans-faqs-relating-to-waivers-of-the-60-day-rollover-requirement] Accessed on May 09, 2017. 119. Ibid. 120. Ibid.

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5. The taxpayer makes the contribution to the plan or IRA as soon as practicable after the reason(s) listed above no longer prevent the taxpayer from making the contribution. The requirement is deemed satisfied if the taxpayer makes the contribution within 30 days after the reason no longer prevents the taxpayer from making the contribution. 2 There is no IRS fee for using the self-certification procedure.121 EFFECT OF SELF-CERTIFICATION A plan administrator or IRA trustee can rely on a taxpayer’s self-certification in determining whether the taxpayer satisfied the conditions for a waiver of the 60-day rollover requirement. However, the plan administrator or IRA trustee cannot rely on the self-certification for other purposes or if the administrator or trustee has actual knowledge that contradicts the self-certification.122 A taxpayer can report the contribution as a valid rollover unless they are later informed otherwise by the IRS. A self- certification is not a waiver by the IRS of the 60-day requirement. During the course of an examination, the IRS may consider whether the taxpayer meets the requirements for a waiver. In this situation, the taxpayer may be subject to additions to income and penalties.123

MODEL LETTER A taxpayer can make the certification by using the following model letter on a word-for-word basis or by using a substantially similar letter. The taxpayer presents the letter to the financial institution receiving the late rollover contribution.124 The taxpayer should keep a copy of the certification letter and have it available if the IRS requests it.

121. Ibid. 122. Rev. Proc. 2016-47, 2016-37 IRB 346. 123. Ibid. 124. Ibid.

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Certification for Late Rollover Contribution Name Address City, State, ZIP Code Date: ______Plan Administrator/Financial Institution Address City, State, ZIP Code Dear Sir or Madam: Pursuant to Internal Revenue Service Revenue Procedure 2016-47, I certify that my contribution of $ [ENTER AMOUNT] missed the 60-day rollover deadline for the reason(s) listed below under Reasons for Late Contribution. I am making this contribution as soon as practicable after the reason or reasons listed below no longer prevent me from making the contribution. I understand that this certification concerns only the 60-day requirement for a rollover and that, to complete the rollover, I must comply with all other tax law requirements for a valid rollover and with your rollover procedures. Pursuant to Revenue Procedure 2016-47, unless you have actual knowledge to the contrary, you may rely on this certification to show that I have satisfied the conditions for a waiver of the 60-day rollover requirement for the amount identified above. You may not rely on this certification in determining whether the contribution satisfies other requirements for a valid rollover. Reasons for Late Contribution I intended to make the rollover within 60 days after receiving the distribution but was unable to do so for the following reason(s) (check all that apply): ___ An error was committed by the financial institution making the distribution or receiving the contribution. ___ The distribution was in the form of a check and the check was misplaced and never cashed. ___ The distribution was deposited into and remained in an account that I mistakenly thought was ___ a retirement plan or IRA. ___ My principal residence was severely damaged. ___ One of my family members died. ___ I or one of my family members was seriously ill. ___ I was incarcerated. ___ Restrictions were imposed by a foreign country. ___ A postal error occurred. ___ The distribution was made on account of an IRS levy and the proceeds of the levy have been returned ___ to me. ___ The party making the distribution delayed providing information that the receiving plan or IRA required ___ to complete the rollover despite my reasonable efforts to obtain the information. Signature I declare that the representations made in this document are true and that the IRS has not previously denied a request for a waiver of the 60-day rollover requirement with respect to a rollover of all or part of the distribution to which this contribution relates. I understand that in the event I am audited and the IRS does not grant a waiver for this contribution, I may be subject to income and excise taxes, interest, and penalties. If the contribution is made to an IRA, I understand you will be required to report the contribution to the IRS. I also understand that I should retain a copy of this signed certification with my tax records. Signature: ______

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DAILY FANTASY SPORTS

Daily fantasy sports (DFS) played on the Internet are a multi-billion-dollar business in the United States. These 2 activities are contests played over short time periods, such as a single day or week of a season. Contestants who play DFS pay an entry fee that enables them to create virtual teams based on sports figures from actual team rosters. Contestants’ virtual teams compete against other virtual teams based on the statistical performance of the actual sports figures during that day’s games.125 Is it considered gambling to participate in these games? The Unlawful Internet Gambling Enforcement Act of 2006 (UIGEA) prohibits gambling businesses from knowingly accepting payments in connection with the participation of another person in a bet or wager that involves the use of the Internet and that is unlawful under any federal or state law.126 The law specifically excludes fantasy sports that meet certain requirements under which they are allegedly games of skill rather than chance.127 Some sponsors of DFS games allege that this exception means DFS games are legal. However, that is not universally the case. States have authority to decide whether DFS are legal in their jurisdictions. Some states’ attorneys general have declared that DFS games are gambling.128 However, legislative efforts are increasingly underway to legalize DFS.129 Regardless of the legal status, contestants’ winnings from DFS are includable in gross income, the same as any other legal or illegal source of income. However, whether the activity is gambling or a game of skill affects how it is treated for income tax purposes. There is no DFS guidance yet from the IRS. Gambling winnings are reported by the payor to the IRS on Form W-2G, Certain Gambling Winnings. Winnings from games of skill are reported on Form 1099-MISC.130 Gambling (wagering) losses are deductible only to the extent of winnings,131 but losses from games of skill are not limited. In addition, some states do not allow state income tax deductions for gambling losses even to the extent of winnings.132

TREATMENT AS EARNINGS FROM GAMES OF SKILL DFS sponsors report contestants’ winnings in box 3 (“other income”) of Form 1099-MISC. For income tax purposes, winnings are reported as “other income” on line 21 of Form 1040, U.S. Individual Income Tax Return.133 Losses are reported as “other expenses” on line 23 of Schedule A, Itemized Deductions.134 Because losses are miscellaneous itemized deductions, they are deductible only to the extent they exceed 2% of adjusted gross income (AGI).135 Miscellaneous itemized deductions are also an alternative minimum tax (AMT) preference item and, therefore, are not allowable in computing alternative minimum taxable income (AMTI).136 Finally, unless the taxpayer is in the trade or business of engaging in DFS, expenses are deductible only to the extent of gross income from the activity.137

125. Daily Fantasy Sports Business Gets a Dose of Reality. Woodward, Curt. Jan. 6, 2017. Boston Globe. [www.bostonglobe.com/business/2017/ 01/06/daily-fantasy-sports-business-gets-dose-reality/8ShpChIgaD2S8UKguJbdQP/story.html] Accessed on Mar. 17, 2017. 126. Unlawful Internet Gambling Enforcement Act of 2006 Overview. FDIC. [www.fdic.gov/news/news/financial/2010/fil10035a.pdf] Accessed on Feb. 10, 2017. 127. 31 USC §5362(1)(E)(ix). 128. Legislative Tracker: Daily Fantasy Sports, Sports Betting. Legal Sports Report.com. [www.legalsportsreport.com/dfs-bill-tracker] Accessed on Feb. 23, 2017. 129. Ibid. 130. Ltr. Rul. 200532025 (May 3, 2005); Instructions for Form 1099-MISC. 131. IRC §165(d). 132. Additions/Subtractions. Illinois Department of Revenue. [www.revenue.state.il.us/Individuals/Credits/AdditionsSubtractions.htm] Accessed on Feb. 10, 2017. 133. IRS Pub. 525, Taxable and Nontaxable Income. 134. Temp. Treas. Reg. §1.67-1T(a)(1)(iv). 135. IRC §67(a). 136. IRC §56(b)(1)(A)(i). 137. See IRC §183(b)(2), if considered an activity not engaged in for profit; IRC §165(d), if considered gambling.

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In some cases, the practical result of the deductibility limitations applicable to DFS may be full inclusion of winnings in gross income. • A taxpayer who does not itemize deductions reports all winnings on line 21 but cannot deduct expenses, which requires a Schedule A. • A taxpayer who itemizes deductions can deduct DFS expenses on Schedule A. However, if DFS are not treated as gambling, then deductions are only allowed to the extent that all miscellaneous itemized deductions exceed 2% of AGI. Because this is also an AMT preference item, the taxpayer may pay AMT.

TREATMENT AS GAMBLING WINNINGS Gambling winnings are reported on line 21 of Form 1040 as “other income,” but losses from recreational gambling are reported on line 28 of Schedule A as “other miscellaneous deductions.” Losses are not subject to the 2%-of- AGI limitation and are not preferences in determining AMTI. However, they are deductible only to the extent of gambling winnings.138 Even for professional gamblers, losses are deductible only to the extent of winnings.139 Because professional gamblers report gambling activities on Schedule C, Profit or Loss From Business, all expenses (other than wagers) related to the activity are deductible in determining AGI, not just their wagers. This can actually create a loss from the gambling activity because only the wager portion is subject to the winnings limitation. In determining whether a gambler is a professional engaged in a trade or business, courts hold taxpayers to a much higher standard than is the case for nongambling trades or businesses. The following are some principles derived from cases that have dealt with the issue. • To rise to the level of professional gambling, the gambling activity should be the taxpayer’s full-time occupation. If the taxpayer has another occupation, gambling is generally not seen as being full-time unless the other occupation is part-time and the amount of time devoted to gambling is significantly more than that devoted to the other occupation.140 • If the taxpayer has significant income from sources other than gambling, courts view the taxpayer as not earning a livelihood from gambling. Because most gambling cases involve losses in excess of winnings, it is difficult for a taxpayer to win on this point. The courts look to the taxpayer’s genuine desire for profit, even if this is unreasonable. Nongambling sources of income should be minimal for the taxpayer to be considered a professional gambler.141 • Frequency and regularity of gambling activities are important. Taxpayers who gamble occasionally, even if they do so frequently, are not engaged in the activity with the requisite regularity to be considered professional gamblers.142 • Courts often apply hobby loss factors under IRC §183 in determining whether a taxpayer is in the trade or business of gambling. The court’s analysis includes such factors as adequacy of recordkeeping, whether the taxpayer has conducted proper research into the gambling activity, whether the taxpayer sought professional advice from others, etc.143

138. IRC §165(d). 139. See, e.g., Boyd v. U.S., 762 F.2d 1369 (9th Cir. 1985). 140. See, e.g, Moore v. Comm’r, TC Memo 2011-173 (Jul. 18, 2011). 141. Ibid. 142. See, e.g, Free-Pacheco v. U.S., 117 Fed. Cl. 228 (2014). 143. See Treas. Reg. §1.183-2(b); see also Merkin v. Comm’r, TC Memo 2008-146 (Jun. 5, 2008).

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Whereas gambling usually occurs at a casino or other physical location, DFS activities exclusively occur online. A commonly cited factor in denying gamblers professional status is their lack of credible evidence supporting the time spent on gambling versus nongambling income-producing activities. Gamblers who play at casinos may have the benefit of a player’s card that automatically records time spent gambling. DFS contestants spend more time analyzing 2 players they will pick for their teams than actually interacting with the DFS provider. Unless a player maintains credible contemporaneous documentation of all the time spent on DFS activities, it is unlikely the contestant will succeed in convincing the IRS or Tax Court they have spent enough time to consider the DFS activities a trade or business. Consequently, qualifying as a professional DFS contestant is very difficult to prove.

SUMMARY Following is a summary of important points in this section. • All normal tax rules apply to individuals who engage in Internet transactions. • Receipts from web-based sources are generally includable in gross income unless they are clearly a gift. • Charitable contributions made through crowdfunding sites that are not §501(c)(3) exempt organizations are subject to the same substantiation requirements as those that are. • Documentation for contributions of $250 or more must be obtained directly from the charity no later than the date a return is filed. A website receipt is not sufficient for this purpose. • Charitable contribution deductions are available only for contributions to qualified charitable organizations, not to individuals. • Crowdfunding receipts in exchange for anything of value are likely to be trade or business income subject to SE tax. • Regular sales on eBay may also be treated as trade or business income subject to SE tax. • Airbnb hosts who provide guest amenities not necessary for occupancy of the rented space — such as breakfasts or free guest use of swimming pools, Jacuzzis, or bicycles — may be providing significant services resulting in rent being treated as SE income. • An IRS CP2000 notice, based on Form 1099-K, may be the first indication that a client is engaged in Internet transactions. • A person who organizes crowdfunding campaigns on behalf of someone else and who wishes to avoid possible receipt of a Form 1099-K should provide to the PSE the name and taxpayer identification number of the beneficiary of the campaign.

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LEGAL FEES

A taxpayer can generally deduct the following types of legal expenses.144 • Those that are incurred in attempting to produce or collect taxable income145 • Fees paid in connection with the determination, collection, or refund of any tax (This includes expenses paid for tax counsel, tax preparation, or tax proceedings.146) • Fees related to either doing or keeping the taxpayer’s job (e.g., fees to defend against criminal charges arising out of the taxpayer’s trade or business) •Fees for tax advice related to a divorce if the bill specifies how much is for tax advice and it is determined in a reasonable manner147 • Fees paid to collect taxable alimony148 The taxpayer can deduct expenses of resolving tax issues related to business profit or loss (on Schedule C, Profit or Loss From Business), rentals or royalties (on Schedule E, Supplemental Income and Loss), or farm income and expenses (on Schedule F, Profit or Loss From Farming). The taxpayer can deduct expenses of resolving nonbusiness tax issues on Schedule A, Itemized Deductions, as a miscellaneous itemized deduction subject to the 2%-of-AGI threshold.149 Amounts received from litigation attributable to personal physical injuries or physical sickness are generally nontaxable.150 Legal fees relating to this nontaxable income are not deductible. Amounts received from lawsuits attributable to claims other than personal physical injuries and physical sickness are taxable income.151 The attorney fees incurred are generally a miscellaneous itemized deduction. Miscellaneous itemized deductions subject to the 2%- of-AGI threshold are not allowed for purposes of AMT.

UNLAWFUL DISCRIMINATION A taxpayer may be able to deduct attorney fees and court costs as an adjustment to income, instead of as a miscellaneous itemized deduction. Such treatment applies to actions settled or decided after October 22, 2004, involving the following types of claims, which are specified in IRC §62(a)(20).152 • Claims of unlawful discrimination (A detailed listing of what constitutes a “claim of unlawful discrimination” is found in IRC §62(e).) • Claims against the U.S. government • Claims made under section 1862(b)(3)(A) of the Social Security Act

144. IRS Pub. 529, Miscellaneous Deductions. 145. Treas. Reg. §1.212-1(a). 146. Treas. Reg. §1.212-1(l). 147. Ibid. 148. Treas. Reg. §1.262-1(b)(7). 149. Treas. Reg. §1.212-1; IRS Pub. 529, Miscellaneous Deductions. 150. IRC §104. 151. Comm’r v. John W. Banks II, 543 U.S. 426 (2005). 152. IRC §62(a)(20); IRS Pub. 529, Miscellaneous Deductions.

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The taxpayer includes the amount of such claims on line 36 of Form 1040. On the dotted line next to line 36, the amount of the deduction should be entered and identified as “UDC.”153 The following rules apply.154 • The deduction is limited to the amount of the judgment or settlement included in the taxpayer’s income for the 2 tax year. • The attorney fees and court costs must be paid by the taxpayer or on the taxpayer’s behalf in connection with the claim. • The judgment or settlement must occur after October 22, 2004. The proceeds from the settlement should generally be entered on Form 1040, line 21 (“other income”). However, if the taxpayer receives a settlement in an employment-related lawsuit (e.g., for unlawful discrimination or involuntary termination), the portion of the proceeds that relate to lost wages should be reported on line 7 (“wages, salaries, tips, etc.”).155 This portion of the proceeds is subject to social security and Medicare taxation.156 Example 6. Kathleen filed a lawsuit against Shears, Inc., alleging employment discrimination on the basis of her age and gender. In 2016, Kathleen and Shears entered into a settlement agreement under which Shears agreed to pay Kathleen $262,500, of which $12,500 was for lost wages. Kathleen paid a total of $152,000 in attorney’s fees and court costs in 2016.157 Kathleen reports the settlement of the lawsuit on her Form 1040 as follows. • The wages of $12,500 is reported on line 7. • The $250,000 balance of the settlement proceeds is reported on line 21. • The attorney’s fees and court costs of $152,000 are deducted on line 36, with “UDC” entered on the dotted line.

Contingent Fees The Supreme Court’s decision in Comm’r v. John W. Banks II 158 settled the issue of whether contingent attorney fees are includable in the gross income of successful litigants. The Supreme Court held that they are. After full inclusion in AGI, the attorney fees are generally deductible on Schedule A as a miscellaneous itemized deduction subject to the 2%-of-AGI limitation.159 This rule can result in AMT liability for the recipient in the year any large taxable damage award is received. This is because miscellaneous itemized deductions are not allowed for AMT purposes.160 An exception to the general rule was created by a provision of the American Jobs Creation Act of 2004. As mentioned earlier, an adjustment in arriving at AGI is allowed for legal fees paid in connection with claims specified in IRC §62(a)(20).

153. Instructions to Form 1040. 154. IRC §62(a)(20); IRS Pub. 525, Taxable and Nontaxable Income. 155. IRS Pub. 4345, Settlements—Taxability. 156. Ibid. 157. Based on Simpson v. Comm’r, 141 TC No. 10 (2013); IRC §62(a)(20). 158. Comm’r v. John W. Banks II, 543 U.S. 426 (2005). 159. Treas. Reg. §1.212-1; IRS Pub. 529, Miscellaneous Deductions. 160. IRC §56(b)(1)(A)(i).

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Example 7. Mistie, who is physically handicapped, sued her former employer for unlawful discrimination. Her lawsuit claimed that her dismissal was illegal under a provision of the Americans with Disabilities Act of 1990. The terms of her contingent fee agreement with her attorney provided that she was entitled to keep 70% of any eventual court judgment. Her attorney would retain 30% of the award as payment for his legal services. The suit began in 2014, and an out-of-court settlement with the former employer was finalized in 2016. Mistie’s former employer agreed to pay $200,000 of back wages to settle the lawsuit. A 2016 Form W-2, Wage and Tax Statement, was issued to Mistie for the $200,000. Mistie paid no out-of-pocket legal expenses prior to the settlement. Mistie reported the $200,000 of back wages on line 7 on her 2016 Form 1040. She deducted the contingent attorney fee of $60,000 ($200,000 × 30%) on line 36 of Form 1040 with “UDC” written on the dotted line next to line 36. Example 8. Use the same facts as Example 7, except that Mistie’s lawsuit involved alleged securities fraud by her former broker instead of a claim of unlawful discrimination. Any contingent attorney fees she pays for a settlement of that lawsuit are deductible only as a miscellaneous itemized deduction on Schedule A. Mistie may have a 2016 AMT liability due to the AMT adjustment for miscellaneous itemized deductions.

WHISTLEBLOWER CLAIMS The Tax Relief and Health Care Act of 2006 created IRC §62(a)(21), which provides an above-the-line deduction for attorney fees and court costs associated with suits involving whistleblower claims. The attorney fees or court costs must have been paid in connection with a whistleblower award for providing information regarding violations of tax laws. In addition, the information must have been provided on or after December 20, 2006. As is the case for claims of unlawful discrimination, the deduction is limited to the amount includable in the taxpayer’s gross income for the tax year in which the deduction is claimed.161

161. IRC §62(a)(21); Lawsuits, Awards, and Settlements Audit Techniques Guide. May 2011. IRS. [www.irs.gov/pub/irs-utl/ lawsuitesawardssettlements.pdf] Accessed on May 8, 2017.

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Defining Business Income...... B119 Health Flexible Spending Arrangement...... B147 Trade or Business Income Health Reimbursement Arrangements...... B148 vs. Not-for-Profit Income ...... B119 Health Savings Account ...... B150 3 Individual vs. Entity Income Bonus Depreciation ...... B154 Subject to FICA and SECA...... B126 Bonus Depreciation on Plants...... B155 FICA and SECA ...... B126 Sale of Business Assets...... B156 Assignment of Income ...... B129 IRC §1231 Property...... B156 Industry-Specific Businesses ...... B130 IRC §1245 Property...... B159 Investor vs. Trader ...... B130 IRC §1250 Property...... B159 Landlord vs. Real Estate Professional ...... B139 Correcting Depreciation Errors...... B159 Small Business Stock ...... B141 Adoption of an Accounting Method...... B159 IRC §1202 Qualified Small Business Stock B141 Change in Accounting Method...... B160 IRC §1244 Losses on Small Business Stock B144 Making the Correction...... B161 Small Business Deductions for FSAs, HRAs, and HSAs ...... B146 Sale of Asset Acquired in Like-Kind Exchange ..B163 Cafeteria Plans ...... B146

About the Authors Marc C. Lovell, JD, LLM, MS, headed a private law practice from 2001 through 2010 with principal practice areas in federal, state, local and international taxation and tax litigation. He served as Assistant Director, Tax Education and Outreach of the University of Illinois Tax School program from 2011 to 2016. Marc is presently Director, Tax Department, High Net Worth Private Client Services for CBIZ Tofias in their Boston, Massachusetts office. Marc obtained his JD and LLM from Wayne State University Law School, and his MS in Library and Information Science from the University of Illinois. Kelly Wingard is a freelance writer and 35-year veteran tax practitioner with Kates Tax Service in Decatur, IL. Kelly graduated from Greenville College and has nearly completed a Legal Studies Master’s degree at the University of Illinois Springfield. Kelly interned with the Illinois Senate, where she analyzed legislation for the revenue committee. One of her proudest accomplishments is spearheading a bill to allow Illinois unemployment recipients to voluntarily elect to have state withholding from their benefit checks. It passed unanimously.

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Chapter Summary

There are important distinctions between trade or business income and not-for-profit income. Trade or business income is reported on Schedule C along with associated business expenses and the resulting net income or loss is a component of the taxpayer’s taxable income and self-employment (SE) income. Not-for- profit income is reported on Form 1040, line 21 (other income), and expenses are deducted on Schedule A. Not-for-profit income is not subject to SE tax. The factors used to distinguish between these income types are described. The income and employment tax treatment of sole proprietorships, partnerships, S corporations, and C corporations are described. S corporations offer opportunities to save SE tax on shareholders’ distributive income but the transfer of income between taxpayers, particularly for employment tax savings, can be impeded by the assignment of income doctrine. Securities investors and traders are compared. Absent a “mark-to-market” (MTM) election, both types of taxpayers report trading income on Schedule D and Form 8949. However, whereas investors claim investment-related expenses on Schedule A, traders deduct trading expenses on Schedule C and may also qualify for office in the home deductions. Investment interest deductions, capital loss rules, and MTM transactions are also addressed. Landlords and real estate professionals both derive income from real estate rentals and are subject to ordinary income tax but not SE tax. Losses of real estate professionals are usually fully deductible, but the passive activity rules may restrict deductible losses for landlords. Two Code sections provide tax incentives to small business investors. IRC §1202 allows noncorporate taxpayers to exclude a substantial portion of gain from the sale or exchange of qualified small business stock (QSBS). IRC §1244 allows eligible taxpayers disposing of QSBS to reduce ordinary income by up to $50,000 ($100,000 if MFJ) of QSBS losses. Small business taxpayers utilizing a qualifying medical expense reimbursement plan (i.e., HSA, FSA, or HRA) enjoy significant tax benefits. FSAs are particularly advantageous because pre-tax employee contributions are not subject to employer FICA withholding and are exempt from income and FICA taxes for the employee. The 2015 PATH Act extended bonus depreciation for eligible property acquired and placed in service before January 1, 2020. The PATH Act also added two new eligible property classes (qualified improvement property and preproduction costs of fruit and nut-bearing plants). Business property dispositions are subject to loss recapture rules. A net §1231 gain is recharacterized as ordinary income to the extent of the §1231 losses within the preceding five years. IRC §1245 gain is recaptured as ordinary income, to the extent of depreciation previously taken on the asset. For IRC §1250 property, gain is recaptured as ordinary income to the extent that the depreciation previously claimed exceeded straight-line depreciation. Taxpayers may file either a Form 3115 or an amended return to correct erroneous depreciation deductions in certain situations. Depending on the circumstances, there are automatic and advance consent procedures. No gain or loss is recognized under the like-kind exchange (LKE) rules, if qualified business or investment property is exchanged for other like-kind property in a qualifying transaction. However, certain adjustments may be required to the basis of the acquired property.

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DEFINING BUSINESS INCOME

Note. This chapter discusses trade or business income as reported on Schedule C. Trade or business income may also be reported on Schedule E, Schedule F, or as pass-through income from a partnership or S corporation.

What constitutes trade or business income? Understanding the answer to this question is key to determining the following. 3 • Whether expenses can be directly or indirectly deducted from income • Whether expenses in excess of income from an activity can create an ordinary business loss • Whether the resulting income is subject to self-employment (SE) tax in addition to income tax • Whether the income qualifies for purposes of the earned income credit

Caution. There are a number of nontax consequences to classifying an activity as a business or as a not-for- profit activity. For example, the classification can affect borrowing ability and social security benefits.

Business income generally arises from two types of transactions. 1. Nonemployee income generated from fee-based services 2. Product sales Although this seems to narrow the question of whether income is business-related, the Code is not that straightforward. • If someone drives their neighbor 150 miles to and from the airport and their neighbor pays them $100 for their services, do they have a driving business? • If someone gets paid by the state to babysit full time for their grandchildren, do they have a babysitting business? • If someone makes and sells crafts for pleasure with no expectation of profit, do they have a craft business? The answers to these questions are “probably not,” although each scenario would be subject to facts-and- circumstances testing to fully determine whether the activity actually constitutes a trade or business.

TRADE OR BUSINESS INCOME VS. NOT-FOR-PROFIT INCOME

Note. For comprehensive coverage of hobby vs. for-profit activities, see the 2013 University of Illinois Federal Tax Workbook, Volume C, Chapter 3: Hobby Losses. This can be found at uofi.tax/arc [taxschool.illinois.edu/taxbookarchive].

Nonemployee income related to the sale of products or services is classified as either trade or business income or not- for-profit income.

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As shown in the following table, ordinary and necessary business expenses reduce trade or business income before income and SE taxes are imposed.1 Not-for-profit income can be offset only up to the amount of income from the activity and only if the taxpayer can itemize deductions. Not-for-profit income is taxed at the taxpayer’s ordinary income tax rate. SE tax does not apply. 2 3 4 5 6

Trade or Business Income Not-for-Profit Income Cost of goods sold Directly deducted Reduces gross receipts Deduction for expenses Directly deducted Indirectly deducted, but only if the taxpayer can itemize 2 Expenses in excess of income Loss allowed 3 No loss allowed 4 Subject to SE tax Yes 5 No 6 Where reported on Form 1040 Schedule C or F Line 21 (other income)

Simply receiving money from selling products or services is not a firm indication that a taxpayer is engaged in a trade or business. In 1940, the Supreme Court decision in Deputy v. du Pont determined that “carrying on any trade or business . . . involves holding one’s self out to others as engaged in the selling of goods or services.”7 Taxpayers must openly represent themselves to potential customers as being “in” business.

Continuity and Regularity Rev. Rul. 58-112 stipulates two factors that should be considered “in conjunction with other existent facts” when determining whether income arises from a trade or business.8 Both of these factors must be present for an activity to be considered a trade or business. 1. Continuity and regularity of activities, as distinguished from an occasional or sporadic activity. 2. The purpose of livelihood or profit from the activity In this ruling, the IRS determined that income a taxpayer received in four payments from facilitating the sale of his company’s stock to a corporation was not trade or business income because the taxpayer engaged in this transaction only one time. Rev. Rul. 55-4319 states that a person regularly engaged in a nonemployee occupation or profession is considered to be engaged in a trade or business. In this ruling, the IRS found that a person who accepts payment for “occasional” speaking engagements is not engaged in a trade or business. This regularity requirement is also in Rev. Rul. 77–35610 as it applies to speechmaking. In 1977, a member of Congress requested a ruling on whether he was subject to SE tax on $1,500 he received from 10 speaking engagements during the tax year. The Congress member received frequent invitations to speak but accepted only a limited number of engagements based on his availability.

1. IRC §162. 2. IRS Pub. 535, Business Expenses. 3. Ibid. 4. IRC §183(b)(2). 5. IRC §1402. 6. Rev. Rul. 55-258, 1955-1 CB 433. 7. Deputy et al. v. du Pont, 308 U.S. 488 (1940), Frankfurter, J., concurring. 8. Rev. Rul. 58-112, 1958-1 CB 323. 9. Rev. Rul. 55-431, 1955-2 CB 312. 10. Rev. Rul. 77-356, 1977-2 CB 317.

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The IRS determined the Congress member was engaged in a separate trade or business apart from his Congressional employment and that the income from speechmaking was subject to SE tax. The ruling stated “[t]he frequency of the speaking engagements indicates a degree of recurrence, continuity, and availability for speech making, and the amount received during the year was compensatory.” There is no definitive test to determine the degree of continuity and regularity required to be considered a trade or business. Each case is evaluated on its own unique set of facts and circumstances.11 3 Note. The 2-factor test of Rev. Rul. 58-112 was affirmed by the U.S. Supreme Court in the landmark case, Comm’r v. Groetzinger.11

Good-Faith Profit Motive The IRS clarifies that taxpayers must display a “good faith” profit motive for an activity to rise to the level of a trade or business. It is important to note that the IRS does not stipulate an activity must make a profit, only that the taxpayer intends to go into business to make a profit. If an endeavor is unprofitable, the IRS expects the taxpayer “to make ongoing efforts” to make the activity profitable.12 Treas. Reg. §1.183-2(b) provides a list of nine relevant factors that normally may be used to assess a taxpayer’s profit motive. This list is not considered exhaustive, and the regulation cautions that no single factor determines a profit motive. These rules are often referred to as the “hobby vs. business” rules. The regulation further states that profit motive should not be presumed or discarded based simply on the number of factors for or against a profit motive. The courts accord more weight to objective facts than to the taxpayer’s statement of intent.13 Factors Used to Determine Profit Motive. All facts and circumstances regarding an activity should be taken into account to determine profit motive, including, but not limited to, the following factors.14 1. The manner in which the taxpayer carries on the activity — If the taxpayer carries on the activity in a businesslike manner and maintains complete and accurate books and records, this may indicate the taxpayer has a profit motive. A change of operating methods, adoption of new technologies, or abandonment of unprofitable methods may also indicate a profit motive. 2. The expertise of the taxpayer and the taxpayer’s advisors — Preparation for the activity by studying its accepted business, economic, and scientific practices may indicate the taxpayer has a profit motive. If a taxpayer has such preparation or obtains expert advice but does not carry on the activity in accordance with such practices, a lack of intent to derive profit may be indicated. 3. The time and effort the taxpayer expends in carrying on the activity — The fact that the taxpayer devotes much of their personal time and effort to carrying on an activity, particularly if the activity does not have substantial personal or recreational aspects, may indicate an intention to derive a profit. A taxpayer’s withdrawal from another occupation to devote most of their energies to the activity may also be evidence that the activity is engaged in for profit. 4. The taxpayer’s expectation that assets used in the business may appreciate in value — The taxpayer may intend to derive a profit from the operation of the activity if an overall profit will result when appreciation in the value of assets used in the activity is realized.

11. Comm’r v. Groetzinger, 480 U.S. 23 (1987); see also Batok v. Comm’r, TC Memo 1992-727 (Dec. 28, 1992). 12. Business Activities. Jan. 5, 2017. IRS. [irs.gov/businesses/small-businesses-self-employed/business-activities] Accessed on May 6, 2017. 13. See e.g., Dreicer v. Comm’r, 78 TC 642 (1982). 14. Treas. Reg. §1.183-2(b).

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5. The taxpayer’s record of prior business successes or failures — The fact that the taxpayer has engaged in similar activities in the past and converted them from unprofitable to profitable enterprises may indicate that the taxpayer is engaged in the present activity for profit. 6. The taxpayer’s history of income and losses from the particular activity — If losses are sustained because of unforeseen or fortuitous circumstances that are beyond the control of the taxpayer, such losses would not be an indication that the activity is not engaged in for profit. A series of years in which net income was realized is strong evidence that the activity is engaged in for profit. 7. The amount of occasional profits, if any, that are earned — The amount of profits in relation to the amount of losses incurred, and in relation to the amount of the taxpayer’s investment and the value of the assets used in the activity, may provide useful criteria in determining the taxpayer’s intent. 8. The taxpayer’s financial status aside from the activity — The fact that the taxpayer does not have substantial income or capital from sources other than the activity may indicate that an activity is engaged in for profit. Substantial income from sources other than the activity (particularly if the losses from the activity generate substantial tax benefits) may indicate that the activity is not engaged in for profit. 9. The amount of personal pleasure or recreational value the taxpayer receives from the activity — The presence of personal motives in carrying on an activity may indicate that the activity is not engaged in for profit, especially when there are recreational or personal elements involved. An activity is not treated as not engaged in for profit merely because the taxpayer has purposes or motivations other than solely to make a profit. Also, the fact that the taxpayer derives personal pleasure from engaging in the activity is not sufficient to cause the activity to be classified as not engaged in for profit. Presumption of Profit. Under IRC §183, a taxpayer is presumed to have a profit motive if the taxpayer’s income from an activity exceeds expenses for the activity in three out of five of the previous consecutive tax years.15 Taxpayers engaged in breeding, training, showing, or racing horses are presumed to have a profit motive if they show a profit in two out of seven consecutive tax years.16 The profit presumption is a semi-safe harbor for taxpayers. The IRS can still argue against the taxpayer’s profit motive, but the burden of proof shifts from the taxpayer to the IRS if the taxpayer satisfies the presumption test.17 To postpone an IRS decision on whether an activity is engaged in for profit, taxpayers may elect to file Form 5213, Election to Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit. If the taxpayer timely files this form, the IRS generally postpones the determination until after the end of the fourth tax year (or sixth tax year for a horse activity). To make the election, the taxpayer must file this form within three years after the due date (excluding extensions) of their return for the first tax year in which they engaged in the activity, or within 60 days after receiving a notice that the IRS proposes to disallow deductions attributable to the activity.18

Trade or Business Income and Expense Reporting A sole proprietor reports trade or business income on Schedule C, Profit or Loss From Business. Ordinary and necessary business expenses can be deducted from trade or business income. The resulting net income or loss is factored into the taxpayer’s taxable income and used as the starting point for computing SE tax. Ordinary and necessary business expenses include noncapital expenses that are appropriate and useful to carrying on the business.19

15. IRC §183(d). 16. Ibid. 17. IRC §183: Activities Not Engaged in For Profit (ATG). Jun. 2009. IRS. [irs.gov/pub/irs-utl/irc183activitiesnotengagedin for profit.pdf] Accessed on May 25, 2017. 18. Instructions for Form 5213. 19. Welch v. Helvering, 290 U.S. 111 (1933).

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SE Tax Rates. For sole proprietors, net SE income from Schedule C is reported on Schedule SE, Self-Employment Tax. A 15.3% SE tax is imposed on 92.35% of net SE income, if net SE income is $400 or more.

Note. For more information on SE tax, see the discussion on SECA tax in the “Individual vs. Entity Income Subject to FICA and SECA” section of this chapter.

Example 1. Mary’s net 2017 income from her dog grooming business was $10,000. She had no other income 3 subject to SE tax. Mary’s 2017 SE tax is computed as follows.

Net profit from Schedule C $10,000 Multiply net profit by 92.35% × 92.35% Amount subject to SE tax $ 9,235 Multiplied by 15.3% SE tax rate × 15.3% SE tax $ 1,413

Not-for-Profit Income and Expense Reporting If it is determined that an activity is not engaged in for profit, gross income (net of cost of goods sold) from the activity is reported on Form 1040, line 21 (other income), and expenses are deducted on Schedule A, Itemized Deductions. Gross Income Defined. Gross income for an activity not engaged in for profit equals gross receipts less the cost of goods sold, as long as this practice is consistently followed and conforms to generally accepted acounting methods.20 Treas. Reg. §1.183-1(e) defines not-for-profit gross income as including the total of all gains from the sale, exchange, or other disposition of property, and all other gross receipts derived from such activity. This generally includes capital gains and rents received for the use of property held in connection with the not-for-profit activity. Expense Categorization. Treas. Reg. §1.183-1(b) stipulates three ordered categories of deductions for expenses related to not-for-profit activities. All three categories of expenses are deductible on the taxpayer’s Schedule A in the following order. • Tier 1. These are expenses that would otherwise be deductible under other sections of the Code, including mortgage interest, real estate taxes, contributions, and casualty and theft losses. These expenses are included in their respective sections of Schedule A. • Tier 2. These are expenses that would be deductible if the activity were engaged in for profit, such as rent, labor costs, and mileage. These expenses are limited to the activity’s income minus any expenses related to the activity that are deducted in Tier 1. These expenses are deducted as miscellaneous itemized deductions only to the extent the taxpayer’s total miscellaneous itemized deductions exceed 2% of adjusted gross income (AGI). • Tier 3. These are expenses related to basis adjustments, such as depreciation, amortization, partially worthless debts, and casualty loss deductions disallowed in Tier 1. These expenses are allowed only to the extent that the activity’s income exceeds Tier 1 and Tier 2 expenses. Tier 3 allowable expenses are deducted as miscellaneous itemized deductions subject to the 2% of AGI limitation. The regulations provide a method for allocating basis adjustments if the deductions in Tier 3 are limited by income from the activity.21 Comprehensive examples are included in Treas. Reg. §1.183-1.

20. Treas. Reg. §1.183-1(e). 21. Treas. Reg. §1.183-1(b)(2)-(3).

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These limitations on how a not-for-profit activity’s expenses are deducted and the classification of an activity as not-for- profit impact a number of other tax provisions. The following table summarizes the most significant considerations.

Trade or Business Not Engaged in for Profit Payment of SE tax on profit Yes No SE health insurance deduction Yes No Income qualifies for contribution to retirement plans Yes No Standard mileage rate for vehicle expenses allowed Yes No Expenses lower AGI Yes No a Expenses deductible for AMT purposes Yes No Expenses deductible for state income tax purposes Yes Varies by state Expenses in excess of income deductible Yes No Losses on activity can create net operating losses Yes No

a AGI affects a number of other factors, including taxation of social security benefits, the deduction for IRA contributions, the deduction for student loan interest, itemized deductions subject to AGI floors, etc.

The following examples illustrate how classifying an activity as a trade or business can reduce a taxpayer’s tax burden despite the related SE taxes. Example 2. Marlene and Donna are identical twin sisters who each provide babysitting services on an ongoing basis. Marlene intends to use her babysitting business to supplement her other income. She spends a great deal of time promoting her services. Donna, known to all as Mama D, has a dozen grandchildren and babysits exclusively for family members, who pay her nominally to cover her expenses. Both sisters’ babysitting services meet the test of being more than occasional or sporadic activities. However, only Marlene intends to generate a profit. Mama D’s primary intent is to be with her grandchildren. Accordingly, Marlene’s babysitting service qualifies as a trade or business and Mama D’s does not. In 2016, Marlene and Mama D have identical income and expenses, as shown in the following table.

Income $5,000 Expenses Tax preparation fees for business 100 Supplies (diapers, wipes, paper towels, etc.) 200 Meals provided 700 Home office expenses 1,000 Total expenses $2,000

Both sisters have $25,000 in taxable income from other sources. Their 2016 babysitting income is subject to 15% federal income tax and 3.75% Illinois income tax. Marlene’s babysitting services represent trade or business income, so she reports $5,000 in gross receipts on her Schedule C. Her babysitting income counts toward her social security earnings. Her $3,000 ($5,000 – $2,000) net business income is transferred to Schedule SE, and she is subject to $424 of self-employment tax ($3,000 × 92.35% × 15.3%). As shown later, Marlene’s total tax liability from her babysitting business is $947. Because Mama D babysits solely for her grandchildren and for nominal fees, her babysitting services are deemed to be a not-for-profit activity. Therefore, Mama D reports her $5,000 gross income from babysitting on her Form 1040, line 21. She is not subject to SE tax on her earnings, and consequently, her babysitting income does not count toward her social security earnings. Mama D must report her babysitting expenses on Schedule A. Unfortunately for Mama D, her itemized deductions are less than the $6,300 standard deduction.

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A summary comparing Marlene and Mama D’s income, expenses, and taxes follows. Despite the differences in how their income and expenses were reported, the net tax result is nearly identical.

Marlene Mama D Gross income from daycare $5,000 $5,000 Allowable deductions (2,000) (0) Deduction for half of SE tax (212) 3 Net taxable income $2,788 $5,000

Net SE tax $ 424 $ 0 Federal income tax on babysitting income at 15% 418 750 Illinois income tax on babysitting income at 3.75% 105 188 Total tax paid $ 947 $ 938

Percentage of tax paid on $3,000 (actual net profit) 31.6% 31.3%

Example 3. Use the same facts as Example 2, except Marlene and Mama D each paid $2,900 in out-of-pocket medical insurance premiums. Marlene is allowed to deduct the cost of her health insurance premiums as an adjustment to income on page 1 of her Form 1040. The deduction is limited to the amount of her net income from her babysitting business, less the deduction for half of her SE tax and any SE retirement plan contributions.22 Marlene’s net daycare income is $3,000. She is allowed a $212 deduction for half of her SE tax ($424 ÷ 2). She did not make any retirement plan contributions. This brings her allowable self-employed health insurance deduction to $2,788 ($3,000 – $212). Marlene claims this $2,788 deduction on Form 1040, line 29, as an adjustment to gross income. Therefore, it lowers her federal and Illinois income taxes by $523 (($2,788 × 15%) + ($2,788 × 3.75%)). It does not affect Marlene’s SE tax. The SE health insurance deduction lowers Marlene’s total tax liability on $3,000 of net babysitting income to $424 ($947 – $523). This is 14.1% ($424 ÷ $3,000) of her net daycare income. Mama D realizes no tax benefit from her medical premiums expense. She would claim her health insurance premiums as an itemized deduction, subject to reduction of 10% of her AGI. Mama D’s 2016 AGI is $30,000, so she would reduce her allowable medical deduction by $3,000 ($30,000 × 10%). She has no other medical expenses, so none of her medical premiums exceed the $3,000 threshold.

Marlene’s tax on her for-profit activity was $424, compared to Mama D’s $938 tax on the same income from her not-for-profit activity. Marlene accrues social security benefits on her net income, while Mama D does not.

Observation. The outcomes in Example 2 and Example 3 would be much different if the taxpayers did not have any significant expenses related to the income. Without deductible expenses, it may be more beneficial for an activity to be classified as a not-for-profit endeavor despite the various limitations.

Caution. The determination of whether an activity is a trade or business must be based on the facts of the situation, not the desired tax result. Very often, the most significant factor is the continuity and regularity of the taxpayer’s involvement in the activity. If the taxpayer’s involvement is not continuous and regular, the existence of an intent to generate a profit is irrelevant. Because this factor can vary from year to year, tax practitioners should evaluate this issue annually.

22. IRC 162(l)(2).

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INDIVIDUAL VS. ENTITY INCOME SUBJECT TO FICA AND SECA

A trade or business activity can be conducted as one of the following tax entities. • Sole proprietorship • Partnership • S corporation • C corporation A limited liability company (LLC) is a legal entity formed in accordance with state law. Although a business organized as an LLC is a separate legal entity under state law, its status for federal tax purposes is determined solely on the basis of the entity classification regulations.23 A single-member LLC generally is treated as a sole proprietorship. LLCs with two or more members are considered a partnership unless the members elect corporation status for tax purposes. The type of tax entity under which a trade or business organizes is important for employment tax purposes. Businesses must pay employment taxes on the wages of employees. Business owners’ compensation may be subject to employee payroll taxes or SE taxes depending on the business’s entity type and other factors.

Observation. Generally, employers also are subject to federal and state unemployment taxes and worker’s compensation insurance contributions based on employee wages. These tax burdens may tempt employers to classify a worker as an independent contractor rather than as an employee. For more information on the importance of worker classification, see the 2017 University of Illinois Federal Tax Workbook, Volume A, Chapter 2: Employment Issues.

FICA AND SECA FICA and SECA taxes stem from two tax acts. • The Federal Insurance Contributions Act (FICA) • The Self-Employed Contributions Act (SECA)

FICA Tax FICA tax is composed of two elements — old age, survivors, and disability insurance (OASDI) and hospital insurance, commonly called Medicare.24 The overall FICA tax rate is 15.3% of gross taxable wages, of which 12.4% is allocated to OASDI and 2.9% to Medicare. The employee’s share is 6.2% of OASDI and 1.45% of Medicare. Employers withhold the employee’s share of FICA taxes from the employee’s gross taxable wages. Employers are required to match these amounts, reporting and remitting the full FICA tax to the government. 25

Note. Employers are responsible for collecting and remitting the entire amount of FICA tax on wages paid on behalf of employees. If the employer fails to withhold the correct amount of FICA taxes from an employee, the employer still is required to remit the full amount of tax due. Employers who do not comply with employment tax law may be subject to criminal and civil sanctions.25

23. Treas. Reg. §§301.7701-1 to 301.7701-3. 24. IRC §3101(b). 25. IRC §§6672 and 7202.

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In 2017, social security earnings are capped at $127,200.26 Earnings above this amount are not subject to the 12.4% OASDI tax. There is no limit on earnings subject to Medicare tax. In fact, the employee’s portion of the Medicare tax rate increases by 0.9% on earnings in excess of $200,000 for taxpayers filing under the single, head of household, and qualifying widow(er) statuses, and earning in excess of $250,000 for married filing jointly filers ($125,000 for married filing separately filers).27 The employer is not subject to the Medicare surcharge, and thus does not have to match contributions on the additional 0.9% tax.28 However, the employer is required to withhold the 0.9% surtax on employee Medicare wages in 3 excess of $200,000.29

Observation. The 0.9% Medicare surtax was imposed under the Patient Protection and Affordable Care Act and amended by the Health Care and Education Reconciliation Act of 2010.

SECA Tax The SECA tax rate is 15.3% of 92.35% of net earnings from self-employment. The allocation of SECA tax is the same as the allocation of FICA taxes: 12.4% of SE tax is allocated to social security and 2.9% to Medicare. The same $127,200 cap applies to 2017 social security earnings. The Medicare surtax applies to self-employed taxpayers, but it is not part of the SE tax. This surtax is imposed on the combined total wages and net SE income reported on the tax return.30 Self-employed individuals are essentially both employer and employee. Because there is no employer to pay the matching portion of OASDI and Medicare taxes, the self-employed person is responsible for the full amount of tax due on SE income. Employees do not pay income tax on the employer’s matching portion of OASDI and Medicare taxes. This matching portion is 7.65% (15.3% ÷ 2). To equalize this benefit for self-employed taxpayers, they are required to pay taxes on only 92.35% (100% − 7.65%) of their net SE income.

Note. As mentioned earlier, self-employed taxpayers are allowed to deduct half of the amount of the SE tax paid as an adjustment to income on Form 1040, line 27 (an “above the line” adjustment that reduces federal adjusted gross income). Because the SE tax does not include any Medicare surtax, this surtax is not used to compute the SE tax adjustment to gross income.

Sole Proprietor. Sole proprietors report income from trade or business activities on Schedule C and pay SE tax on net SE income. As mentioned earlier, if a taxpayer’s total combined net SE income is less than $400 ($433 × 92.35%), the taxpayer has no liability for SE tax.31 Partnership. A partnership, as a pass-through entity, does not pay any income tax. It passes the partnership’s income, gains, deductions, losses, and credits through to each partner in accordance with their percentages of partnership interests.

26. 2017 Social Security Changes. Social Security Administration. [www.ssa.gov/news/press/factsheets/colafacts2017.pdf] Accessed on June 1, 2017. 27. IRC §3101(b)(2). 28. Questions and Answers for the Additional Medicare Tax. Dec. 6, 2016. IRS. [www.irs.gov/businesses/small-businesses-self-employed/ questions-and-answers-for-the-additional-medicare-tax] Accessed on Jun. 7, 2017. 29. IRC §3102(f). 30. IRC §1401(b)(2). 31. IRC §1402(b)(2).

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Partnerships file Form 1065, U.S. Return of Partnership Income. The partnership gives each partner a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., which outlines what each partner must report on their individual returns. Spouses who operate a business together may elect to treat their business as a qualified joint venture instead of a partnership. This election avoids the need to file a partnership return. To qualify for this election: • Both spouses must materially participate in the ownership and operation of the business, • There may be no other members of the partnership, and • Each spouse must separately report their share of the business’s income, gain, loss, deductions, and credits.32

Observation. Many small businesses are operated as sole proprietorships when in fact they are “mom and pop” operations in which both spouses work in the business. When reporting as a sole proprietorship, only one spouse is credited with social security and Medicare earnings from the business. With a qualified joint venture election, both spouses receive credit for their earnings.

Note. For a more thorough discussion of partners, see the 2017 University of Illinois Federal Tax Workbook, Volume B, Chapter 4: Partner Issues. For a detailed discussion of partnerships, see the 2017 University of Illinois Federal Tax Workbook, Volume B, Chapter 5: Partnership Issues.

S Corporation. An S corporation is a pass-through entity that generally does not pay tax at the entity level. S corporations file Form 1120S, U.S. Income Tax Return for an S Corporation. S corporations provide shareholders with Schedule K-1, Shareholder’s Share of Income, Deductions, Credits, etc. Unlike a partnership, distributive income from an S corporation is not subject to SE tax.33 However, an S corporation shareholder who works in the business must be paid reasonable compensation as a corporate employee before receiving nonwage dividends.34 This reasonable compensation requirement eliminates a loophole that would allow active S corporation shareholders to avoid employment taxes. However, unlike sole proprietors and general partners, S corporation shareholders can avoid employment taxes on the profits of the business that exceed a reasonable compensation for their services. Reasonable compensation varies from industry to industry and shareholder to shareholder. The compensation amount never exceeds the amount directly or indirectly received by the shareholder. However, if the shareholder received cash or property or the right to receive cash or property, a salary amount must be established at a reasonable and appropriate level.35 Shareholders’ compensation is subject to IRS scrutiny when shareholders take distributions from the company and receive little or no compensation for services rendered to the corporation.

Note. For detailed information about S corporations, see the 2016 University of Illinois Federal Tax Workbook, Volume B, Chapter 4: S Corporation Entity Issues. For detailed information about S corporation shareholders, see the 2016 University of Illinois Federal Tax Workbook, Volume A, Chapter 2: S Corporation Shareholder Issues.

32. IRC §761(f). 33. Rev. Rul. 59-221, 1959-1 CB 225. 34. S Corporation Compensation and Medical Insurance Issues. Mar. 21, 2017. IRS. [www.irs.gov/businesses/small-businesses-self-employed/ s-corporation-compensation-and-medical-insurance-issues] Accessed on Jun. 15, 2017; IRC §3121(d). 35. Wage Compensation for S Corporation Officers. Aug. 2008. IRS. [www.irs.gov/uac/wage-compensation-for-s-corporation-officers] Accessed on Jun. 7, 2017.

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C Corporation. C corporations are taxed at the entity level. Dividends paid to shareholders are taxed twice — once at the corporate level and again at the shareholder level. Because of this double taxation of dividends, C corporations gain an advantage by paying higher salaries, which are deductible by the corporation. For this reason, C corporations may deduct only reasonable compensation paid to shareholder-employees.36 Wages are subject to employment taxes, but dividend payments are not. ASSIGNMENT OF INCOME 3 The expense of employment taxes compels some taxpayers to search for creative ways to escape this additional tax burden. The assignment of income doctrine prohibits the practice of transferring income to a person or entity that would pay less tax on the income than the person who earned it.37 However, there are legal ways to structure the assignment of income from an individual to an entity. The execution of this structure is complex and requires integrating tax law, corporate law, and other laws that regulate specific industries. Fleischer v. Comm’r, a recent tax court case, exemplifies a failed attempt to assign income from an individual to an S corporation for the purpose of limiting employment taxes.38 Ryan Fleischer was a financial planner who started his own company after working as an employee managing customers for other firms. On the advice of his attorney and CPA, Fleischer incorporated the investment advisory firm Fleischer Wealth Plan (FWP) on February 7, 2006, electing S corporation status. He was the corporation’s sole shareholder and the president, secretary, and treasurer of FWP. Fleischer was licensed to sell securities, but FWP was not licensed. Five days before FWP was incorporated, Fleischer signed an agreement to represent Linsco/Private Ledger Financial Services (LPL) financial products. He did not register his corporation with LPL. On February, 28, 2006, Fleischer entered into an employment agreement with FWP. On March 13, 2008, Fleischer entered into a broker contract with Mass Mutual, signing it in his personal capacity and not as an officer of FWP. In fact, FWP was not referenced in the contract at all. FWP paid Fleischer a salary, on which the corporation paid employment taxes. Fleischer reported this Form W-2 income, as well as his distributive share of income from the S corporation, on his personal tax return. He did not pay employment taxes on the S corporation’s distributive share of income. Fleischer reported the following income from FWP for each of the years in question.

Nonpassive Schedule E Income Tax Year Wages (ordinary business income from the S corporation) 2009 $34,851 $ 11,924 2010 34,856 147,642 2011 34,996 115,327

The IRS issued a notice of deficiency, on which it asserted that the distributive share of FWP income was actually Fleischer’s SE income from sales and that he owed SE taxes on this income. The IRS determined deficiencies for tax years 2009, 2010, and 2011 totaling $41,563.

36. Treas. Reg. §1.162-7(b)(3). 37. Lucas v. Earl, 281 U.S. 111 (1930). 38. Fleischer v. Comm’r, TC Memo 2016-238 (Dec. 29, 2016).

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Generally, income is taxed to the person who earned the income. However, in the case of a corporation and a service- provider employee, the court asks “who controls the earning of the income.”39 Two elements must be found to determine that a corporation controls the income. 1. The service provider must be an employee of the corporation “whom the corporation can direct and control in a meaningful sense.” 2. A contract or other indication of an agreement must exist between the corporation and the person or entity using the services that recognizes the corporation’s controlling position. Fleischer argued that FWP could not contract directly with LPL or Mass Mutual because FWP was not licensed to sell securities. However, the court found that securities laws and regulations do not prohibit a corporation from becoming a registered entity. Fleischer also argued that FWP was a valid corporation and that it should be recognized as a separate taxable entity. The court did not challenge FWP’s validity, but relied on Wilson v. U.S. to find that the corporation’s validity “does not preclude reallocation under the assignment of income doctrine.”40 The court sided with the IRS, finding that Fleischer failed to establish that a contract existed between FWP and LPL or between FWP and Mass Mutual showing that FWP had meaningful control over Fleischer. Accordingly, Fleisher was liable for SE tax on the distributive share of income he reported from FWP.

Note. For more information on the Fleischer case, see the 2017 University of Illinois Federal Tax Workbook, Volume A, Chapter 7: Rulings and Cases.

INDUSTRY-SPECIFIC BUSINESSES

Taxpayers can be engaged in relatively similar activities, but the activities’ tax treatment may differ, depending on each taxpayer’s circumstances. The following sections describe some of these distinctions as well as background information on some specific types of businesses that can produce different tax treatments.

INVESTOR VS. TRADER Securities come in two forms: debt and equity. Debt securities, such as bonds and certificates of deposit, represent money owed to the investor from the issuer. Debt securities are also called fixed-income securities. Equity securities represent ownership. An investor who holds a share of stock has equity in the corporation. Stockholders share in the company’s profits and losses and generally can vote on who directs the corporation and on major issues affecting their stake. The term securities as defined in IRC §475(c)(2) includes stock shares; beneficial ownership interests in certain partnerships and trusts; notes, bonds, debentures, or other evidence of indebtedness; and other financial instruments. Commodities represent tangible goods, such as gold, corn, and oil. Commodities are traded like securities, but instead of buying a specifically identifiable security (e.g., Apple stock), commodities buyers purchase a unit of goods (e.g., apples).

39. Johnson v. Comm’r, 78 TC 882, 891 (1982). 40. Wilson v. U.S., 530 F. 2d 772, 778 (8th Cir. 1976).

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Before the advent of the Internet, trading required the services of a professional stockbroker. After the World Wide Web was introduced in 1990,41 Internet trading companies sprang up, lowering commission costs and making buying and selling easier and less expensive. Now, anyone with a smart phone or computer and an online trading account can buy and sell securities and commodities anywhere they can get Internet reception. The ease of transacting security and commodity purchases and sales created the “day trader” phenomenon. Day traders try to capitalize on market fluctuations throughout the trading day. They are not interested in long-term growth and generally close out all their positions within a single market day. 3 Buying and selling securities is generally considered a passive activity. However, some taxpayers have elevated their level of activity when trading securities to the point that their activity constitutes a trade or business. Congress added IRC §475 to the Code in 1993 to adapt to the changing trading environment brought about by Internet transactions. The distinction between investors (passive activity) and traders (trade or business activity) makes a difference in the manner in which expenses are deducted and the tax rate that applies to gains. It also may make a difference in how gains and losses are computed and how much loss can be deducted. Distinguishing between investors and traders and the corresponding tax treatment of their trading activity requires a careful analysis of facts and circumstances. The following terms and descriptions help to categorize a taxpayer’s level of trading. • Investor — Investors trade casually with an aim toward long-term gain. Investors seek money from dividends and capital appreciation rather than quick market swings. • Trader — Traders approach trading as a full-time business rather than a hobby and generally receive their chief support from trading activities. Their trades are frequent, regular, continuous, and substantial. They trade solely for their own accounts. • Dealers — Dealers make their living trading for customers, rather than trading solely for their own accounts. Dealers and their tax situations are not discussed in this section.

Investors Individual investors report their trading transactions on Schedule D, Capital Gains and Losses; Form 6781, Gains and Losses from Section 1256 Contracts and Straddles; and Form 8949, Sales and Other Dispositions of Capital Assets. Wash Sales. Investor transactions are subject to wash-sale rules.42 These rules prevent investors from creating paper losses by selling stocks for a price that is below their basis and then putting themselves in the same investment position by purchasing substantially identical stock within a short period of time. Wash-sale rules apply to stocks sold at a loss and replaced within a 61-day period extending from 30 days before to 30 days after the loss sale.43 When a wash sale occurs, investors must adjust the basis of their replacement stock, thereby deferring these losses until the replacement stock is sold (presuming the sale does not create another wash sale transaction).44

41. History of the Web. World Wide Web Foundation. [webfoundation.org/about/vision/history-of-the-web] Accessed on Jun. 16, 2017. 42. IRC §1091. 43. IRC §1091(e). 44. IRC §1091(a).

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Investor Expense Deductions. Investors can claim investment-related expenses on Schedule A, Itemized Deductions, as miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) limitation.45 Investment- related expenses include costs related to producing investment income, such as investment advice, publications, workshop fees, and legal and accounting fees.46 Investors also can claim a deduction for investment-related interest expense, but this deduction is limited to total investment income less investment expenses.47 Investment interest in excess of this limitation carries forward.48 Commissions and costs associated with buying and selling specific securities are not deductible investment expenses. Instead, these costs are treated as basis adjustments and are used to compute gain or loss on disposition.49 Investors cannot claim a home office deduction, even if they use their office regularly and exclusively for investing.50 Investors may lose the advantages of Schedule A deductions if they do not have enough deductions to itemize, their investment expenses do not exceed 2% of their AGI, or their itemized deductions are limited under IRC §68. Investors who are subject to alternative minimum tax (AMT) also lose the tax benefit of their miscellaneous itemized deductions.51 Investor Capital Loss Limitation. Investors who have capital losses in excess of their capital gains from securities transactions are allowed to deduct the lesser of the excess capital loss over any capital gain, or $3,000 per year ($1,500 for taxpayers filing married filing separately (MFS)).52 Unused capital losses are carried forward until used.53 Example 4. Lisa Jones sold 1,000 shares of Taco Takeout on May 6, 2016, for a capital loss of $10,000. On May 30, 2016, she sold 1,000 shares of Sit-down Sushi for a capital gain of $6,000. Lisa filed as single and she had no other security transactions in 2016. Lisa can claim a capital loss deduction of $3,000 on her 2016 tax return, which is the lesser of her $4,000 ($10,000 − $6,000) excess loss over her capital gains and her $3,000 capital loss limitation. Lisa carries forward her excess capital loss of $1,000 ($4,000 actual loss − $3,000 allowed loss) to her 2017 return. If Lisa has no other stock transactions in 2017, she can deduct this $1,000 carryforward balance as a $1,000 excess capital loss on her 2017 return. If she has other stock transactions in 2017, she includes this $1,000 carryover loss with her other transactions to aggregate her gains and losses for 2017. Investor Tax Rates. Investors receive favorable capital gains tax rates54 on their long-term investments (generally investments they have held for more than one year55). Investors do not pay SE taxes on their trading income.56

45. Temp. Treas. Reg. §1.67-1T(a)(1)(ii). 46. IRS Pub. 550, Investment Income and Expenses. 47. IRC §163(d). 48. IRC §163(d)(2). 49. IRS Pub. 550, Investment Income and Expenses. 50. IRS Pub. 587, Business Use of Your Home, p. 3 (2016). 51. IRC §56(b)(1)(A)(i). 52. IRC §1211(b). 53. IRC §1212(b). 54. IRC §1(h). 55. IRC §1222(3). 56. Tax Topic 429 — Traders in Securities (Information for Form 1040 Filers). May 1, 2017. IRS. [www.irs.gov/taxtopics/tc429.html] Accessed on Jun. 30, 2017.

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The table below shows the 2017 capital gains tax rates for each tax bracket. 57 58 59

Tax Bracket Long-Term Capital Gains Tax Rate 10% 0% 15% 0% 25% 15% 28% 15% 3 33% 15% 35% 15% 39.6% 20%

Note. Effective January 1, 2013, the Affordable Care Act imposed a 3.8% surtax on the net investment income of certain taxpayers, including estates and trusts.57 This net investment income tax (NIIT) applies to taxpayers with modified AGI exceeding $200,000 for single and head of household filers, $250,000 for qualifying widow(er)s and married filing jointly (MFJ) filers, and $125,000 for married filing separately (MFS) filers.58 Net investment income includes, but is not limited to, income derived from trading activities, such as dividends and capital gains. It applies to both investors and traders.59

Traders Special tax rules apply to traders, i.e., those who have elevated their securities transactions to the point that their trading is considered a business activity. At a minimum, to be deemed a trader, a taxpayer must meet all three of the following requirements.60 1. Seek profits from daily market movements rather than dividends, interest, or capital appreciation 2. Display substantial trading activity 3. Engage in continuous and regular trading activity While there are no quantitative values used to define substantial, continuous, and regular trading patterns, the IRS considers the following factors when determining whether a taxpayer is deemed a trader or an investor.61 • The length of the holding period for securities bought and sold • The frequency and dollar amount of trades made during the tax year • The extent to which the taxpayer derives a livelihood from trading activities • The amount of time the taxpayer devotes to trading activities The Tax Court denied trader status to a taxpayer who executed 535 trades over 121 days in a tax year. The court decided that the number of trading days “was not substantial” and thereby did not merit trader status.62

57. IRC §1411. 58. Ibid. 59. Ibid. 60. IRS Pub. 550, Investment Income and Expenses. 61. Ibid. 62. Sharon Nelson v. Comm’r, TC Memo 2013-259 (Nov. 13, 2013).

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A taxpayer may be deemed a trader for some securities and an investor for others. Securities that a trader holds for investment do not qualify for the special rules for traders. Traders must separately identify and record any investment securities in their records on the date of purchase.63 64

Note. The IRS advises traders to hold investment securities in a separate brokerage account for ease of identification.64

Trader Expense Deductions. One advantage to attaining trader status is that the trader can deduct trading expenses on Schedule C, rather than Schedule A. Investment interest is not limited to net investment income on Schedule C, so traders can deduct the full amount of any interest paid in connection with their trading activity. 65 Commissions and costs associated with buying and selling specific securities are not deductible investment expenses. Instead, these costs are treated as basis adjustments used to compute gain or loss on disposition.66 If otherwise qualified, traders are allowed a home office deduction on Schedule C because they are considered to be engaged in a trade or business activity. Although traders report their trading business expenses on Schedule C, they do not report their trading income on this form. If a trader does not make a “mark-to-market” (MTM) election (discussed later in this section), the trader reports their trading transactions on Schedule D and Form 8949.67 If a trader makes the MTM election, they report their trading transactions in part II of Form 4797, Sales of Business Property.

Caution. Because traders do not report their income on Schedule C, tax preparation software may limit the home office deduction to the business-use percentage for real estate taxes, mortgage interest, mortgage insurance premiums, and casualty losses. Because no profit is shown on the trader’s Schedule C, the operating expenses of the home office (e.g., utilities, insurance, and maintenance) and the depreciation allowance would not be deductible in the current year. However, the instructions for Form 8829, Expenses for Business Use of Your Home, (part II, line 8) state that a taxpayer can include in the calculation of the home office deduction any net gains in excess of losses reported on Schedule D (via Form 8949) and Form 4797 that are allocated to the use of the home office for trade or business. Practitioners are advised to consult their specific software instructions for special coding or manual entry requirements needed to properly attribute the trader’s income for the home office deduction calculation.

Trader Capital Loss Limitation. Traders who do not make an MTM election are treated the same as investors regarding capital loss limitations. The losses of traders who do not make an MTM election are considered capital losses subject to the $3,000 ($1,500 for MFS filers) annual loss limitation. Also, the wash-sale rules (discussed in the “Investors” section) apply to traders who do not make the MTM election. 68 69 Trader Tax Rates. Even though a trader is considered to have a business, a trader’s net trading income is not subject to SE tax.68 The capital gains tax rates that apply to investors also apply to traders who do not make an MTM election.69

63. Topic 429 — Traders in Securities (Information for Form 1040 Filers). May 1, 2017. IRS. [www.irs.gov/taxtopics/tc429.html] Accessed on Jun. 30, 2017; IRS Pub. 550, Investment Income and Expenses. 64. Ibid. 65. IRS Pub. 550, Investment Income and Expenses, p. 71 (2016). 66. IRS Pub. 550, Investment Income and Expenses. 67. IRS Pub. 550, Investment Income and Expenses, p. 71 (2016). 68. IRC §475(f)(1)(D). 69. Topic 429 — Traders in Securities (Information for Form 1040 Filers). May 1, 2017. IRS. [www.irs.gov/taxtopics/tc429.html] Accessed on Jun. 30, 2017.

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Mark-to-Market Transactions Congress added IRC §475(f) to the Code in 1997. This MTM provision allows securities and commodities traders to elect to receive the same MTM tax treatment required for dealers. 70 Generally, recognition of income, gain, or loss only occurs when a stock is sold or exchanged. However, §475(f) allows securities and commodities traders to recognize income on mark-to-market holdings at the end of each tax year based on increases and decreases in the fair market value (FMV) of these holdings. 3 MTM gains and losses are recognized as ordinary income.71 This means traders lose the advantage of favorable capital gains tax rates in exchange for being able to deduct capital losses in full in the year they are recognized. 71

Observation. Traders and dealers (i.e., those who trade for a living rather than casually invest in the market) generally do not benefit from the favorable long-term capital gains tax rates because they seldom hold security positions for over a year. Because their trading activities are frequent and often speculative, they also can experience large capital losses. This makes the §475(f) election an attractive option for traders.

When traders make an MTM election, they report all shares held in their trading accounts (i.e., not their investment accounts) as sold for FMV on the last day of the tax year.72 Traders then report these deemed sales along with their actual business trading activity during the year in part II of Form 4797.73 Expenses allocated to the trading business are reported on Schedule C.74 Sales of securities held for investment are reported on the trader’s Schedule D.75 Investor-related expenses are deducted on Schedule A.76 The following table shows the categories of taxpayers eligible for MTM tax treatment.

Taxpayer Category Mark-to-Market Tax Treatment Investor Not eligible Securities trader Eligible by election under §475(f)(1) Commodities trader Eligible by election under §475(f)(2) Securities dealer Mandated by §475(a) Commodities dealer Eligible by election under §475(e)

70. Security dealers are required to use mark-to-market reporting under §475(a); commodities dealers may elect MTM treatment under §475(e). 71. IRC §475(d)(3)(A)(i). 72. IRC §475(f)(1)(A)(i). 73. Instructions for Form 4797. 74. IRS Pub. 550, Investment Income and Expenses, p. 71 (2016). 75. Ibid. 76. IRS Pub. 550, Investment Income and Expenses, p. 35 (2016).

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Manner of Election. To make the §475(f) election, taxpayers must include a statement on their tax return for the year prior to the year they wish the election to be effective.77 The statement must be attached to the timely filed return (not including extensions) or to the timely filed extension request for that year. It must include all of the following information.7877 78 • A declaration that the taxpayer is making the election under IRC §475(f) • Specific identification of the first tax year for which the election is effective • Mention of the trade or business for which the election is being made Taxpayers who wish to receive MTM treatment effective for the 2018 tax year must make the election by April 17, 2018, by attaching a statement to the taxpayer’s timely filed 2017 return or request for extension. Late elections are rarely allowed.79 Along with this election, taxpayers should file Form 3115, Application for Change in Accounting Method, using the designated automatic accounting method change number “64.”80 Benefits of a §475(f) Election. Choosing the MTM election offers tax advantages to eligible traders. For example, this election frees the eligible trader from wash-sale rules and capital-loss limitations.81 Furthermore, because losses are ordinary rather than capital in nature, they can give rise to net operating loss carrybacks and carryforwards. Because marked positions are deemed sold at FMV, a §475(f) election relieves taxpayers from the burden of tracking historical bases. Marked securities and commodities receive a new basis each year, as if they were reacquired for FMV on the date of the deemed sale. Disadvantages of a §475(f) Election. The most obvious disadvantage of an MTM election is the loss of the preferential capital gains tax rates. However, this is not as detrimental as it appears because most traders do not hold positions long enough to take advantage of this tax break. Taxpayers electing §475(f) also lose the ability to defer gain or loss by controlling the timing of sales. Deemed yearend sales also can create phantom gains that generate tax liability without generating the cash with which to satisfy the liability. Traders that elect MTM tax treatment lose the benefit of IRC §1256. This section deems certain contracts and options as sold at yearend for 60% long-term and 40% short-term gain or loss, regardless of how long the positions were held.82 83

Note. Traders who currently have large capital loss carryovers may lose the ability to offset any large gains if they elect the ordinary gain/loss treatment under §475(f). Taxpayers may circumvent this problem by specifically identifying stocks they hold for investment that can be used to take advantage of any unused capital loss carryovers.83

77. Instructions for Schedule D. 78. IRS Pub. 550, Investment Income and Expenses, p. 71 (2016). 79. Topic 429 — Traders in Securities (Information for Form 1040 Filers). May 1, 2017. IRS. [www.irs.gov/taxtopics/tc429.html] Accessed on Jun. 29, 2017. 80. Rev. Proc. 2017-30, 2017-18 IRB 1131. 81. Topic 429 — Traders in Securities (Information for Form 1040 Filers). May 1, 2017. IRS. [www.irs.gov/taxtopics/tc429.html] Accessed on Jun. 29, 2017. 82. IRC §1256(a). 83. IRC §475(f)(1)(B).

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Revocation of Election. Until recently, the §475(f) election could be revoked only with IRS consent. Rev. Proc. 2015- 14 now allows taxpayers to automatically switch from the MTM method to a realization (or cash) method.84 The taxpayer requesting revocation must file a “notification statement” by the original due date of the preceding year return, without extensions. The statement can be filed with an extension of time to file the return or with the tax return for the tax year preceding the year of change. This provides an opportunity window of 3.5 months in the beginning of the tax year to decide whether to revoke the election, mirroring the timing allowed to make the §475(f) election.85 3 April 17, 2018, is the deadline to file the notification statement for revocations effective for the 2018 calendar year. The notification statement must include all of the following:86 • Name of taxpayer with 475(f) election in place • Statement requesting the accounting method change to a realization method • Beginning and ending dates for year of change • Types of instruments subject to the method change • Statement revoking the taxpayer’s 475(f) election The taxpayer must then file Form 3115 with their tax return under standard automatic method change procedures described in Rev. Proc. 2015-13, effective for forms filed on or after January 16, 2017. In the year preceding the year of revocation, the taxpayer accounts for gain or loss on a “cut-off” basis by making a final mark of any elected securities or commodities for ordinary gain/loss treatment. As a result of the final mark, gain or loss attributable to those securities and/or commodities is recognized on the last business day of the year preceding the year of change. Once the revocation is properly made, the trader must resume the capital gain/loss realization method of accounting for the year of change and all subsequent years.87 A trader may request reinstatement of the §475(f) election after a 5-year waiting period. Reinstatement is not automatic.88

84. Rev. Proc. 2015-14, 2015-5 IRB 450 (§23.02). 85. Ibid. 86. Ibid. 87. Rev. Proc. 2015-14, 2015-5 IRB 450 (§23.02(5)). 88. Rev. Proc. 2015-14, 2015-5 IRB 450 (§23.02(7)(a)).

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Summary. The following table summarizes the tax differences between investors and traders, including a comparison of traders who make the MTM election and those who do not make the election.

Trader Tax Attribute Investor No MTM Election With MTM Election

SE tax No No No

Gain/loss treatment Capital Capital Ordinary

Loss limit $3,000 ($1,500 MFS) $3,000 ($1,500 MFS) Unlimited

Market gains Deferred until Deferred until Recognized at the disposition disposition end of tax year (constructive sale)

Wash-sale rules Apply Apply Do not apply

Where to report Form 8949 and Form 8949 and Form 4797, part II income from trading Schedule D Schedule D transactions

Where to report Schedule A Schedule C Schedule C trading expenses miscellaneous itemized deductions subject to 2% of AGI floor

Investment interest Limited to investment Unlimited Unlimited expense deduction income

Office in the home Not allowed Allowable Allowable deduction

IRC §179 deduction Not allowed Allowable Allowable

Effect of expenses on None Expenses reduce AGI Expenses reduce AGI AGI

Expenses used to No, misc. itemized Yes Yes reduce AMT deductions are disallowed for AMT

Losses qualify for NOL No No Yes

Caution. It is important for tax practitioners to be aware of the MTM election and to keep clients informed of their options. In a January 31, 2010 article, Michael Harmon, J.D., CPA, and William Kulsrud, Ph.D., CPA, reported that an accountant was required to pay his former client $2.5 million for negligence because the client was not informed of the MTM election.89

89. Sec. 475 Mark-to-Market Election. Harmon, Michael and Kulsrud, William. Jan. 31, 2010. The Tax Advisor. [www.thetaxadviser.com/ issues/2010/feb/sec475mark-to-marketelection.html#fn_14] Accessed on Jun. 29, 2017.

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LANDLORD VS. REAL ESTATE PROFESSIONAL Renting real estate is generally a passive activity.90 Property owners can deduct ordinary and necessary expenses in connection with the operation of their rental activities, including allowed or allowable depreciation on the rental structure and other capital assets connected with the rental activity. Depreciation is not allowed for land.

Landlords Landlords are property owners who exchange the use of their property for income. Landlords with profits generally do 3 not pay SE taxes on their net rental income.91 These profits are subject to ordinary income tax. Landlords with losses may be subject to passive loss restrictions.92 The amount of the restriction depends on the landlords’ level of participation in the rental activity, their percentage of ownership of the property, their AGI, and their filing status. Landlords’ participation in the rental activity can be deemed passive or active. Active participation means the landlord owns at least 10% of the rental property93 and is involved in managing the operation of the rental unit, such as finding tenants, enforcing rental terms, hiring repairmen, etc.94 In general, landlords who actively participate in a rental activity can deduct up to $25,000 in passive rental losses if their AGI is under $100,000. This passive-loss limitation is reduced for actively participating landlords with an AGI between $100,000 and $150,000, and eliminated for those with an AGI over $150,000. If a landlord’s filing status is MFS, the passive-loss limit is $12,500 if their AGI is under $50,000, and the deduction phases out completely at $75,000.95 Landlords who do not actively participate in the real estate activity can only deduct passive losses up to the amount of their passive income.96 Disallowed passive activity losses may be carried forward to the next tax year until used or until the taxpayer disposes of the property. 97

Real Estate Professionals Certain taxpayers can avoid application of the passive-loss rules if they meet the qualifications to be designated as a real estate professional in a real property trade or business. IRC §469(c)(7)(C) defines real property trade or business to encompass any real property: • Development and redevelopment, • Construction and reconstruction, • Acquisition, • Conversion, • Rental, • Operation, • Management, • Leasing, and • Brokerage trade or business.

90. IRC §469(c)(2). 91. IRC §1402(a)(1). 92. IRC §469. 93. IRC §469(i)(6)(A). 94. IRS Pub. 925, Passive Activity and At-Risk Rules, p.4 (2016). 95. IRC §469(i); Special limitations apply to surviving spouses and taxpayers with rehabilitation credits, commercial revitalization deductions, and low-income housing credits. 96. IRC §§469(a) and (d)(1). 97. IRC §§469(b) and (g).

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To be deemed a real estate professional, a taxpayer must meet two tests.98 1. The taxpayer must materially participate in real property trades or businesses over half the total time the taxpayer spends on all trades or businesses during the tax year. 2. The taxpayer must perform over 750 hours of service during the tax year materially participating in real property trades or businesses. Taxpayers may elect to group rental real estate activities for purposes of the above tests.99 A grouping election may also be necessary to meet the material participation test. Material participation100 means involvement in the rental operations on a regular, continuous, and substantial basis during the tax year.101 Time spent as an employee does not count toward the material participation tests unless the employee is at least a 5% owner of the company.102 100 101 102 A qualified real estate professional is not subject to the additional 3.8% NIIT on their rental real estate activity if they qualify for the safe harbor in Treas. Reg. §1.1411-4(g)(7)(i). To qualify for the safe harbor, the real estate professional must: • Participate in the rental real estate activity for more than 500 hours during the year, or • Have participated in the activity for more than 500 hours in any five tax years during the 10 tax years immediately preceding the current tax year. If the real estate professional fails to satisfy the preceding safe harbor requirements, they may still be able to exclude their rental real estate income from net investment income if they can demonstrate that they are excluded from the NIIT under another provision of IRC §1411.103 Real estate professionals do not pay SE tax on their rental real estate income.104 The rental income for a real estate professional is not considered passive under IRC §469(c)(7). Therefore, the income is not considered “disqualified income” for purposes of the earned income credit computation under IRC §32(i). Real estate professionals report their rental income and expenses on Schedule E, Supplemental Income and Loss. They enter the net income or loss of all rental real estate activities in which they materially participated during the tax year on Schedule E, part V, line 43.

Note. For more information about real estate professionals, grouping rules, and material participation, see the 2014 University of Illinois Federal Tax Workbook, Volume B, Chapter 4: Passive Activities. This can be found at uofi.tax/arc [taxschool.illinois. edu/taxbookarchive].

98. IRC §469(c)(7)(B). 99. IRC §469(c)(7)(A). 100. IRS Pub. 925, Passive Activity and At-Risk Rules, sets forth seven tests for determining material participation. 101. IRC §469(h)(1). 102. IRC §469(c)(7)(D)(ii). 103. Treas. Reg. §1.1411-4(g)(7)(iii). 104. IRC §1402(a)(1).

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SMALL BUSINESS STOCK

Congress uses the Code not only to fund the government, but also to help shape the economy. Two such economy- shaping provisions are contained in IRC §§1202 and 1244. These Code sections encourage investment in qualifying small business corporations by providing tax incentives to investors.

IRC §1202 QUALIFIED SMALL BUSINESS STOCK 3 IRC §1202 allows noncorporate taxpayers to exclude a substantial portion of gain from the sale or exchange of qualified small business stock (QSBS). The excludable portion is determined by the acquisition date of the QSBS. Exclusion percentages range from 50% to 100% of gain, as shown in the following table.105 106

Acquisition Date Exclusion Percentage

August 11, 1993, through February 17, 2009 50% 106 February 18, 2009, through September 27, 2010 75% September 28, 2010, and after 100%

Congress increased the QSBS exclusion percentage to 100% effective September 28, 2010.107 They also eliminated the AMT adjustment that previously applied.108 The 3.8% NIIT does not apply to gain from QSBS, because that tax applies only to taxable income.109 The 100% exclusion rate was made permanent by the Protecting Americans from Tax Hikes Act (PATH Act) of 2015.110

Note. Although the federal government allows 100% of gain from the sale or exchange of QSBS to be excluded from tax, not all states follow federal tax law in this regard.

The exclusion is limited to the greater of $10 million ($5 million for MFS taxpayers) or 10 times the taxpayer’s adjusted basis in the QSBS.111 Taxpayers report the sale or exchange of QSBS on Form 8949, part II. The letter “Q” is placed in column (f) and the amount of the exclusion is reported as a negative number in column (g).112

105. Instructions for Schedule D. 106. This exclusion percentage increased to 60% for QSBS designated as an empowerment zone business. IRC §1202(a)(2)(A). 107. IRC §1202(a)(4)(A). 108. IRC §1202(a)(4)(C). 109. IRC §1411(c)(1)(A)(iii). 110. PL 114-113, Division Q (Dec. 18, 2015). 111. IRC §1202(b). 112. Instructions for Form 8949.

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Stock Qualifications To qualify for §1202 treatment, QSBS must meet the following criteria. 1. The stock must have been issued by a C corporation that as of the date of issue: 113 • Did not have aggregate gross assets of $50 million or more both before and immediately after the stock issuance, and • Agrees to furnish reports to the government and shareholders verifying its QSBS status. 2. The stock’s original issue date must have been after August 10, 1993 (the Revenue Reconciliation Act of 1993’s enactment date).114 3. The stock must have been acquired by the taxpayer at the stock’s original issue, directly or through an underwriter, in one of the following manners.115 • In exchange for money or property other than stock • As compensation for services provided to the issuing corporation (other than services performed as an underwriter of the stock) 4. The stock must be in a corporation that meets the active business requirement during substantially all of the taxpayer’s holding period.116 This requirement is met if at least 80% of the corporation’s assets (by value) are used in the active conduct of one or more qualified trades or businesses.117 A qualified trade or business means any trade or business other than the following.118 • Any field in which the principal asset is the reputation or skill of one or more of the corporation’s employees, including services provided in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services • Banking, insurance, financing, leasing, investing, or similar activities • Farming, including raising or harvesting trees • Production or extraction of products from mines, wells, and other natural deposits • Hotels, motels, restaurants, and similar businesses 5. The stock must have been held by the taxpayer for more than five years before its sale or exchange.119

113. IRC §§1202(d)(1)(A)–(C). 114. IRC §1202(c)(1). 115. IRC §§1202(c)(1)(B)(i)–(ii). 116. IRC §1202(c)(2). 117. IRC §1202(e)(1)(A). 118. IRC §1202(e)(3). 119. IRC §1202(b)(2).

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Taxpayers who do not meet the 5-year holding period requirement may elect to defer gain from the sale of otherwise qualifying small business stock in an IRC §1045 rollover. This is accomplished by reinvesting the gain in QSBS within 60 days of the sale or exchange of the former small business stock. Gain is recognized only to the extent the amount realized on the sale exceeds: • The cost of QSBS purchased by the taxpayer during the 60-day period beginning on the date of the sale, reduced by 3 • Any portion of the cost previously taken into account under §1045. To qualify for the §1045 deferment, taxpayers must have held the original stock for more than six months.120

Corporation Qualifications To be eligible for the §1202 exclusion, stock must be issued by a domestic C corporation that is not one of the following.121 • A domestic international sales corporation (DISC) or former DISC • A corporation, or its direct or indirect subsidiary, for which an IRC §936 election (Puerto Rico and possession tax credit) is in effect • A regulated investment company, real estate investment trust, or real estate mortgage investment conduit • A cooperative To determine whether a corporation meets the requirements for a qualified small business, all corporations that are members of the same parent-subsidiary controlled group are treated as a single corporation.122 For this purpose, a parent-subsidiary controlled group means one or more chains of corporations connected through stock ownership with a common parent corporation if:123 • Stock possessing more than 50% of the total combined voting power of all classes of stock or more than 50% of the total value of shares of all classes of stock of each of the corporations, except the common parent corporation, is owned (within the meaning of IRC §1563 (d)(1)) by one or more of the other corporations; and • The common parent corporation owns stock possessing more than 50% of the total combined voting power of all classes of stock or more than 50% of the total value of shares of all classes of stock of at least one of the other corporations, excluding stock owned directly by such other corporations.124

Ineligible Stock A corporation’s stock is ineligible for the §1202 exclusion if more than 10% of the total value of the corporation’s assets consists of real estate not used in the active conduct of a qualified trade or business. Owning, dealing in, or renting real property is not considered the active conduct of a qualified trade or business.125 A corporation’s stock also is generally ineligible for the §1202 exclusion for any period during which more than 10% of the total value of the corporation’s assets in excess of liabilities consists of stocks or securities of other corporations.126 Stock and debt held in any of the corporation’s subsidiaries is disregarded for purposes of this calculation.127

120. IRC §1045(a). 121. IRC §1202(e)(4). 122. IRC §1202(d)(3)(A). 123. IRC §1202(d)(3). 124. IRC §1202(d)(3)(B); The provisions of §1563(a)(4), regarding certain controlled groups of life insurance companies subject to tax under §801, do not apply. 125. IRC §1202(e)(7). 126. IRC §1202(e)(5)(B). 127. IRC §1202(e)(5)(A).

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However, assets held to meet the reasonably required working capital needs of a qualified trade or business is considered used in the active conduct of a qualified trade or business.128 Likewise, assets held for investment and that is reasonably expected to be used within two years to finance research and experimentation in a qualified trade or business or to finance increases in the working capital needs of a qualified trade or business is considered used in the active conduct of a trade or business.129 After a corporation exists for two or more years, no more than 50% of the corporation’s working capital assets qualify as used in the active conduct of a qualified trade or business.130

Look-Back Provisions Congress intended the QSBS provision to spur new business development by stipulating that qualifying stock must be newly issued. In order to prevent the reissuance of corporate stock to circumvent this stipulation, two look-back provisions were added to the Code. The first look-back provision states that stock is not QSBS if, in one or more purchases during the 4-year period beginning on the date two years before the stock was issued, the corporation purchases more than a de minimis amount of its stock either directly or indirectly from the taxpayer or a related party.131 Related parties are defined for this purpose by IRC §§267(b) or 707(b).132 A stock purchase exceeds this de minimis threshold if the aggregate amount of the corporation’s purchase exceeds $10,000 and the corporation acquires more than 2% of the stock held by the taxpayer and related parties.133 The second look-back provision states that stock is not QSBS if, in one or more purchases during the 2-year period beginning on the date one year before the issuance of the stock, the issuing corporation purchases: • More than a de minimis amount of its stock, and • The purchased stock has an aggregate value at the time of the respective purchases exceeding 5% of the aggregate value of all of the issuing corporation’s stock as of the beginning of the 2-year period.134 A stock purchase exceeds this de minimis threshold when the aggregate amount of the stock purchase exceeds $10,000 and more than 2% of all outstanding stock is purchased.135

IRC §1244 LOSSES ON SMALL BUSINESS STOCK Generally, losses from the sale or exchange of stock are considered capital losses. Capital losses can be used to offset capital gains, and the excess of capital losses over capital gains can be used to reduce $3,000 ($1,500 for MFS taxpayers) of ordinary income per year.136 IRC §1244 allows an ordinary loss deduction to the following classes of taxpayers.137 • An individual to whom the stock was issued by a small business corporation (defined later) • An individual who is a partner in a partnership at the time the partnership acquired the stock from a small business corporation and whose distributive share of partnership items reflects the loss sustained by the partnership

128. IRC §1202(e)(6)(A). 129. IRC §1202(e)(6)(B). 130. Ibid. 131. Treas. Reg. §1.1202-2(a)(1). 132. IRC §1202(c)(3)(A). 133. Treas. Reg. §1.1202-2(a)(2). 134. Treas. Reg. §1.1202-2(b)(1). 135. Treas. Reg. §1.1202-2(b)(2). 136. IRC §1211(b). 137. Treas. Reg. §1.1244(a)-1.

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Such taxpayers can reduce ordinary income by up to $50,000 ($100,000 if MFJ) of small business stock losses.138 Losses on qualified §1244 stock in excess of this limitation are treated as capital losses, subject to the capital gains limitation.139 Example 5. Greg Thomas, a single filer, sold 1,000 shares of qualified §1244 stock in 2017 at a loss of $55,000. He has one other nonqualified stock transaction during the year with a $1,000 gain. Greg’s total loss on stock transactions is $54,000 ($55,000 – $1,000) in 2017. He claims $50,000 as a §1244 ordinary loss on Form 4797, which leaves him with a $4,000 capital loss on Form 8949. He is limited to a 3 $3,000 capital loss deduction. He carries the unused $1,000 ($4,000 – $3,000) capital loss to 2018. Greg claims $50,000 of ordinary loss and $3,000 of capital loss on his 2017 return. For purposes of §1244, small business stock must meet the following criteria. • The stock must be issued by a domestic corporation.140 • The stock must be issued in exchange for money or property other than stock or securities.141 • The stock must be issued by a small business corporation, which means:142  The aggregate amount of money and other property the corporation received for stock, capital contributions, and paid-in surplus cannot exceed $1 million for all stock issued; and  At the time the property is received by the corporation, the amount taken into account is equal to the corporation’s adjusted basis of any property (other than money) less any liability to which the property is subject or which the corporation assumes. • During the most recent five tax years ending before the loss was sustained, the corporation must have derived more than half of its aggregate gross receipts from sources other than royalties, rents, dividends, interests, annuities, and sales or exchanges of stocks or securities.143 Gross receipts from the sale or exchange of securities are taken into account only to the extent of gains.144 The aggregate gross receipts test does not apply if the corporation’s deductions exceed its gross income during the 5-year look-back period.145 Deductions claimed for net operating loss carryover and carryback purposes and the special dividends-received deduction do not count in this calculation.146 Any amount treated as an ordinary loss under §1244 is considered attributable to a trade or business of the taxpayer for purposes of the net operating loss deduction.147

138. IRC §1244(b). 139. IRC §1244(a). 140. IRC §1244(c). 141. Ibid. 142. IRC §1244(c)(3). 143. IRC §1244(c)(1)(C); For corporations without a 5-year earnings history, see IRC §1244(c)(2)(A). 144. IRC §1244(c)(2)(B). 145. IRC §1244(c)(2)(C). 146. Ibid. 147. IRC §1244(d)(3).

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SMALL BUSINESS DEDUCTIONS FOR FSAs, HRAs, AND HSAs

Generally, for qualifying medical expenses, a taxpayer may reduce tax liability under either of two Code sections. • Take an itemized deduction for qualifying medical expenses in excess of 10% of AGI under IRC §213 • Use a qualifying medical expense reimbursement plan (MERP) under IRC §105 148

Note. For the 2013 through 2016 tax years, a lower 7.5%-of-AGI threshold applied for itemized deductions if the taxpayer or taxpayer’s spouse attained age 65 before the end of the tax year. This provision expired and no longer applies for 2017 and subsequent tax years.148

Qualifying medical expenses are defined in IRC §213 and include expenses to diagnose, treat, or mitigate disease, transportation costs necessary to obtain medical care, amounts paid for prescription drugs or insulin, and medical insurance premiums. Long-term care premiums also qualify, subject to certain limits. For further information on what expenses qualify, see IRS Pub. 502, Medical and Dental Expenses. For taxpayers with small businesses, use of a qualifying MERP may bring important tax advantages. A qualifying MERP can be one of the following. • Flexible spending arrangement (FSA)149 • Health reimbursement arrangement (HRA)150 • Health savings account (HSA)151 The rules governing each of the preceding three types of qualified MERPs, and their respective advantages to the small business owner, differ. Each qualified MERP is discussed in greater detail in this section. 152

Note. The Archer MSA, which is viewed as the precursor to the HSA, is another qualifying MERP. While it is not possible to establish a new Archer MSA after December 31, 2007, such accounts in existence as of that date were grandfathered. This section discusses only the HSAs, FSAs, and HRAs.152

CAFETERIA PLANS A cafeteria plan is a written employer-sponsored benefits package offering employees a choice between two or more benefits consisting of either cash or qualified benefits that may be excluded from income.153 MERPs such as an HSA or FSA are commonly offered as part of a cafeteria plan. An HRA cannot be offered as part of a cafeteria plan.154

148. IRC §213(f). 149. Treas. Regs. §§1.125-1(a)(3)(B) and 1.125-5. 150. IRS Notice 2002-45, 2002-2 CB 93, amplified by Rev. Rul. 2006-36, 2006-36 IRB 353, modified by IRS Notice 2007-22, 2007-10 IRB 670, amplified by IRS Notice 2008-59, 2008-29 IRB 132. 151. IRC §223. 152. IRC §220(i). See also Tax-Advantaged Accounts for Health Care Expenses: Comparison, 2013. Rapaport, Carol. Nov. 8, 2013. Congressional Research Service. [fas.org/sgp/crs/misc/RS21573.pdf] Accessed on Jun. 22, 2017. 153. IRC §125(d) and Prop. Treas. Reg. §1.125-1. 154. Prop. Treas. Reg. §1.125-1(q).

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If a cafeteria plan is used, the following rules apply. • The small business owner, as employer, may not participate in the cafeteria plan155 • Certain nondiscrimination rules under IRC §125 apply. For any cafeteria plan, the small business owner is generally not considered an “employee,” and therefore is prohibited from participating in cafeteria plans. Partners in a partnership and more-than-2% shareholders in S corporations are not considered employees and cannot participate in the cafeteria plan.156 However, shareholders in a 3 C corporation who are also employed by the corporation can participate.157 158

Note. For the definition of a more-than-2% shareholder (referred to as a “2% shareholder”), see IRC §1372(b). While the IRC §318 attribution rules apply to determine who is a 2% shareholder, they do not apply to partners in a partnership.158 Accordingly, a family member of a partner may participate in the cafeteria plan as long as they are genuinely employed by the partnership.

Some accounts, such as HSAs, may be established on a “stand-alone” basis without the use of a cafeteria plan. Such accounts may generally be used by the small business owner. In addition, a cafeteria plan may be structured to provide an employee with the ability to accept a reduction in salary and have the reduction amount contributed into qualified benefit accounts. The cafeteria plan may require the employer to make contributions to employee qualified benefit accounts. A cafeteria plan may also be structured to provide employees with a combination of a salary reduction option and the ability to elect how to use employer funds among the qualified benefit account options offered.159

HEALTH FLEXIBLE SPENDING ARRANGEMENT Generally, an FSA is an account established by the employer for an employee. An employer may contribute to an FSA, and the employee may also contribute pre-tax dollars through a cafeteria plan salary reduction arrangement.160 The FSA is used to reimburse the employee for qualifying health care, dependent care, or adoption expenses.161 FSA distributions to reimburse the employee for qualified expenses are not taxable.162 Medical expenses that qualify for FSA reimbursement are those expenses that would otherwise qualify for the medical expense deduction under IRC §213(d).163 Generally, dependent care expenses must meet the definition found in IRC §129 to qualify for reimbursement.164 Qualifying adoption expenses are those that qualify under an adoption assistance program, as defined in IRC §137.165

Note. For further details on FSA qualifying expenses, see Prop. Treas. Reg. §1.125-5, which governs FSAs.

155. Prop. Treas. Reg. §1.125-1(g). 156. Prop. Treas. Reg. §1.125-1(g)(2); IRC §§401(c) and 1372. 157. Ibid. 158. Treas. Reg. §1.125-1(g)(2). 159. Treas. Reg. §1.125-1(c)(1)(iv). 160. IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans. 161. Treas. Reg. §1.125-5(h). 162. IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans. 163. IRC §105(b). 164. Prop. Treas. Reg. §1.125-5(i). 165. Prop. Treas. Reg. §1.125-5(j).

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The 2017 contribution limit for an FSA is $2,600.166 This amount is subject to an annual inflation adjustment. An FSA does not provide the ability to accumulate funds from year to year. The FSA is subject to the “use-it-or-lose- it” rule: The account holder may forfeit any balance remaining in the account at the end of the plan year for which the FSA is established.167 However, at the employer’s option, a grace period may be established to extend the period during which FSA funds must be used before forfeiture. The maximum grace period is 2½ months after the end of the plan year.168 Furthermore, if the employer does not offer a grace period for the FSA, the employer can provide a $500 rollover of unused funds to the following plan year.169

Note. For more information about FSAs, see the 2017 University of Illinois Federal Tax Workbook, Vol ume A, Chapter 2: Employment Issues.

Tax Savings FSAs funded by employees reduce the employer’s tax liability, because the amounts contributed to FSAs by employees are not subject to FICA taxation. In addition, FSA contributions are not subject to either income or FICA taxation for the employee.170 170

Observation. Although FSAs allow for reimbursement of broader types of expenses than those that qualify under an HSA, the FSA contribution limits are lower, which means potential tax savings are less than those available for an HSA.

Reimbursements to the employee for qualified expenses are excluded from the employee’s income.171

Limitations on Use by Business Owners While FSAs for employees can provide small business owners with savings in payroll taxes, many small business owners are prohibited from using an FSA for their own benefit because an individual must be an employee to use an FSA.172 For purposes of FSA eligibility, the definition of an employee does not include a partner, a 2% shareholder, or a proprietor.173 However, this prohibition does not apply to business owners operating as C corporations.174

HEALTH REIMBURSEMENT ARRANGEMENTS An HRA is a plan funded exclusively by the employer that reimburses employees for qualified medical costs.175 The HRA is a tax-advantaged “self-funded” plan that is subject to nondiscrimination rules.176 Employees receive reimbursement for qualified medical expenses up to a maximum dollar amount for a given period, specified in the terms of the HRA.177 Because the reimbursements are tax-exempt to employees, there is no employee Form 1040 reporting requirement for HRA reimbursement of qualified medical expenses.

166. Rev. Proc. 2016-55, 2016-45 IRB 707. 167. Prop. Treas. Reg. §1.125-5(c); IRS Notice 2005-42, 2005-23 IRB 1204. 168. Prop. Treas. Reg. §1.125-1(e). 169. IRS Notice 2013-71, 2013-47 IRB 532. 170. IRC §3121(a)(2). 171. IRC §125(a). 172. Prop. Treas. Reg. §§1.125-5(a)(1) and (g)(1). 173. Treas. Reg. §1.125-1(g). 174. Treas. Reg. §1.105-5(b) and IRC §1372(a). 175. IRS Notice 2002-45, 2002-28 IRB 93, amplified by IRS Notice 2006-36, 2006-15 IRB 756. 176. See IRC §105(h)(2) and Treas. Reg. §1.105-11. 177. IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans.

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If the HRA plan permits employees to roll over unused amounts from year to year, employees have the opportunity to accumulate HRA funds sufficient to cover future medical costs if they arise.178 However, the employer is not required to offer a rollover provision.

Qualified Small Employer HRA The 21st Century Cures Act,179 signed into law on December 13, 2016, created the qualified small employer HRA, (commonly referred to as the “small employer HRA”). These new small employer HRAs are available effective 3 January 1, 2017. Market reforms for group health plans prohibit imposing lifetime or annual dollar limits on benefits, based on how the Affordable Care Act defines these prohibitions.180 Details regarding these market reforms are found in Treas. Reg. §54.9815-2711.

Note. For further information on applicable market reforms for HRAs and other §105 accounts, see the Department of Labor Technical Release No. 2013-03, Application of Market Reform and other Provisions of the Affordable Care Act to HRAs, Health FSAs, and Certain other Employer Healthcare Arrangements. This can be found at uofi.tax/17b3x2 [www.dol.gov/agencies/ebsa/employers-and-advisers/guidance/technical- releases/13-03].

The 21st Century Cures Act creates a specific exception for the new small employer HRA.181 Therefore, the eligible small business owner may use a small employer HRA without violating these market reforms. To receive reimbursements from a small employer HRA, the employee must have minimum essential coverage (MEC). However, an employee that qualifies for the premium tax credit (PTC) will have their PTC reduced by the amount of the employee’s permitted HRA benefit.182 To qualify as a small employer HRA, the arrangement must meet the following requirements. • Be funded solely by an eligible small employer (generally an employer with under 50 full-time employees)183 • Provide for payment or reimbursement of qualified medical care expenses incurred by the employee (or employee’s family members) after the employee provides proof of coverage to the small business employer184 • Not pay or reimburse more than $4,950 of expenses for a single employee, or more than $10,000 for an employee with family coverage, for the year.185 (These dollar amounts are prorated for eligible employees covered by the HRA for less than a year and are subject to future cost-of-living inflation adjustments.)

178. Ibid. 179. PL 114-255. 180. IRC §9831. 181. IRC §9831(d)(1). 182. IRC §36B(c)(4). 183. IRC §9831(d)(3)(B). 184. IRC §9831(d)(2)(B). 185. Ibid.

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An eligible employee is generally any employee of the employer. However, employers may exclude certain employees, including those who have not completed 90 days of service or who have not attained age 25. Part-time or seasonal employees may also be excluded.186 A small employer HRA must generally provide the same terms to all eligible employees. However, variances in the terms are allowed based on the employee’s age and/or the age of family members and the number of family members covered by the arrangement.187

Note. For further information about small employer HRAs, including the coordination with the PTC, see the 2017 University of Illinois Federal Tax Workbook, Volume A, Chapter 6: New Developments.

HEALTH SAVINGS ACCOUNT HSAs are established by individuals with an HSA-qualified high-deductible health plan (HDHP). The HDHP must meet certain requirements to qualify as coverage that may be used with an HSA. These requirements include a minimum annual deductible amount as well as a limit on the annual out-of-pocket expenses the plan holder may incur for the plan year. The amounts for each of these requirements vary for self-only and family coverage and are subject to adjustments for inflation. The following table provides relevant HDHP amounts and applicable contribution limits for 2017.188

189

HDHP Feature Self-Only Coverage Family Coverage Minimum annual deductible $1,300 $ 2,600 Maximum annual out-of-pocket expenditures 6,550 13,100 Maximum contribution 3,400 6,750

Note. An individual who attained at least age 55 before the end of the tax year and who is not enrolled in Medicare can also make a “catch-up” contribution of $1,000 to their HSA. This $1,000 amount is not subject to an inflation adjustment.189

Contributions to an HSA made by either the taxpayer or the taxpayer’s employer are reported on Form 8889, Health Savings Accounts (HSAs). HSA distributions are also reported on this form.190 If a sole proprietor makes contributions to employee HSAs, those contributions are deductible as an employee benefit programs expense on Schedule C.191

Note. Most of the governing rules for HSAs are found in IRC §223. For additional information about HSAs, see the 2011 University of Illinois Federal Tax Workbook, Chapter 7: Individual Taxpayer Topics. This can be found at uofi.tax/arc [taxschool.illinois.edu/taxbookarchive].

186. IRC §9831(d)(3)(A), referencing IRC §105(h)(3)(B). 187. IRC §9831(d)(2)(C). 188. Rev. Proc. 2016-28, 2016-20 IRB 852. 189. IRC §223(b)(3). 190. Instructions for Form 8889. 191. IRC §162(a).

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If a taxpayer pays qualified medical expenses using a tax-free HSA distribution, they may not also claim these expenses as a medical expense deduction on Schedule A, Itemized Deductions.192 Funds within an HSA remain with the employee who owns the account. This is true regardless of whether the employee changes employers.193 Moreover, any unused funds within the HSA at the end of the year remain in the account and may continue to accumulate year after year until the employee chooses to use them for qualified medical expenses. In addition, if the HSA owner dies, the account may pass to a surviving spouse without immediate tax consequences and the spouse becomes the new account owner.194 195 3

Observation. The ability to accumulate funds within an HSA over a long period means the small business owner may use the HSA for tax-deferral purposes. This ability to accumulate funds is one advantage of the HSA that does not exist with an FSA, because an FSA requires the account holder to use funds contributed each year or lose them (subject to a grace period or an allowable $500 rollover to the following year, as discussed earlier).

Note. For further details on HSAs, including the 20% penalty on distributions not used for qualifying medical expenses195 and the rules regarding excess contributions, see IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans.

Comparability Rules and HSAs196 Generally, if an employer makes contributions to employee HSAs, comparability rules apply.197 These rules require the employer to make comparable contributions to all employees with “comparable coverage.” Comparable coverage refers to the categories of coverage that employees may have. Generally, the two categories of coverage are self-only coverage and family coverage. However, employees with family coverage may be further categorized based on the relationship and number of family members covered.198 However, these comparability rules do not apply to employer contributions made to employee HSAs that are offered through a cafeteria plan. Instead, the cafeteria plan nondiscrimination requirements apply.199 There is a 35% excise tax on an employer who fails to adhere to the comparability rules.200

HSAs and Entity Types201 The tax benefits of HSAs vary by the type of business entity and the individual’s role as an employee or an employer. Employees agree to reduce their salary by the desired HSA contribution amount, and that amount is contributed to their HSA. This is a pretax contribution not subject to income tax or FICA withholding.

192. IRC §223(f)(6). 193. IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans. 194. IRC §223(f)(8). 195. IRC §223(f)(4)(A). 196. TD 9393, 2008-20 IRB 975; and IRC §4980G. 197. IRC §§4980E(a), (d)(1). 198. Treas. Reg. §54.4980G-1. 199. IRC §§4980E(d) and 4980G; Treas. Reg. §54.4980G-5. 200. Treas. Reg. §54.4980G-1. 201. IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans.

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Employers benefit from savings on the employer portion of FICA on the HSA contribution amounts. They may also save federal unemployment taxes on the contribution amounts. In addition, there may be state-level unemployment tax savings, depending on the applicable rules of the state in which the employer does business. Sole Proprietorships and HSAs. A sole proprietor who makes a contribution to their own HSA may claim an above-the-line deduction on line 25 (“health savings account deduction”) of Form 1040 for the amount contributed to the HSA (up to the allowable amount for the year).202 While the proprietor’s contribution to their own HSA is not deductible by the business, HSA contributions made by the proprietorship to employee HSAs are deductible business expenses.203 For a pre-tax contribution, the contribution amount is not included as compensation in box 1 of Form W-2, Wage and Tax Statement, for the employees, but the contribution amount is shown on each employee’s respective Form W-2 in box 12, using code “W” to identify the amount as an HSA contribution made by the employer. The pre-tax contribution amount is not subject to FICA.204 Example 6. Larry is the owner of Big L’s Pizza, a sole proprietorship with three employees. During 2017, Larry contributes $2,000 to his HSA. He also contributes $2,000 to the HSA for each of his three employees, for a total of $6,000 in employee HSA contributions. On Larry’s 2017 tax return, the $2,000 contribution Larry makes to his own HSA is shown on Form 8889, and is deducted on Form 1040, line 25, as an above-the-line deduction. 205 206 207 The $6,000 of employee HSA contributions are deducted as employee benefit program expenses on Larry’s Schedule C.205 These employee HSA contributions are made on a pre-tax basis for each employee. The contribution amount for each employee is shown on their respective Forms W-2 in box 12, using code “W.”

Observation. Larry’s own HSA contribution does not reduce his SE tax,206 but the contribution amount is tax deductible.207 The employee contributions reduce Larry’s SE tax because they are deducted as business expenses on Schedule C and reduce the amount of FICA in connection with employee compensation.

Partnerships and HSAs.208 A partnership contribution to a partner’s HSA could be characterized as a distribution or a guaranteed payment to the partner. The partner’s Schedule K-1 reflects the HSA contribution.

Note. For additional information about HSAs and partnerships, see the 2017 University of Illinois Federal Tax Workbook, Volume B, Chapter 4: Partner Issues.

202. IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans. 203. IRC §162(a)(1) and Treas. Reg. §1.162-10. 204. See General Instructions for Forms W-2 and W-3. 205. Instructions for Schedule C. 206. IRC §162(l)(4). 207. IRC §162(l)(1). 208. IRS Notice 2005-8, 2005-4 IRB 368.

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S Corporations and HSAs. Generally, a contribution to a 2% shareholder’s HSA by an S corporation is included in the shareholder’s taxable income for the year209 and is deductible by the S corporation.210 The S corporation may deduct the amount either as compensation or as an employee benefit expense.211 However, the S corporation shareholder may subsequently deduct the amount of the HSA contribution from income,212 and the contribution amount is not subject to FICA taxation.213 214

Note. The definition of 2% shareholder is subject to the IRC §318 attribution rules to determine if the 2% 3 threshold is met.214

HSA Tax Advantages There are several advantages associated with the use of an HSA. These include the following.215 • Contributions to the HSA may be made by either the employee or employer. • Any income earned on the contributions within the HSA is tax-exempt. • Contributions may be made as late as the tax filing deadline for the year for which the contribution is attributable. • Amounts withdrawn from the HSA by the employee and used for qualified medical expenses are not taxable. • If the employer makes contributions to an employee’s HSA, the contribution amount is not included in the employee’s taxable income and is therefore not subject to FICA.216 The contributions by the small business owner to employee HSAs are tax deductible (and, for an employee, pre-tax contributions may be made). For both the employee and the business owner, an HSA contribution can provide advantages that would not accrue to either party from a wage increase. Example 7. Clayton owns Clay’s Marine Engine (CME), a sole proprietorship with one employee, Frank. Frank, who is CME’s mechanic, has been employed at CME for five years. Frank has a spouse and two minor children and currently has a family health plan that he purchased using his state’s health insurance exchange. In 2016, Frank earned a salary of $67,500, and his marginal tax rate was 25%. Frank and Clayton discuss a 10% raise for 2017. Clayton agrees to give Frank a 10%, or $6,750, increase in salary for 2017. The taxes on this increase are as follows.

Clayton Frank Total Social security tax (6.2%) $419 $ 419 $ 838 Medicare tax (1.45%) 98 98 196 Federal income tax liability (25% marginal tax rate) 1,688 1,688 Total $517 $2,205 $2,722

209. See General Instructions for Forms W-2 and W-3. 210. IRS Notice 2005-8, 2005-4 IRB 368 and IRC §707(c). 211. IRC §162(l)(5). 212. IRC §3121(a)(2)(B). 213. IRS Notice 2005-8, 2005-4 IRB 368. 214. IRS Notice 2008-1, 2008-2 IRB 251. 215. IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans; IRS Pub. 15-B, Employer’s Tax Guide to Fringe Benefits. 216. IRC §3401(a)(22).

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After income and FICA taxes, Frank’s net additional compensation will be $4,545 ($6,750 – $2,205). Alternatively, Clayton could suggest that Frank use an HSA in conjunction with an HDHP. Under this method, Clayton could use the entire $6,750 to fund Frank’s HSA on a pre-tax basis. This would mean the $6,750 increase is not taxable to Frank, which saves him $2,205. Clayton would also save $517, which is the employer portion of FICA on the salary increase. In addition, any income earned on the $6,750 HSA contribution is tax-exempt. Frank would not pay any income tax on amounts withdrawn from the HSA to cover qualified medical expenses. Clayton could deduct the $6,750 as an employee benefit program expense on his Schedule C for CME.

BONUS DEPRECIATION

The Protecting Americans from Tax Hikes Act (PATH Act) of 2015217 extends the ability to claim bonus depreciation and makes some substantive changes to the bonus depreciation rules. Generally, the PATH Act extends bonus depreciation for eligible property acquired and placed in service before January 1, 2020.218 However, the bonus rate is phased down, as indicated in the following table.219

Year Eligible Property Placed in Service a Bonus Rate 2015 through 2017 50% 2018 40% 2019 30% 2020 and subsequent years 0%

a The percentages apply to certain longer-lived and transportation property placed in service one year later.

The PATH Act also makes changes to the definition of eligible property. Eligible property is property placed into service before January 1, 2020, that falls into one of the following categories.220 • Modified accelerated cost recovery system (MACRS) property with a recovery period of 20 years or less • Computer software (as defined in IRC §167(f)(1)(B)) that would otherwise qualify for a depreciation deduction • Water utility property • Qualified improvement property (QIP) 221 222

Note. Under the bonus depreciation property rules, the original use of eligible property must have been by the taxpayer.221 This differs from the rule for qualifying IRC §179 property, which can be used property acquired by the taxpayer.222

217. PL 114-113 (Dec. 18, 2015). 218. IRC §168(k)(2)(A)(iii). 219. IRC §168(k)(6). 220. IRC §168(k)(2). 221. IRC §168(k)(2)(A)(ii). 222. IRC §179(d).

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QIP is a new category of property created by the PATH Act.223 QIP is any improvement to an interior portion of a building that is nonresidential real property. The improvement must be placed in service after the date the building was first placed in service.224 Expenditures associated with the following are excluded from the definition of QIP.225 • The enlargement of a building • An elevator or escalator 3 • A building’s internal structural framework The PATH Act makes permanent the 15-year recovery period226 on qualified leasehold improvement property (QLIP),227 qualified restaurant property (QRP),228 and qualified retail improvement property (QRIP).229 Under the changes made by the PATH Act,230 any QLIP, QRP, or QRIP placed into service after 2015 must meet the definition of QIP to qualify for bonus depreciation. Under the QIP definition, QLIP does not need to be subject to a lease.231 Moreover, before the PATH Act changes, QLIP needed to be placed in service more than three years after the building was first placed in service. This 3-year requirement no longer applies.232

Note. For additional details on these PATH Act changes, see uofi.tax/17b3x3 [www.journalofaccountancy. com/issues/2016/may/new-bonus-depreciation-provisions.html].

BONUS DEPRECIATION ON PLANTS The PATH Act also extends bonus depreciation to fruit-bearing and nut-bearing plants. Such plants are generally not considered to be placed in service before they bear fruit or nuts and generate income.233 Costs incurred before the plants generate income, referred to as “preproduction costs,” were previously not eligible for bonus depreciation. Under the PATH Act, such preproduction costs for fruit- and nut-bearing plants either planted or grafted after December 31, 2015, and before January 1, 2020, are eligible for bonus depreciation.234 The bonus depreciation on such plants is subject to the phase-down rule for the bonus depreciation rate discussed earlier.235 236

Note. Once such plants are placed into service, the basis of the plants must be reduced by the amount of bonus depreciation claimed.236 For further information on bonus depreciation for fruit- and nut-bearing plants, see IRC §168(k)(5) and IRS Pub. 225, Farmer’s Tax Guide.

223. IRC §168(k)(3)(A). 224. Ibid. 225. IRC §168(k)(3)(B). 226. IRC §168(e)(3)(E). 227. IRC §168(e)(6). 228. IRC §168(e)(7). 229. IRC §168(e)(8). 230. IRC §168(k)(3) as amended by the PATH Act. 231. Ibid. 232. Ibid. 233. IRS Pub. 225, Farmer’s Tax Guide. 234. IRC §168(k)(5). 235. IRC §168(k)(5)(F). 236. IRC §168(k)(5)(A)(ii).

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SALE OF BUSINESS ASSETS

Generally, a “capital asset” is defined as property held by the taxpayer, excluding such items as business property or inventory.237 The sale of a capital asset may lead to a short- or long-term capital gain or loss as defined in the Code.238 Business asset sales, however, are generally subject to other specific rules discussed in this section, because assets held for use within a trade or business are considered noncapital assets.239 Three Code sections must be considered when determining how to correctly report the sale of a business asset. These Code sections are summarized in the following table.

IRC §1231 IRC §1245 IRC §1250

• Most depreciable assets used • Gain from depreciable personal • Gain from depreciable real in a trade or business that are property (tangible or intangible) estate that is not IRC §1245 held for more than one year and certain specific-purpose property • Excludes inventory, property real estate held by the taxpayer for sale • Excludes most buildings or to customers in the ordinary structural components of course of business, and certain buildings other property

Note. For more detailed definitions and exclusions that fall under each of the three Code sections, see IRC §§1231(b), 1245(a)(3) and (b), and 1250(c) and (d).

IRC §1231 PROPERTY For §1231 property dispositions, gains and losses are netted each year. If gains for the year exceed losses, those gains and losses are treated as long-term capital gains and losses.240 However, if losses equal or exceed gains for the year, the gains and losses are treated as ordinary.241 The sale or exchange of real or depreciable property used in a trade or business is reported on Form 4797, Sales of Business Property. Form 4797 may be filed with an individual, partnership, C corporation, or S corporation return. Generally, gains or losses are shown on Form 4797, part I. Net gains are carried to Schedule D as a long-term capital loss, and net losses are carried to Form 4797, part II, as an ordinary loss.242 For years in which there is a net gain, a 5-year look-back period may serve to recharacterize some or all of the year’s net gain as ordinary to the extent of the §1231 losses within the 5-year look-back period.243 The amount of aggregate losses within the 5-year look-back period that has not yet been used to recharacterize any gain is referred to as a nonrecaptured net §1231 loss.

237. IRC §1221(a). 238. IRC §1222. 239. IRS Pub. 544, Sales and Other Dispositions of Assets. 240. IRC §1231(a)(1). 241. IRC §1231(a)(2). 242. IRS Pub. 544, Sales and Other Dispositions of Assets. 243. IRC §1231(c).

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Example 8. Clarkson Paper (CP) has been gradually selling older paper production equipment since 2012 as part of an overall program to update its production capability. Prior to 2011, CP did not sell any business assets. Most of the asset sales in these prior years resulted in a loss, but some assets were sold at a gain. After netting all such gains and losses, each year has a resulting net loss with the exception of 2014, during which no assets were sold. The following losses are attributable to each of the last five years as a result of these asset sales. 3 Year Amount 2011 ($ 6,000) 2012 (4,000) 2013 (7,000) 2014 0 2015 (1,000) Total ($18,000)

In 2016, CP decides to accept an offer from a local automobile parts distributor to purchase CP’s conveyor belt system. Because the conveyor belt system is very valuable to the automobile parts distributor, CP can sell the system at a profit of $32,000. CP accepts the offer and sells the conveyor system, recognizing a $32,000 gain. The conveyor system is the only asset sold in 2016. In 2016, the total of $18,000 shown in the preceding table is the amount of CP’s nonrecaptured net §1231 loss. The 5-year look-back period is 2011 through 2015. While the $32,000 gain from the sale of the conveyor system would normally be characterized under IRC §1231 as long-term capital gain, this gain is recharacterized as ordinary income to the extent of the $18,000 nonrecaptured net §1231 loss.244 Accordingly, CP reports the 2016 conveyor system gain as follows.

Ordinary gain $18,000 Long-term capital gain 14,000 Total gain reported $32,000

The relevant portion of CP’s 2016 Form 4797 follows.

244. Ibid.

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For Example 8

Example 9. Use the same facts as Example 8, except in 2014, CP sold an antique printing press to a museum and recognized gain of $20,000. No other assets were disposed of in 2014. Within the 5-year look-back period, CP has an unrecaptured net §1231 loss of $17,000, calculated as follows.

2011 ($ 6,000) 2012 (4,000) 2013 (7,000) Total ($17,000)

The $20,000 gain on the sale of the antique printing press in 2014 is treated as ordinary gain up to the amount of the nonrecaptured net §1231 loss of $17,000. The $20,000 gain on the sale in 2014 is reported as follows.

Ordinary gain $17,000 Long-term capital gain 3,000 Total gain reported $20,000

This leaves no nonrecaptured net §1231 loss amount remaining at the end of 2014 because the accumulated $17,000 IRC §1231 loss was applied against the 2014 IRC §1231 gain on the antique printing press. Accordingly, the only nonrecaptured net §1231 loss amount to be applied against the 2016 conveyor system sale is the $1,000 loss from 2015. Therefore, of the $32,000 gain in 2016, $1,000 is characterized as ordinary gain and the remaining $31,000 is characterized as a long-term capital gain.

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IRC §1245 PROPERTY The general rule for the disposition of IRC §1245 property requires the recapture of any gain as ordinary income, up to the amount of any depreciation previously taken on the asset.245 Gain in excess of prior depreciation is considered IRC §1231 gain and is treated as long-term capital gain for assets held more than one year.246 If the IRC §1245 property is sold at a loss, the loss is considered an IRC §1231 loss and is treated as an ordinary loss, which may be claimed against the taxpayer’s ordinary income. Property used in a trade or business with a holding period of one year or less is not IRC §1231 property, and gains or losses are ordinary.247 3 IRC §1250 PROPERTY For dispositions of IRC §1250 property, a special rule applies if an accelerated depreciation method is used to generate depreciation deductions in excess of those that would be available under the straight-line method. If an accelerated depreciation method is used, then any gain must be treated as ordinary income to the extent of the past depreciation claimed that exceeds the amount of straight-line depreciation.248 If the IRC §1250 property held for more than one year is sold at a loss, the loss is considered an IRC §1231 loss and is treated as ordinary, which may be claimed against the taxpayer’s ordinary income. If such property has a holding period of one year or less, any resulting gain or loss upon disposition is ordinary.249

Note. For further details on nonrecaptured net §1231 gain and the treatment of gains or losses on the disposal of IRC §§1245 and 1250 property, see the instructions to Form 4797 and IRS Pub. 544, Sales and Other Dispositions of Assets.

CORRECTING DEPRECIATION ERRORS

In order to correct an error involving depreciation deductions, it is necessary to take the following three steps. 1. Determine if there has been an adoption of an accounting method 2. Determine whether the required depreciation correction represents a change in accounting method 3. Make the correction This section explains these steps and includes a review of some of the key IRS guidance in this area.

ADOPTION OF AN ACCOUNTING METHOD To correct a depreciation error, it must first be determined whether the taxpayer adopted an accounting method. Generally, an accounting method is adopted when the taxpayer files an initial return.250 However, a taxpayer adopts a permissible method of accounting when it uses that method once on a tax return. If the taxpayer uses an impermissible method, that method is only adopted upon the filing of two consecutive returns.251

Note. For exceptions to the 2-year rule for an impermissible method, see Rev. Proc. 2016-29, modified by IRS Notice 2017-6.

245. IRC §1245(a). 246. IRC §§1231(a)(1) and 1231(a)(3)(A)(ii)(II). 247. Treas. Reg. §1.1221-1(b) and IRC §1231(a)(3)(A)(ii)(II). 248. IRC §1250(a)(1). 249. Treas. Reg. §1.1221-1(b). 250. Treas. Reg. §1.446-1(e)(1). 251. Rev. Rul. 90-38, 1990-1 CB 57 and IRM 4.11.6.3 (2005).

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Generally, a permissible accounting method includes the cash method, the accrual method, or other methods or combination of permissible methods that clearly reflect income and are consistently used.252 Once a taxpayer adopts an accounting method, certain depreciation error corrections may constitute a change in accounting method. The IRS’s consent is generally required for the change in accounting method, which the taxpayer obtains by filing Form 3115, Application for Change in Accounting Method. An amended tax return may not be used to correct the error for open years.

CHANGE IN ACCOUNTING METHOD IRS guidance provides a detailed list of the various types of depreciation changes that constitute a change in accounting method253 and the types of depreciation changes that do not represent a change in accounting method.254 The following table summarizes changes in depreciation and indicates whether such changes, if required to correct depreciation errors made in prior years, represent a change in accounting method.255 256 257 258

259 260 Change in Accounting Method Not a Change in Accounting Method

• Depreciation method • A mathematical or posting error 256 • Period of recovery • A change in the use of the asset that • Convention triggers a change in recovery period or • method From depreciable to nondepreciable • asset (or vice versa) To correct internal inconsistencies (such • as identical assets not depreciated Bonus depreciation amount(s) claimed identically) 257 and corrections in other affected • depreciation deductions Making a late depreciation election or revoking a timely made election • Single-asset depreciation to pooled-asset • 258 depreciation (or vice versa) Change in the placed-in-service date • Misclassification of an asset

Note. This IRS guidance on depreciation corrections and changes in accounting method applies for assets placed in service on or after December 30, 2003.259 For depreciation corrections involving assets placed in service before December 30, 2003, amended returns may be filed to make the necessary corrections for open years or a Form 3115 may be used.260

Note. A change from expensing to capitalizing an amount also constitutes a change in accounting method. For further details, see CCA 201231004.

252. Treas. Reg. §1.446-1(c). 253. Treas. Reg. §1.446-1(e)(2)(ii)(d)(2). 254. Treas. Reg. §1.446-1(e)(2)(ii)(d)(3). 255. Treas. Reg. §1.446-1(e)(2)(ii)(d). 256. Treas. Reg. §1.446-1(e)(2)(ii)(b). The term “mathematical or posting error” is not defined in the IRS guidance regarding depreciation corrections. However, this same term is defined in IRC §6213(g)(2) in connection with summary assessments for additional tax without notice due to mathematical or posting errors. Presumably, the same definition applies to depreciation errors. 257. H.E. Butt Grocery Company v. U.S., 108 F.Supp. 2d 709 (W.D. Texas 2000). 258. For the special rules applicable to a change in an asset’s placed-in-service date, see Treas. Reg. §1.446-1(e)(2)(ii)(d)(3)(v). 259. Treas. Regs. §§1.446-1(e)(4) and 1.167(e)-1. 260. Chief Counsel Notice 2004-007 (Jan. 28, 2004), clarified by Chief Counsel Notice 2004-024 (July 14, 2004).

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Note. For more information about filing Form 3115 to correct depreciation, including a detailed example with a completed Form 3115, see the 2015 University of Illinois Federal Tax Workbook, Volume B, Chapter 1: Depreciation. This can be found at uofi.tax/arc [taxschool.illinois.edu/taxbookarchive].

MAKING THE CORRECTION 3 If a taxpayer has filed only one return using an impermissible method of depreciating property, they have not adopted an accounting method. The taxpayer may file either a Form 3115 or an amended return making the required corrections.261 Generally, an IRC §481(a) adjustment may be required by taxpayers who change their accounting method using Form 3115.262 The adjustment is necessary to prevent duplication or omission of items as a result of the accounting method change.

Note. For additional information on IRC §481(a) adjustments, see the instructions to Form 3115, Application for Change in Accounting Method.

If a taxpayer filed two or more consecutive returns using an impermissible method, they have adopted an accounting method.263 This generally means that amended returns cannot be filed to make the necessary correction. The IRS advance or automatic consent procedures, within Form 3115, must be used.264

Automatic Consent Taxpayers who adopted an accounting method and need to correct depreciation amounts may qualify for automatic consent under Rev. Proc. 2017-30.265 Automatic consent changes do not require the IRS’s express approval.

Note. Taxpayers who qualify for automatic consent must generally use automatic consent procedures when filing Form 3115. For further details on automatic consent, see the instructions to Form 3115.

To qualify for automatic consent, the taxpayer must generally meet the following requirements. • The taxpayer must have used an incorrect depreciation method for at least two tax years prior to the year of change. • The taxpayer is making a change in depreciation that constitutes a change in accounting method. • The taxpayer owns the depreciable asset at the beginning of the tax year of change. Exceptions to the preceding requirements exist that may allow other taxpayers who have adopted an accounting method to use Rev. Proc. 2017-30 automatic consent procedures to correct depreciation. For example, a taxpayer may still qualify if they fail to meet the 2-year requirement because they placed the property in service in the year immediately preceding the year of change.266

261. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.01(1)(b)). 262. IRC §481(a) and Treas. Reg. §1.481-1. 263. Rev. Rul. 90-38, 1990-1 CB 57 and Rev. Proc. 2007-16, 2007-4 IRB 358. 264. Rev. Proc. 2007-16, 2007-4 IRB 358. 265. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.01(1)(a)). 266. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.01(1)(b)).

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In addition, automatic consent may be available to a taxpayer who seeks an accounting method change in connection with the depreciation of an asset sold during the year if inadequate depreciation was claimed (or if no depreciation was claimed) for that asset.267 If the taxpayer qualifies to use the automatic consent procedure under Rev. Proc. 2017-30, the taxpayer may make the necessary corrections using Form 3115 with an appropriate IRC §481(a) adjustment. Availability of Automatic Consent. Automatic consent to correct depreciation under Rev. Proc. 2017-30 is not available in all instances. Rev. Proc. 2017-30 provides a list of changes to which Rev. Proc. 2017-30 does not apply. Among the items in this list are depreciation changes such as the following.268 • Changes associated with making or revoking certain elections, including IRC §179 • Changes for property for which depreciation is determined using the asset depreciation range (ADR) depreciation • Changes for property for which a tax credit was claimed Change from One Permissible Method to Another. Rev. Proc. 2017-30 provides for automatic consent for certain changes from one permissible method to another.269 Some of the permissible-to-permissible method changes covered under Rev. Proc. 2017-30 that may provide for automatic consent include the following. • Change in general asset account treatment because of change in use of MACRS property270 • Change in qualified nonpersonal use vans and light trucks271 • Change for certain leasehold improvements272 • Change for dispositions of buildings or structural components273 and tangible depreciable assets274

Note. Rev. Proc. 2017-30 contains the most recent list of changes for which automatic consent is available. This list is extensive and covers many areas that are outside the scope of this section. Practitioners should become familiar with the contents of Rev. Proc. 2017-30 before filing a Form 3115.

Advance Consent If the taxpayer, after adopting an accounting method, does not qualify for automatic consent to make the necessary corrections to depreciation amounts claimed, the taxpayer may file Form 3115 under the advance (nonautomatic) consent provisions of Rev. Proc. 2015-13.275 Such a request requires IRS consent.

Note. For further details on filing Form 3115 under the advance consent procedures, see Rev. Proc. 2015-13 and the instructions to Form 3115.

267. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.07). 268. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.01(1)(c)). 269. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.02). 270. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.04). 271. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.06). 272. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.11). 273. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.13). 274. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.15). 275. Rev. Proc. 2015-13, 2015-5 IRB 419.

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Reduced Filing Requirement for Qualified Small Taxpayers Rev. Proc. 2017-30 provides a reduced filing requirement for qualified small taxpayers.276 Taxpayers qualify if they have $10 million or less in average annual gross receipts for the three years preceding the year of accounting method change.277

Note. The calculation of average annual gross receipts is subject to special rules. For further details, see Treas. Reg. §1.263(a)-3(h)(3). 3

Qualifying small taxpayers are required to complete only select parts of Form 3115 instead of completing the entire form.278 If required, such taxpayers make an appropriate §481(a) adjustment279 and basis adjustment280 for the affected asset(s).

Note. For additional details on these reduced filing requirements for qualified small taxpayers, see Rev. Proc. 2017-30, Section 6.01(4).

SALE OF ASSET ACQUIRED IN LIKE-KIND EXCHANGE

Under the like-kind exchange (LKE) rules, no gain or loss is recognized if qualified business or investment property is exchanged for other qualifying property of like kind in a qualifying transaction.

Note. For details on LKE transactions and the qualifying rules, see IRC §1031 and the related regulations.

Generally, in an LKE transaction, the basis of the property relinquished becomes the basis in the property acquired.281 This substituted basis is subject to various adjustments. The basis is decreased by the amount of any money the taxpayer receives in the exchange transaction. Basis is increased by any recognized gain and decreased by any recognized loss on the property exchange transaction. All taxpayers involved in LKE transactions must disclose the details of the transaction to the IRS using Form 8824, Like-Kind Exchanges.282 The basis adjustments are entered in part III of the form. The basis amount shown on Form 8824, after required adjustments, is the acquirer’s beginning basis in the acquired property. This substituted basis amount, after all required adjustments, is the beginning basis amount used for depreciation deduction purposes during the acquirer’s holding period.283 When the LKE property is sold, the sale is first reported on Form 8824. Any resulting gain or loss is then shown on Form 4797. The sale of the LKE property may be subject to IRC §§1231, 1245, or 1250 rules, depending upon the nature of the property and the acquirer’s holding period.

276. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.01(4)). 277. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.01(4)(b)). 278. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.01(4)(a)). 279. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.01(5)). 280. Rev. Proc. 2017-30, 2017-18 IRB 1131 (Section 6.01(6)). 281. IRC §1031(d). 282. Instructions for Form 8824. 283. Treas. Reg. §1.1016-10.

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B164 2017 Volume B — Chapter 3: Small Business Issues Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook Chapter 4: Partner Issues

Taxation of Partnership Income to Partners ...... B167 Netting Ordinary Income (Loss) and Guaranteed Payments...... B198 Unreimbursed Partnership Expenses...... B170 IRC §179 Deduction...... B199 Transactions Between Partners and the Partnership...... B170 Basis ...... B199 Outside Basis in Partnership Interest...... B171 Active Participation Requirement ...... B199 General Basis Rule...... B171 The Annual §179 Deduction Limit...... B200 4 Liabilities’ Effect on Basis...... B175 Business Income Limitation...... B200 The Three Loss Limitations...... B176 Claiming the IRC §179 Deduction ...... B201 Basis ...... B176 Disposition of IRC §179 Property ...... B202 At-Risk Rules ...... B177 Loans by a Partner...... B202 Passive Loss ...... B181 Loans to Buy an Ownership Interest ...... B202 Comprehensive Example Loans Incurred by a Partner of the Three Loss Limitations...... B183 for Partnership Purposes ...... B206 Distributions...... B192 Income from Discharge of Indebtedness...... B206 Current Distribution of Assets...... B192 Net Investment Income Tax ...... B207 Proportionate Distribution of All Assets .... B193 Disposition of a Partnership Interest...... B208 Disproportionate Distributions...... B193 Holding Period ...... B208 Guaranteed Payments to Partners...... B194 Gain or Loss on Sale or Exchange ...... B208 Fringe Benefits ...... B194 Installment Sale Method ...... B209 Self-Employment Taxes...... B197 Family Gift of a Partnership Interest ...... B209 SE Tax on Distributions ...... B197 Abandonment of a Partnership Interest...... B211 SE Tax on Guaranteed Payments ...... B198

About the Authors Peg Phillips, CPA, is a writer and editor for the University of Illinois Tax School. She has been with the program since 2003. Peg graduated from the University of Illinois with high honors in accounting and passed the CPA exam in 1989. She currently owns and operates Phillips Tax Service in Pekin, IL. Kenneth Wright has a law degree and a Master of Laws in Taxation from the University of Florida. He has been in private practice and has taught continuing education courses for the University of Missouri, the IRS, the AICPA, and the American Bar Association among others. Ken has served as Vice Chair of the Taxpayer Advocacy Panel, a Federal Advisory Group to the IRS, and was the first non-IRS recipient of the National Taxpayer Advocate Award for his work with the IRS on cancellation of indebtedness income and individual bankruptcy tax issues.

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Chapter Summary

Although a partnership is usually not subject to income tax, it is treated as a separate entity for tax reporting purposes. Each partner is then taxed on their distributive share of partnership income or loss. For tax purposes, a partnership is treated as owning its assets as a separate entity, with its partners owning interests in that entity. Partners’ outside bases in their partnership interest are determined separately from the partnership’s inside basis in its assets. The three loss limitations (basis, at-risk, and passive activity) and the order in which they are applied are explained. These rules limit the losses deductible by a partner from a partnership. A partner does not recognize gain or loss for current distributions of money and marketable securities unless the money and/or the FMV of the securities distributed exceed the partner’s adjusted partnership basis. Similarly, a partner does not recognize gain in a liquidating distribution if the distributed assets do not exceed the partner’s adjusted outside basis. Guaranteed payments to partners may include fringe benefits. These payments are ordinary income and may be offset by the partner’s share of the partnership’s ordinary loss. It is the partnership’s responsibility to report each partner’s share of self-employment (SE) earnings. The distributive shares of income from a partnership are SE earnings for general partners but are not for limited partners. However, guaranteed payments are always SE earnings. The IRC §179 annual dollar and taxable income limitations apply at both the partnership and partner levels. If a partner does not actively or materially participate in the partnership’s activities, they cannot claim the §179 deduction from the partnership. Interest expense associated with the debt-financed acquisition of a partnership interest is allocated based on the assets owned by the partnership or under tracing rules. Partners report such interest expense on either Schedule E or Schedule A, depending on the type of expenditure to which the interest expense is allocated. Partners must generally include their share of cancellation of debt (COD) income in their gross income. The effect of COD on a partner’s basis is described. A partnership interest is a capital asset. The disposition of the interest results in long- or short-term gain or loss depending on the selling partner’s holding period. Family partnerships are subject to special rules to prevent income-shifting from high-income family partners to low-income family partners. In general, there is no gain or loss on the transfer of a partnership interest by gift but additional rules apply when the partnership interest is gifted or sold to a family partner.

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TAXATION OF PARTNERSHIP INCOME TO PARTNERS

A partnership is treated as a separate entity for purposes of computing income, gains, losses, deductions, and credits for each tax year. However, the partnership entity is generally not subject to income tax. Instead, each partner is taxed on their distributive share of partnership income or loss. The distributive share does not typically equal what was actually distributed by the partnership. A partner’s share of separately and nonseparately stated items is reported to the partner on Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc. The character of any item of income, gain, loss, deduction, or credit is determined at the partnership level.1 Separately stated items are identified on Schedule K-1 or disclosed with the Schedule K-1 (shown on the following pages). All other nonseparately stated income and deductions from the business operations of the partnership 4 are included in ordinary business income (loss) on Schedule K-1. Guaranteed payments are compensation to partners for services or use of capital. These payments are not determined by the partner’s share of the partnership’s profits. As discussed later in the chapter, guaranteed payments may include certain fringe benefits and may be subject to self-employment taxes. Otherwise deductible losses cannot exceed the outside adjusted basis of the partner’s partnership interest at the end of the tax year in which the loss occurs.2 In addition, losses are subject to the at-risk and passive activity loss rules. All of these limitations are discussed later in the chapter.

1. Treas. Reg. §1.702-1(a). See also Schedule K-1 (Form 1065) and related instructions. 2. IRC §704(d).

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UNREIMBURSED PARTNERSHIP EXPENSES

A partner may incur out-of-pocket expenses related to a partnership. The partner may only deduct these expenses from gross income when the partnership agreement requires the partner to pay such expenses.3 Because partners are, by definition, not employees of the partnership, the deduction for out-of-pocket expenses is not subject to the 2% floor for unreimbursed employee expenses.4 Unreimbursed expenses are deducted in part II of Schedule E, Supplemental Income and Loss. The total deductible expenses are listed separately from other amounts from the partnership and identified using code “UPE.”5 If the unreimbursed expenses are from an active conduct of a trade or business, then these expenses also reduce the self- employment income on Schedule SE.

TRANSACTIONS BETWEEN PARTNERS AND THE PARTNERSHIP

A partner may have transactions with the partnership other than as a partner. The general rule is that payments for services performed for a partnership by a partner that are outside their status as a partner are treated in the same manner as between unrelated parties. The same rule holds for the use of capital, sales, and exchanges between a partner and the partnership.6 However, the following limitations apply. 1. The gain on sales of property other than capital assets by a partner with a more than 50% capital or profits interest, either directly or indirectly, is treated as ordinary income. The term “property other than capital assets” includes (but is not limited to) trade accounts receivable, inventory, stock in trade, and depreciable or real property used in the trade or business.7 Direct or indirect ownership includes interests of brothers, sisters, spouses, ancestors, and lineal descendants, as well as a share of any partnership interest owned by a corporation, partnership, or trust in which the partner has an interest.8 2. Losses on sales or exchanges are disallowed when the sale is between a partner and a partnership in which the partner owns, directly or indirectly, more than a 50% interest.9 3. In the case of farm real estate rental arrangements between a managing partner, landlords, and the partnership in which they materially participate, the court and the IRS ruled that rental income from either a crop share or a cash lease is considered self-employment (SE) income for the landlord.10 The key appears to be that the arrangement designates that the partner is involved to a material degree, through the partnership, in the production and management of agricultural commodities. 11

Note. The 8th Circuit determined that cash rents in these situations are not subject to SE tax if a fair market rent is paid.11 However, the IRS issued a nonacquiescence on the 8th Circuit decision.

3. See, e.g., Johnson v. Comm’r, TC Memo 1984-598 (Nov. 19, 1984). 4. Ibid. 5. Instructions for Schedule E. 6. IRC §707(a); See also Heggestad v. Comm’r, 91 TC 778 (Oct. 17, 1988). 7. IRC §707(b)(2); See also Treas. Reg. §1.707-1(b)(2). (Regulation does not reflect PL 98–369.) 8. IRC §707(b)(3); IRC §267(b). See also Treas. Reg. §1.707-1(b)(3). See Rev. Rul. 67-105, 1967-1 CB 167 for an example of a citrus grove sale between related parties. 9. IRC §707(b)(1); See also Treas. Reg. §1.707-1(b)(1). 10. Lee and Pearlene Mizell v. Comm’r, 70 TCM 1469 (Nov. 29, 1995). 11. Bot v. Comm’r, 78 TCM 220 (Aug. 3, 1999); Hennen v. Comm’r, 78 TCM 445 (Sep. 16, 1999); McNamara v. Comm’r, 78 TCM 530 (Oct. 4, 1999), rev’d and rem’d 236 F.3d 410 (8th Cir. 2000), nonacq. IRB 2003-42.

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OUTSIDE BASIS IN PARTNERSHIP INTEREST

GENERAL BASIS RULE For income tax purposes, a partnership is treated as owning its assets as a separate entity, and its partners own partnership interests in that entity. This is an application of the entity rule of partnership taxation. Under this approach, partners’ outside bases in their partnership interest are determined separately from the partnership’s inside basis in its assets. This is the origin of the terms outside basis and inside basis, which refer to partner and partnership bases, respectively. At the time of the partnership’s formation, the total inside bases the partnership has in all of its assets plus its liabilities 4 is equal to the sum of the outside bases of all the partners. This is due to the following requirements. • A partner’s basis in the partnership interest is equal to the partner’s basis in contributed assets (increased by any gain recognized under IRC §721(b) for partnerships treated as investment partnerships)12 plus the partner’s share of partnership liabilities.13 • The partnership uses a contributing partner’s basis as its own basis in the contributed assets plus any gain recognized under IRC §721(b).14 Often, such basis equality continues for years because the continuing adjustments made to the inside basis of partnership assets are reflected in the outside bases of the partners.15

12. IRC §722. 13. IRC §752. 14. IRC §723. 15. IRC §705.

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Example 1. Enid and Fox each contribute $100 cash to form EF, LLP. The LLP uses $150 to purchase a rental property. The partnership’s initial balance sheet follows.

Adjusted Basis Book Value Asset: Cash $ 50 $ 50 Building 150 150 Total $200 $200

Member: Enid $100 $100 Fox 100 100 Total $200 $200

During its first year of operation, EF earns $20 of income, net of expenses other than depreciation, which is $10. All items are allocated equally between the two members. The LLP has a $20 increase in cash that has a basis of $20. It also has a $10 depreciation deduction that reduces its basis in the building by $10. These changes to the LLP’s inside basis are reflected in the members’ changes in their outside bases.

Adjusted Basis Book Value Asset: Cash $ 70 $ 70 Building 140 140 Total $210 $210 Member: Enid $105 $105 Fox 105 105 Total $210 $210

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Partner’s Outside Basis The correct calculation of a partner’s outside basis is necessary for determining: 1. The partner’s share of partnership losses that can be deducted,16 2. The income tax consequences of distributions of money and property from the partnership,17 and 3. Gain or loss on a sale or other disposition of the partnership interest.18 A partner’s original basis in a partnership depends on how it was acquired, as explained for the following situations. • If the partner acquires the partnership interest in connection with contributions of cash or property to the partnership, the partner’s basis is generally the sum of cash and the adjusted basis of assets transferred to 4 the partnership. This is exchanged (or substituted) basis.19 • If the partner is required to recognize gain under IRC §721(b) on contributions of securities to an investment partnership, the partner’s basis is increased by the gain recognized.20 • If the partner acquires the interest by cash purchase, the partner’s basis is their cost of such interest.21 • If a partnership interest is gifted, the donor’s basis carries over to the donee.22 If the fair market value (FMV) of the gifted interest is less than the donor’s basis, the donee’s basis for determining loss is the FMV.23 • If the partner acquires the interest from a decedent, the basis is the FMV of the partnership interest on the deceased partner’s date of death,24 reduced by the decedent’s share of partnership items that would have constituted income in respect of a decedent in the hands of the deceased partner, such as cash receivables.25 • A creditor’s basis in a partnership interest received in exchange for forgiving a partnership’s debt is the lesser of the amount of debt forgiven or the FMV of the interest acquired.26 • A partner’s basis is increased when the partner assumes partnership liabilities and decreased when the partnership assumes the partner’s liabilities.27 Liabilities treated as assumed by a transferee partner or partnership when transferred property is encumbered are limited to the property’s FMV.28

Note. Liabilities are discussed in detail in the 2017 University of Illinois Federal Tax Workbook, Volume B, Chapter 5: Partnership Issues.

16. IRC §704(d). 17. IRC §§731 and 732. 18. IRC §§736 and 741. 19. IRC §722. 20. Ibid. 21. IRC §1012. 22. IRC §1015. 23. IRC §1015(a). 24. IRC §1014. 25. See, e.g., George Edward Quick Trust v. Comm’r, 54 TC 1336 (1970), aff’d per curiam 444 F.2d 90 (8th Cir. 1971). 26. IRC §108(e)(8). 27. IRC §752. 28. IRC §752(c).

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Example 2. Alpha contributes to a partnership in exchange for a partnership interest. His contribution consists of $10,000 cash, a secured personal note for $40,000, and property with an FMV of $20,000 and a basis of $10,000. Alpha’s basis in the partnership interest and capital account are as follows.

Asset Basis FMV Cash $10,000 $10,000 Secured note 0 40,000 Property 10,000 20,000 Total $20,000 $70,000

After a partner’s initial basis is determined, it is continually adjusted as follows. 1. Basis is increased by the following items. • Additional contributions of cash and basis of property contributed to the partnership and allocation of additional partnership liabilities29 • The partner’s distributive share of nonseparately computed and separately stated income30 • The partner’s distributive share of partnership tax-exempt income31 • The partner’s distributive share of the excess of the deductions for depletion over the partner’s share of the partnership’s basis in the property32 2. Basis is decreased, but not below zero, by the following items.33 • The amount of money and the adjusted basis of property distributed to the partner by the partnership, including money attributable to a partner’s reduction in partnership liabilities allocated to the partner34 • The partner’s distributive share of separately and nonseparately stated partnership losses, including capital losses • The partner’s distributive share of nondeductible partnership expenses that are not capital expenditures • The amount of the partner’s deduction for depletion for any partnership oil and gas wells, up to the partner’s proportionate share of the partnership’s adjusted basis for such properties Partners generally determine the basis of their partnership interests at the end of the partnership’s tax year. It may be necessary to compute a partner’s basis during the partnership’s tax year rather than at the end of the year, however, if: • The partnership tax year closes for a partner because of a sale or liquidation of the partner’s entire partnership interest,35 or • A partner receives a distribution of cash from the partnership in excess of their partnership basis (rather than a draw).36

29. Treas. Reg. §1.722-1. 30. IRC §705(a)(1)(A). 31. IRC §705(a)(1)(B). 32. IRC §705(a)(1)(C). 33. IRC §§705(a)(2) and (3). 34. IRC §733. 35. IRC §706(c)(2)(A). 36. IRC §731(a)(1).

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As mentioned earlier, if a partner inherits a partnership interest from a decedent and the interest is included in the decedent’s gross estate, the basis is equal to the partnership interest’s FMV on the decedent’s date of death.37 The FMV basis then must be reduced by the deceased partner’s share of any items of the partnership on the decedent partner’s date of death which, had the deceased partner held them directly, would have been income in respect of a decedent (IRD) in the hands of the deceased partner.38

Note. It is therefore necessary for anyone acquiring a partnership interest from a decedent to know, on the decedent’s date of death, all items of the partnership that would have been IRD if the decedent had held them directly. This includes such things as cash basis accounts receivable of the partnership and rental crop shares. It also includes gain on the disposition of any asset which, on the decedent’s date of death, the partnership had contracted to sell and for which there were no material contingencies remaining unsatisfied at the time of the 4 decedent’s death. This information should be reported by the partnership on the deceased partner’s Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., as supplementary information.

Example 3. Frances was a 50% partner in a cash basis partnership before her death. The FMV of the partnership interest is $50. The partnership assets include a $20 account receivable, of which $10 is Frances’s share. Because the $10 would have constituted IRD if held directly by Frances, the outside partnership basis must be reduced by $10, from $50 to $40. When the receivable is actually collected and passed through to Frances’s successor, the outside partnership basis will increase from $40 to $50. A liquidation of Frances’s interest for $50 would therefore result in no gain or loss. Without the outside basis reduction, collection of the receivable would increase the partnership basis from $50 to $60. Redemption of the partnership interest for its $50 FMV therefore would result in a $10 loss, offsetting the effect of the $10 of IRD (although the loss would be a capital loss and the IRD would be ordinary income).

LIABILITIES’ EFFECT ON BASIS A partner’s outside basis is adjusted for increases and decreases in their proportionate share of any debt owed by the partnership. Additional liabilities increase basis while reductions in liabilities reduce basis. The partnership is responsible for reporting the partner’s share of liabilities on Schedule K-1 in part II, section K.

Note. For a comprehensive discussion of the allocation of partnership liabilities to the partners, see the 2017 University of Illinois Federal Tax Workbook, Volume B, Chapter 5: Partnership Issues.

37. IRC §1014. 38. IRC §1014(c). See, e.g., George Edward Quick Trust v. Comm’r, 54 TC 1336 (1970), aff’d per curiam 444 F.2d 90 (8th Cir. 1971).

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THE THREE LOSS LIMITATIONS

Three different sets of rules may limit the amount of losses deductible by a partner in a partnership. These limitations, in the order in which they are applied, are as follows. 1. The basis limitation under IRC §704 2. The at-risk rules under IRC §465 3. The passive activity loss rules under IRC §469

BASIS A partner’s distributive share of aggregate business losses and separately stated items may exceed the partner’s outside basis. If this occurs, the overall limitation on losses39 must be allocated to the partner’s distributive share of each loss.40 This allocation is made based on the proportion that each loss bears to the total of all losses.41 However, for this purpose, the total losses for the tax year are the sum of the partner’s distributive share of losses for the current year, as well as any losses disallowed and carried forward from prior years.42 Disallowed losses for the current year are carried forward to subsequent tax years.43 Example 4. At the beginning of 2016, Adam had a $3,000 basis in his partnership interest. Adam’s Schedule K-1 for 2016 shows the following.

Ordinary business income $4,000 Short-term capital loss (5,000) IRC §1231 loss (9,000)

Adam’s beginning basis was increased by his share of ordinary business income. Therefore, his adjusted basis before losses was $7,000 ($3,000 + $4,000). Adam’s share of the losses was $14,000 ($5,000 + $9,000). Because Adam’s share of losses exceeded his basis, he prorated the losses as shown in the following table.

Total Allocation Calculation Deductible Loss Carryover

ï1231 loss ($9,000) ($9,000 ÷ $14,000) × $7,000 ($4,500) ($4,500) Short-term capital loss (5,000) ($5,000 ÷ $14,000) × $7,000 (2,500) (2,500) Total losses ($14,000) ($7,000) ($7,000) Remaining basis $ 0

Guaranteed payments to a partner do not affect basis. Accordingly, even if a partner has taxable income from the partnership due to the receipt of guaranteed payments, any losses are still subject to the basis limitations.44

39. IRC §704(d). 40. Treas. Reg. §1.704-1(d)(2). 41. Ibid. 42. Ibid. 43. Treas. Reg. §1.704-1(d)(1). 44. IRS Pub. 541, Partnerships.

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Example 5. At the beginning of 2016, Eve had a zero basis in her partnership interest. Her Schedule K-1 for 2016 shows the following.

Ordinary business loss ($6,000) Guaranteed payments 10,000

Eve could not claim the loss on her 2016 return because it exceeded her basis. The $6,000 loss was carried forward to 2017. However, Eve was still required to report the $10,000 of guaranteed payments as ordinary income for 2016. Gains upon liquidation or disposition of a partnership interest do not increase basis. Therefore, any losses carried forward due to basis limitations are not allowed upon disposition of the interest. This is logical, because the partner 4 did not incur an economic loss from the disallowed losses.

AT-RISK RULES The at-risk rules are a possible limitation on each partner’s ability to deduct a pass-through loss from the partnership even when the losses are not limited by the basis rules. The at-risk rules cover any trade or business or income-producing activity. Under the at-risk rules, a partner can only claim a loss up to the amount for which they are at risk. The partner is at risk for the following. 1. The amount of money plus the adjusted basis of property contributed to the partnership 2. The amounts the partner borrowed for use in the partnership activity as long as the partner is either: a. Personally liable for repayment, or b. The partner pledged property as security for the debt. Certain debts do not increase basis under the at-risk rules.45 In most cases, nonrecourse debts or debts with a guarantee or stop-loss provision are not considered to place the member in additional risk and therefore do not increase basis for the partner. Prop. Treas. Reg. §1.465-1 indicates that the appropriate time to calculate at-risk basis is at the end of the tax year for the business entity. In addition, this proposed regulation also notes that in applying the at-risk rules, “…substance will prevail over form. Regardless of the form a transaction may take, the taxpayer’s amount at risk will not be increased if the transaction is inconsistent with normal commercial practices or is, in essence, a device to avoid section 465.”

45. Amounts borrowed from persons (or their relatives) having an interest in the business activity do not qualify, with some exceptions. See IRC §465(b)(3).

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Example 6. In 2015, Charlie and Deborah establish their new partnership, C & D Design. During 2015, Charlie contributes various assets with a $40,000 FMV and a cost basis of $30,000, plus $80,000 cash. Of this cash contribution, $70,000 was a bank loan guaranteed by Charlie’s mother. Deborah contributed assets with a $60,000 FMV and a basis of $40,000, plus $60,000 cash from a mortgage loan secured by her home. Charlie and Deborah are equal owners of the partnership. For 2015, the partnership reports a $100,000 loss. No other contributions were made by either partner to the partnership during the year. Charlie’s and Deborah’s basis amounts for the end of the 2015 tax year under the at-risk rules are calculated as follows.

Charlie Deborah Cash $10,000 $ 0 Asset basis 30,000 40,000 Qualifying debt 0 60,000 Total basis under at-risk rules $40,000 $100,000

Because Charlie’s debt had a guarantee, it does not provide him with basis under the at-risk rules. Conversely, Deborah’s mortgage loan, for which she pledged her home as security, provides her with additional basis under the at-risk rules. The $100,000 loss for 2015 is shared equally by Charlie and Deborah, providing them each with an allocated loss of $50,000. This is reported on each of their respective Schedules K-1. Charlie can only claim the loss up to the amount of his $40,000 basis for the year. Because he only has $40,000 at risk in the business endeavor, the at-risk rules limit the amount of loss he can claim. Accordingly, he claims $40,000 of the $50,000 loss in 2015. The excess loss of $10,000 is a suspended loss46 that carries forward to 2016 and can be claimed in 2016 or a future year only if and when Charlie has sufficient basis. 46 Deborah has more than enough basis ($100,000) to deduct her $50,000 share of the loss for 2015.

Adjustment to the Partner’s At-Risk Amount Each partner’s at-risk amount is adjusted annually. It is increased by the additional amount of money or property basis and qualified debt contributed to the business. It is reduced by losses allowed in prior years under the at-risk rules and by the amount of distributions made by the partnership. The at-risk amount is reduced if previously qualifying debt subsequently becomes unqualified. This could occur if someone else guarantees the debt or if the debt becomes nonrecourse. Conversely, when debt that previously did not qualify as basis is changed and becomes qualified, the debt increases basis.

Note. Form 6198, At-Risk Limitations, is used to calculate the amounts at risk and determine the amount of deductible losses for the current tax year.

46. IRC §465(a)(2).

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Example 7. Use the same facts as Example 6. During 2016, Charlie’s mother removes her guarantee on his loan and Deborah contributes an additional $10,000 of cash to the business. For the beginning of 2016, adjustments to the basis figures for Charlie and Deborah are made to reflect the changes that occurred in 2015. To arrive at the correct basis figures for each partner for 2016, each partner’s basis is reduced by the amounts of their respective losses that were allowed in 2015 under the at-risk rules. Moreover, for changes occurring during 2016, Charlie’s loan no longer has a guarantee. Therefore, it qualifies as additional basis under the at-risk rules. Similarly, Deborah’s additional cash contribution qualifies as additional basis for her. The adjustments are as follows.

Charlie Deborah 4 2015 beginning basis $40,000 $100,000 Less: 2015 losses allowed (40,000) (50,000) Subtotal $ 0 $ 50,000 Plus: additional cash, property basis, or qualified debt during 2016 70,000 10,000 2016 ending basis $70,000 $ 60,000

Example 8. Use the same facts as Example 7. C & D Design has a 2016 loss of $60,000. Charlie and Deborah equally share the loss — $30,000 each. For 2016, Charlie has enough basis ($70,000) to claim the $10,000 suspended loss from 2015 in addition to the full amount of his $30,000 share of the loss for 2016. His total allowed loss in 2016 is $40,000. Likewise, Deborah’s $60,000 basis is enough for her to claim her $30,000 loss for 2016. For the start of 2017, Charlie’s basis under the at-risk rules is his $70,000 basis at the end of 2016 minus the total losses ($40,000) allowed for 2016. His basis is $30,000 ($70,000 − $40,000) at the beginning of 2017. This subsequently is adjusted for any additional increases or decreases applicable during 2017 to arrive at the basis figure for the end of 2017. Similarly, Deborah’s at-risk basis at the beginning of 2017 is her $60,000 basis for 2016 less the allowed $30,000 loss. Her adjusted at-risk basis is $30,000. This is adjusted at the end of 2017 for any applicable changes for activities having an impact on at-risk basis during 2017.

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At-Risk Recapture When a partner’s at-risk amount is negative for the tax year, they must recapture at least a portion of the losses previously allowed. This is accomplished by increasing the year’s income from the partnership by the lesser of: • The negative at-risk amount (expressed as a positive income amount), or • The total amount of losses deducted in previous tax years minus any amounts previously added to income under this recapture rule. Example 9. Use the same facts as in Example 8. During the 2017 tax year, Charlie’s mother again agrees to place a guarantee on his loan, which is still $70,000. The partnership reports a loss of $10,000, which is split equally between Charlie and Deborah. Charlie and Deborah claimed the following allowed losses under the at-risk rules for 2015 and 2016.

Charlie Deborah 2015 loss claimed $40,000 $50,000 2016 loss claimed 40,000 30,000 Total prior year losses $80,000 $80,000

Charlie’s basis under the at-risk rules as at the end of 2017 is as follows.

2017 beginning basis $30,000 Reduction in basis due to renewed debt guarantee (70,000) 2017 ending basis ($40,000)

Charlie’s basis has become negative. This triggers recapture of at least part of the $80,000 of losses he claimed in prior years. The amount to recapture is the lesser of: • The negative at-risk amount, expressed as a positive number ($40,000), or • The total amount of losses deducted in previous tax years minus any amounts previously added to income under the recapture rule ($80,000). Therefore, the amount recaptured is $40,000. Charlie must report an additional $40,000 of ordinary income for 2017. The recaptured $40,000 becomes a suspended carryforward loss for Charlie. He and Deborah split the $10,000 loss for 2017 equally. For Charlie, this $5,000 loss adds to the $40,000 suspended loss that carries forward to 2018 and future years. It can be claimed against future basis increases. Deborah already has sufficient basis for 2017 ($30,000) to claim her $5,000 loss.

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PASSIVE LOSS47 In addition to complying with basis requirements and at-risk rules, losses from a partnership are subject to the passive loss limitations. Passive activities include all trades or businesses in which the taxpayer does not materially participate, as well as most rental activities. Certain limited exceptions apply for real estate professionals.48 In general, under the passive loss rules, a loss or credit from a passive activity may only be used to the extent the taxpayer has income from a passive activity. If passive activity losses exceed a taxpayer’s passive activity income, the losses are suspended until the taxpayer has sufficient income from the activity giving rise to the passive loss or from some other passive activity. The losses also cease to be suspended when the taxpayer disposes of the entire interest in the activity in a fully taxable transaction. 4 Note. Any losses suspended under the passive loss rules should be listed on Form 8582, Passive Activity Loss Limitations.

Material Participation An individual partner materially participates in an activity during a tax year if the partner meets one of the following tests.49 1. The individual participates for more than 500 hours. 2. The individual’s participation in the activity constitutes substantially all of the participation in such activity by all of the participants (including nonpartners). 3. The individual participates in the activity for more than 100 hours and no other individual participates in the activity more than the individual. 4. The activity is a significant participation activity and the individual’s aggregate participation in all significant participation activities exceeds 500 hours. 5. The individual materially participated in the activity for five of the preceding 10 tax years (regardless of whether they were consecutive). 6. The activity is a personal service activity and the individual materially participated in any three preceding years (regardless of whether they were consecutive). 7. Based on the facts and circumstances, the individual participates on a regular, continuous, and substantial basis.50 50

47. IRC §469. 48. IRC §469(c)(7). 49. Temp. Treas. Reg. §1.469-5T. 50. IRC §469(h)(1). See also Gregg v. U.S., 186 F.Supp.2d 1123 (D. Or. 2001).

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Limited Partners Under IRC §469(h)(2), limited partners do not qualify as materially participating in their partnership’s activities except as allowed under the regulations. The same restriction applies to the active participation tests for rental real estate activities.51 The regulations provide an exception for a limited partner who satisfies test 1, 5, or 6 for material participation.52 In addition, these regulations provide that if a limited partner is also a general partner, the limited partnership interest is treated as a general partnership interest.53 These provisions apply to limited partnerships (LPs) that must have at least one general partner and at least one limited partner.54 It was initially the IRS’s position that because of their limited liability under state law, members of LLCs and LLPs (limited liability partnerships) were limited partners for purposes of determining material participation. However, both the Tax Court and the Court of Federal Claims have held that LLC and LLP members’ interests are not IRC §469(h)(2) limited partnership interests subject to the more stringent test for material participation under the passive activity rules. This is because both LLC members and LLP partners can be treated as “general partners” under state laws.55 Members of LLCs and LLPs are therefore entitled to use all seven material participation tests.

51. IRC §469(i)(6)(C). 52. Temp. Treas. Reg. §1.469-5T(e)(2). 53. Temp. Treas. Reg. §1.469-5T(e)(3)(ii). 54. Revised Uniform Limited Partnership Act. 55. Thompson v. U.S., 87 Fed. Cl. 728 (Fed. Cl. 2009); Garnett v. Comm’r, 132 TC No. 19 (2009).

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COMPREHENSIVE EXAMPLE OF THE THREE LOSS LIMITATIONS To determine whether a Schedule K-1 loss is deductible, the following three steps are applied in order. Step 1. Determine the partner’s basis in their ownership interest. Step 2. Ascertain what amount, if any, of this initial basis is considered at risk. Step 3. Determine whether the passive loss rules apply, and limit the loss to any passive income. Example 10. In 2015, Ben contributed $10,000 cash to J&B, LLC, and received a 50% interest in return. The LLC is taxed as a partnership. Ben also loaned $40,000 to the LLC. In 2015, J&B borrowed $60,000 to purchase equipment without any of the partners guaranteeing the debt. Ben did not materially participate in the business operations. 4 Ben also realized $30,000 from the sale of a rental property that is characterized as passive income. He actively participated in the rental property activity. The partnership incurred a loss for 2015. Ben’s distributive share of the loss was $100,000. The partnership did not make any distributions in 2015. Ben’s 2015 Form 6198, Form 8582, and page 2 of Schedule E follow the explanations of the three steps. Step 1. What was Ben’s basis before considering the loss? Ben’s initial basis was calculated as follows.

Cash contributed $10,000 Personal loan to partnership 40,000 Allocable share of the partnership’s nonrecourse debt (50% of $60,000) 30,000 Total initial basis $80,000

Ben’s $80,000 basis was insufficient to deduct the entire $100,000 loss. Therefore, $20,000 of the loss ($100,000 – $80,000) was suspended due to lack of basis. The remaining $80,000 loss was subject to at-risk and passive loss limitations.

Note. There is no IRS form or schedule to report losses suspended due to the basis limitations. On Ben’s 2015 Form 6198, shown later, line 1 shows the $80,000 loss allowable after the basis limitation.

Step 2. What was Ben’s at-risk amount? Ben bore no economic risk of loss for his $30,000 share of the LLC’s nonrecourse debt. Consequently, even if the partnership failed to pay this debt, Ben would not be personally liable for its repayment. Therefore, of Ben’s $80,000 basis (Step 1), only $50,000 is considered at risk. Accordingly, $30,000 of the $80,000 loss (as allowed under the basis rules) was suspended under the at-risk rules. Step 3. How do the passive loss rules limit the deduction of the $50,000 loss from Step 2? Because Ben had $30,000 of passive income from other sources, $30,000 of the $50,000 loss (as allowed after applying the basis and the at-risk rules) was deductible. The remaining $20,000 loss was suspended under the passive activity rules.

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For Example 10

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For Example 10

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For Example 10

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For Example 10

Summary of results for Example 10:

Losses Suspended Applicable Limitation By the Applicable Limitation Basis $20,000 At-risk 30,000 Passive activity 20,000 Total suspended losses $70,000

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Example 11. Use the same facts as Example 10. In 2016, Ben’s share of the LLC’s net income was $50,000. Ben continued to hold this interest strictly as an investment and did not materially participate in the business. He had no rental properties in 2016 and had no other net passive income for the year. There was no change in the company’s debt. Ben’s 2016 Form 8582 and Schedule E, page 2, follow the explanations of the three steps. Step 1. Ben’s basis of zero from 2015 was increased to $50,000 by his share of the partnership’s net income. The $20,000 of suspended loss due to basis limitations from 2015 was allowed on his 2016 return. His ending basis for 2016 was calculated as follows.

Basis at the beginning of 2016 $ 0 2016 LLC income 50,000 Initial basis for 2016 $50,000 2015 loss suspended due to lack of basis (20,000) Basis at the end of 2016 $30,000

Step 2. The $50,000 of net income increased Ben’s at-risk amount. The $30,000 of losses suspended due to the at-risk limitations from 2015 was allowed on his 2016 return. His ending at-risk basis for 2016 was calculated as follows.

Basis at risk at the beginning of 2016 $ 0 2016 LLC income 50,000 Initial at-risk basis for 2016 $50,000 2015 loss suspended due to at-risk rules (30,000) Basis at risk at the end of 2016 $20,000

Note. To calculate the amount reported on line 1 of Form 6198, Ben subtracted his $20,000 carryforward loss allowed in 2016 (as calculated in Step 1 for basis) from his $50,000 of 2016 income to arrive at his 2016 net income of $30,000. Then, in accordance with the instructions for Form 6198, he combined his prior loss of $30,000 (that was suspended in 2015 due to the at-risk rules) with the 2016 net income. Accordingly, he entered zero on line 1 of his Form 6198. He reported no other amounts on Form 6198 (not shown).

Step 3. The $50,000 of Schedule K-1 income was passive. However, this income did not release any of the $20,000 suspended passive loss from 2015 because all of the 2016 income was absorbed by the suspended basis and at-risk losses. Therefore, the $20,000 suspended passive loss from 2015 continued to be suspended and was carried forward to 2017. The following selected forms and schedules from Ben’s 2016 return show how the loss was reported. Note that the $50,000 of released losses from 2015 were not combined with the 2016 income on page 2 of Schedule E. The total $50,000 loss carryforward ($20,000 from basis limitations allowed under Step 1 and $30,000 from at-risk limitations allowed under Step 2) was entered as a separate item with “PYA” (prior year amount) written in column (a). Ben checked the box for yes on line 27 to indicate that he was taking a loss suspended from a prior tax year. The remainder of the suspended $20,000 passive loss from 2015 is shown on the Form 8582. However, with no passive income to offset, Ben carries forward the suspended passive loss to 2017.

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For Example 11

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For Example 11

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For Example 11

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DISTRIBUTIONS

Partnership distributions are classified as either current or liquidating. A distribution that does not liquidate a partner’s entire interest is a current distribution.56 If a partner’s entire interest is terminated after the distribution, the interest has been liquidated. Liquidation may be accomplished through a single distribution or a series of distributions to the partner by the partnership.

Note. For more information on liquidating distributions, see the 2017 University of Illinois Federal Tax Workbook, Volume B, Chapter 5: Partnership Issues.

CURRENT DISTRIBUTION OF ASSETS Money and marketable securities can be withdrawn with no recognition of gain or loss unless the money and/or the FMV of the securities distributed exceeds the partner’s adjusted basis in the partnership.57 If any other assets (aside from cash or securities) are distributed, the partner’s adjusted basis in the partnership is reduced by the adjusted basis of the asset to the partnership.58 When there is a distribution of money and property in the same transaction, the money reduces the member’s outside basis first.59 Any remaining outside basis is reduced by property basis.60 The basis of the assets distributed to the partner equals the adjusted basis of the assets in the partnership immediately prior to the distribution.61 However, the basis may not exceed the outside basis in the partner interest after any reduction for cash and marketable securities received.62 If depreciable property is distributed to a partner, the partner continues the cost-recovery method and life as established on the partnership books as long as the adjusted basis in the partner’s hands is the same as what was included on the partnership books.63 When IRC §§1245 or 1250 recapture is associated with the depreciable asset, the sale or exchange rules under IRC §751 for unrealized receivables and inventory items may apply (discussed later). A partner who contributed property to the partnership may be required to recognize a gain or loss if the property is distributed. This applies if the contributed property is distributed to a partner other than the contributing partner within seven years after being contributed.64 This rule is designed to prevent shifting of income from one partner to another. 65

Note. The rule for contributed property also applies to a successor to the partner’s interest.65

Example 12. Amie contributed an asset with a basis of $1,000 and an FMV of $1,500 in exchange for an interest in a partnership. Immediately thereafter, the partnership distributed the asset to Barry, another partner. Amie reported a $500 gain on her personal return, which increased her basis. Barry’s basis was reduced by the $1,500 FMV of the asset.

Note. For more information about distributions, see the 2017 University of Illinois Federal Tax Workbook, Volume B, Chapter 5: Partnership Issues.

56. Treas. Reg. §1.761-1(d). 57. IRC §§731(a)(1) and 731(c). See also Treas. Reg. §1.731-1(a)(1). 58. IRC §732. 59. IRC §732(a)(2). 60. Ibid. 61. Ibid. 62. IRC §732(a)(1). 63. IRC §168(i)(7). 64. IRC §704(c)(1)(B). 65. Treas. Reg. §1.704-4(d)(2).

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PROPORTIONATE DISTRIBUTION OF ALL ASSETS66 If a partnership is terminated through a distribution of partnership assets, a partner does not recognize a gain as long as the distributed money and/or marketable securities does not exceed the partner’s adjusted outside basis in the partnership.67 A partner does not recognize loss on a partnership distribution unless all the following requirements are met.68 • The adjusted basis of the partner’s interest in the partnership exceeds the distribution. • The partner’s entire interest in the partnership is liquidated. • The distribution is in money, unrealized receivables, or inventory items. The basis of property received in complete liquidation of a partner’s interest is the adjusted basis of the partner’s 4 interest in the partnership reduced by any money (and/or marketable securities) distributed to the partner in the same transaction. The remaining basis must be divided among the properties received by the partner in the following order. Step 1. Allocate the basis first to unrealized receivables and inventory items included in the distribution by assigning a basis to each item equal to the partnership’s adjusted basis in the item immediately before the distribution. If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess. Step 2. Allocate any remaining basis to properties other than unrealized receivables and inventory items by assigning a basis to each property equal to the partnership’s adjusted basis in the property immediately before the distribution. If the allocable basis exceeds the total of these assigned bases, increase the assigned bases by the amount of the excess. If the total of these assigned bases exceeds the allocable basis, decrease the assigned bases by the amount of the excess. Allocate any basis increases required in step 2 to properties with unrealized appreciation to the extent of the unrealized appreciation. If the basis increase is less than the total unrealized appreciation, allocate it among those properties in proportion to their respective amounts of unrealized appreciation. Allocate any remaining basis increase among all the properties in proportion to their respective FMVs. Allocate any basis decreases required in steps 1 or 2 using the following rules. • Allocate the basis decrease first to items with unrealized depreciation to the extent of the unrealized depreciation. If the basis decrease is less than the total unrealized depreciation, allocate it among those items in proportion to their respective amounts of unrealized depreciation. • Allocate any remaining basis decrease among all the items in proportion to their respective assigned basis amounts as decreased by step 1.

DISPROPORTIONATE DISTRIBUTIONS A partner may receive a distribution of property in exchange for all or a part of their partnership interest. However, any disproportionate distribution of unrealized receivables or substantially appreciated inventory is considered a sale or exchange of the property between the partner and the partnership.69

66. IRS Pub. 541, Partnerships. 67. IRC §731(a)(1). 68. IRC §731(a)(2). 69. IRC §751.

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GUARANTEED PAYMENTS TO PARTNERS

Guaranteed payments to partners are reported on Schedule K-1 in box 4.70 Guaranteed payments may be compensation for services or compensation for the use of capital.71 Guaranteed payments are determined without regard to the partnership’s profit or loss. A guaranteed payment is taxed as ordinary income to the recipient partner72 and may be offset by the partner’s share of the partnership’s ordinary loss. The partner’s taxable share of partnership ordinary income includes both their guaranteed payment and their share of ordinary income. This income is reported on the partner’s return for the year that includes the end of the partnership’s tax year, regardless of the timing of the actual payments.73 73 Example 13. Gary is a general partner of Retiring in Style. The partnership’s tax year ends on June 30. Gary received guaranteed payments of $10,000 per month from July 1, 2016, through June 30, 2017. The entire $120,000 is reported as a guaranteed payment on his Schedule K-1 from the partnership for the fiscal year ending June 30, 2017. Even though he received half of the payments in 2016, he reports the entire $120,000 on his 2017 return along with the other items shown on his Schedule K-1.

FRINGE BENEFITS74 Guaranteed payments include most fringe benefits paid for the benefit of the partners. Some expenses associated with these taxable benefits may be deductible by the partners. Common taxable benefits include the following. • Group-term life insurance premiums75 • Amounts received under accident and health plans76 • Premiums on accident and health insurance paid by the partnership77 • Voluntary and partnership contributions to health savings accounts78 • Meals and lodging provided by the partnership79 • Parking and transit passes provided by the partnership80

70. Partner’s Instructions for Schedule K-1. 71. Treas. Reg. §1.707-1(c). 72. Treas. Reg. §1.707-1(c). See also Falconer v. Comm’r, 40 TC 1011 (Sep. 23, 1963). 73. Treas. Reg. §1.707-1(c). 74. IRS Pub. 15-B, Employer’s Tax Guide to Fringe Benefits. 75. IRS Pub. 15-B, Employer’s Tax Guide to Fringe Benefits. See also IRC §79. 76. Under IRC §105. 77. Under IRC §106. 78. IRS Pub. 15-B, Employer’s Tax Guide to Fringe Benefits. 79. Under IRC §119. 80. Under IRC §132(f)(5)(E).

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Self-Employed Health Insurance81 Health insurance premiums paid by the partnership (directly or as a reimbursement) are included in guaranteed payments. The policy may be in the name of the partnership or in the name of the partner. Premiums for medical, dental, and qualified long-term care insurance paid by the partnership are included in the cost of self-employed health insurance. Eligible premiums may cover the taxpayer, their spouse, their dependents, and their children who were under age 27 at the end of the tax year. Eligible premiums also include Medicare premiums voluntarily paid for the taxpayer and all other qualified individuals,82 as long as the partnership reimburses the partner for the expense. Partnerships should report the qualified amount of health insurance payments in box 13 of Schedule K-1 using Code “M.”83 Partners may deduct the cost of self-employed health insurance from adjusted gross income on line 29 (“self- employed health insurance deduction”) of Form 1040. The deduction is limited to net SE earnings from the 4 partnership.84 Any expense in excess of the net SE earnings may be deducted on Schedule A, Itemized Deductions, subject to the medical expense limitations.85 86

Note. The partner’s Schedule K-1 shows net SE earnings for the year in box 14 using code A.86 However, certain deductions, discussed later, that are passed through from the partnership reduce SE income below the amount reported on the Schedule K-1.

Voluntary and Partnership Contributions to Health Savings Accounts87 Depending on the partnership agreement, contributions by a partnership to a partner’s health savings account (HSA) may be included in distributions or in guaranteed payments. If the payments are made based on the partner’s share of the partnership, the contributions are included in distributions. If they are made as compensation for services rendered, they are included in guaranteed payments. The partnership is not required to report the contributions on Schedule K-1, but, ideally, it will include the contribution amount in the Schedule K-1 supplemental information. Because partners are not considered employees, both voluntary contributions and contributions to HSAs made by the partnership are treated as having been made directly by the partner. Therefore, the partner may deduct all of the HSA contributions made on their behalf, if all other requirements are satisfied. The deduction is calculated on Form 8889, Health Savings Accounts (HSAs). Example 14. Victoria is a limited partner of Griff, Ltd. She does not participate in the activities of the company. In 2016, Griff made a contribution to each partner’s HSA based on the partner’s ownership percentage in the company. Because the contributions were not compensation for services, the payments were classified as cash distributions. Victoria’s Schedule K-1 included a supplemental report showing that her total distributions included $2,000 contributed to her HSA. Victoria’s HSA is a self-only plan. She was under age 55 in 2016, so her annual contribution limit for 2016 is $3,350.88 Because partners are not employees, she was treated as having made the contributions directly. Accordingly, she reported the $2,000 paid on line 2 of her Form 8889, which follows. She did not include the $2,000 on line 9 because the partnership’s contribution is not treated as having been made by an employer.

81. IRS Pub. 535, Business Expenses. 82. CCA 201228037 (Jul. 13, 2012). 83. Partner’s Instructions for Schedule K-1. 84. IRC §162(l)(2)(A). 85. Instructions for Schedule A. 86. Partner’s Instructions for Schedule K-1. 87. IRS Notice 2005-8, 2005-4 IRB 368. See also IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans. 88. IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans.

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For Example 14

89 90

Observation. Victoria could have made an additional contribution for 2016 of $1,350 ($3,350 limit − $2,000 already contributed) to her HSA directly from her own funds at any time before April 18, 2017 (the 2016 return deadline). If she had done that, the amount on line 2 would include both the contribution made by the partnership and the contribution she made directly.89

Caution. In order to contribute to an HSA for a given calendar year, the participant must have an HSA- qualified high deductible health plan in place by December 1 of the calendar year.90

89. Instructions for Form 8889. 90. IRS Pub. 969, Health Savings Accounts and Other Tax-Favored Health Plans.

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91 SELF-EMPLOYMENT TAXES

Note. Partners who perform services in the conduct of the trade or business of the partnership are not employees of the partnership.91

It is the partnership’s responsibility to identify the total amount of income from the partnership subject to SE tax for each partner. The SE amount is reported in box 14 with code “A” on each partner’s Schedule K-1.92 However, the amount reported is before certain deductions that may be claimed on the partner’s personal return. The additional deductions that reduce SE tax may include interest expense, unreimbursed partnership expenses, the §179 deduction, 4 §59(e)(2) expenditures, and depletion.93

SE TAX ON DISTRIBUTIONS General partners are treated as receiving income from self-employment and are subject to SE tax on their distributive shares of income from a partnership.94 There are exceptions for certain types of income distributions, including rent, gain or loss from disposition of property, and investment income.95 Distributive shares of limited partners’ income or loss are excluded from SE earnings.96 Accordingly, a limited partner’s distributive share of income from a partnership is not subject to SE taxes. However, for SE tax purposes, the mere designation of partner as “limited” is not determinative. The Chief Counsel recently made a distinction between partners who “merely” invest in an entity and partners who actively participate in the entity’s business.97 The Chief Counsel concluded that actively participating partners must include the entity’s income in SE income even though they are not designated as general partners.

Note. For purposes of discussing SE taxes in this chapter, the term general partner is also used to describe any LLC/LLP partner whose duties and activity levels are comparable to a general partner’s.

91. Entities. Feb. 6, 2017. IRS. [www.irs.gov/help-resources/tools-faqs/faqs-for-individuals/frequently-asked-tax-questions-answers/small- business-self-employed-other-business/entities/entities-1] Accessed on Aug. 9, 2017. 92. Partner’s Instructions for Schedule K-1. 93. Ibid. 94. IRC §1402(a). 95. IRC §§1402(a)(1)–(3). 96. IRC §1402(a)(13). 97. CCA 201640014 (Jun. 15, 2016).

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SE TAX ON GUARANTEED PAYMENTS Guaranteed payments for services that are made in the course of a partnership’s trade or business are considered SE income and are subject to SE tax.98 This is true regardless of whether the partner is a general or limited partner.99 Guaranteed payments for the use of capital are specifically included in SE income under Treas. Reg. §1.1402(a)-1(b). However, the regulations do not reflect the addition of IRC §1402(a)(13)100 that excludes the distributive share of income allocated to limited partners from SE income. That Code provision, however, specifically includes guaranteed payments for services “actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services” in SE income. Accordingly, it could be argued that a limited partner who provides no services to the partnership is not subject to SE tax on guaranteed payments for the use of capital.

Note. Fringe benefits such as health insurance and HSA contributions that are included in guaranteed payments are also included in SE income. There are no provisions that would allow them to be excluded for SE tax purposes.

NETTING ORDINARY INCOME (LOSS) AND GUARANTEED PAYMENTS101 A taxpayer’s net SE income may include the following. 1. Net income and losses from any sole proprietorships owned by the taxpayer 2. Ordinary business income and losses passed through to the taxpayer as a general partner and adjusted for deductions taken at the partner level 3. Guaranteed payments for services provided to a partnership’s trade or business by general or limited partners 4. Guaranteed payments for use of capital provided to a partnership’s trade or business by a general partner (and possibly a limited partner) Example 15. Mark operates a sole proprietorship providing bike tours of Boston. He also owns a 50% interest in Loved ‘Em and Left ‘Em, LLP (LE & LE, LLP). The LLP specializes in divorce law. Mark and his partner each work full time for the firm. In 2016, Mark’s net SE earnings was composed of the following.

Boston Biking $ 10,000 Net business loss from LE & LE, LLP (3,000) Guaranteed payments from LE & LE, LLP 150,000 Net SE earnings $157,000

98. Treas. Reg. §1.1402(a)-1(b). 99. IRC §1402(a)(13). See also Howell v. Comm’r, TC Memo 2012-303 (Nov. 1, 2012). 100. PL 95-216 added IRC §1402(a)(12); subsequently PL 98-21 changed the paragraph number to (13). 101. Rev. Rul. 56-675, 1956-2 CB 459.

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IRC §179 DEDUCTION

The IRC §179 deduction for qualified property is subject to limitations at both the partnership and individual partner levels.102 After applying the partnership level limitations, the tentative amount deductible by each partner is reported on Schedule K-1.103 Each partner must determine if they can claim the amount of the §179 deduction passed through to them. This determination is based on the following factors. 1. The partner’s basis in the partnership 2. The partner’s participation in the activities of the partnership 4 3. The annual §179 deduction limit 4. The partner’s total business income Because of these limitations, dispositions of §179 property by the partnership are reported separately to each partner. This permits the partner to adjust the gain or loss from disposition based on how much, if any, of the §179 deduction was actually used by the partner. BASIS Each partner must reduce the basis of their partnership interest by the full amount of the partnership’s §179 deduction that is allocated to them, regardless of whether the partner may deduct the entire amount.104 Basis may not be reduced below zero.105 If a partner does not have sufficient basis to claim the entire §179 deduction that passed through to them, the excess deduction is suspended until sufficient basis exists.106 (Calculation of basis is discussed earlier in the chapter.) ACTIVE PARTICIPATION REQUIREMENT The §179 deduction is limited to the taxpayer’s taxable income from the active conduct of any trade or business during the tax year.107 The term trade or business has the same general meaning as used throughout the Code.108 Generally, active conduct means meaningful participation in the management or operation of the trade or business.109 For purposes of the business income limit, if a partner actively participates in one or more of a partnership’s trades or businesses, the business income from all of the partnership’s trades or businesses is included in business income from the partnership.110

Note. The Code specifically uses the term active conduct with respect to the taxpayer’s participation requirement in activities taken into account for purposes of the §179 deduction. This is a lesser standard than material participation. Material participation is defined earlier in the “Passive Loss” section of the chapter. For more information about material participation, see the 2014 University of Illinois Federal Tax Workbook, Volume B, Chapter 4: Passive Activities. This can be found at uofi.tax/arc [taxschool.illinois. edu/taxbookarchive].

102. IRC §179(d)(8). 103. Instructions for Form 1065. 104. Rev. Rul. 89-7, 1989-1 CB 178. 105. IRS Pub. 541, Partnerships. 106. Treas. Reg. §1.179-3(h). 107. IRC §179(b)(3)(A). 108. Treas. Reg. §1.179-2(c)(6)(i). 109. Treas. Reg. §1.179-2(c)(6)(ii). 110. IRS Pub. 946, How To Depreciate Property. 2017 Volume B — Chapter 4: Partner Issues B199 Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook

If a partner neither actively nor materially participates in the partnership’s activities, they cannot claim the §179 deduction that passed through from the partnership. Treas. Reg. §1.179-2(c)(6)(ii) states the following. In the context of section 179, the purpose of the active conduct requirement is to prevent a passive investor in a trade or business from deducting section 179 expenses against taxable income derived from that trade or business. If a partner is not allowed to use the §179 deduction because they fail the active participation test, the disallowed §179 deduction is suspended until the partnership disposes of the asset111 or the partner disposes of their interest in the partnership.112

THE ANNUAL §179 DEDUCTION LIMIT The annual §179 deduction is limited to $510,000 for 2017.113 When a partner receives a distributive share of §179 expenses from multiple sources, the partner’s total §179 expenses may exceed the maximum dollar amount allowable for the tax year. The excess §179 expenses may not be carried over.114 Despite this limitation, the partner’s adjusted basis in their partnership interest must be reduced by the partner’s full distributive share of the §179 deduction passed through to them.115 Example 16. For the 2016 tax year, Erica received a Schedule K-1 from Wright Sisters LLC, which allocated $450,000 of taxable income and $400,000 of §179 expense to her. Erica also received a Schedule K-1 from TakeTwo LLC, which allocated $225,000 of taxable income and $200,000 of §179 expenses to her. The total §179 deductions allocated to her were $600,000 ($400,000 + $200,000). The maximum allowable §179 deduction for 2016 was $500,000.116 Because Erica’s total §179 deduction is $100,000 over the maximum amount allowable for 2016 ($600,000 – $500,000), she cannot carry over the excess to a subsequent year. However, Erica’s basis in her LLC interests must be reduced by the entire amount of the §179 deductions that were allocated to her. When the partnership disposes of the asset or the partner disposes of their partnership interest, the §179 deductions disallowed because of this limitation are taken into account in determining the basis of the disposed property. This adjustment is explained later in this section.

BUSINESS INCOME LIMITATION117 Income for purposes of the business income limit includes the income and losses from all trades or businesses in which the taxpayer actively participates.118 A taxpayer’s business income includes the following. 1. Net income from trades or businesses computed without regard to the §179 deduction 2. IRC §1231 gains (or losses) 3. Interest from working capital of the taxpayer’s trades or businesses 4. Wages, salaries, tips, and other compensation earned as an employee 5. Guaranteed payments received from partnerships

111. Treas. Reg. §1.179-3(f); Instructions for Form 4797. 112. Treas. Reg. §§1.179-3(g) and (h). 113. Rev. Proc. 2016-55, 2016-45 IRB 707. 114. Treas. Reg. §1.179-2(b). 115. Treas. Reg. §1.179-3(h)(1). 116. IRC §179(b)(1). 117. Instructions for Form 4562. See also IRS Pub. 946, How to Depreciate Property. 118. IRC §179(b)(3)(A).

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The deduction for half of the SE tax is not included in the computation of business income. Net operating loss carrybacks and carryforwards are also excluded from this computation, as are unreimbursed employee business expenses. Example 17. Zeke is a limited partner in Magister’s LLC, which did not elect to be taxed as a C or S corporation. Zeke owns 80% of the partnership and actively participates in the activities of the LLC. His 2016 Schedule K-1 shows the following.

Box 1: Ordinary business income (loss) ($80,000) Box 4: Guaranteed payments 130,000 Box 12: Section 179 deduction 40,000 4 Zeke also incurred $2,000 of unreimbursed partnership expenses for use of his personal vehicle for business travel related to the LLC. By agreement between the partners, the partnership does not reimburse partners for mileage expense. Zeke did not have any other trade or business activities in 2016. His business income for purposes of the income limitation was $48,000 as calculated below.

Ordinary business income (loss) ($ 80,000) Unreimbursed partnership expenses (2,000) Guaranteed payments 130,000 Total business income $ 48,000

Zeke was able to deduct all of the $40,000 IRC §179 deduction allocated to him by the LLC. If the partner cannot deduct the entire §179 pass-through expense because of limitations on their personal return, the excess deduction is carried forward.119 Nevertheless, the partner’s basis in the partnership is currently reduced by the entire amount.120 Example 18. Troy is a partner of a partnership that passes through $50,000 of the 2017 net profit to Troy. In addition, it passes through a §179 deduction of $5,000. Troy also operates a Schedule C business. It incurs a loss of $60,000 for the year. Troy has no other earned income. Therefore, his business activities incurred a net loss of $10,000 ($50,000 – $60,000) for the year. Consequently, he is unable to use any of the pass- through §179 deduction. Troy’s basis in his partnership interest was $8,000 at the beginning of the year. At the end of the year, it is $53,000 ($8,000 beginning basis + $50,000 net profit – $5,000 §179 expense). Troy carries the unused §179 deduction forward because of the business income limitation.

CLAIMING THE IRC §179 DEDUCTION 121 If the partner materially participates in the partnership’s activities, the §179 amount reported on Form 4562 is carried to line 28 of Schedule E. If the partner does not materially participate in the partnership’s activities but does actively participate, the amount from Form 4562, line 12, is carried to Form 8582.

119. Treas. Reg. §1.179-3(a). 120. Treas. Reg. §1.179-3(h)(1). 121. Partner’s Instructions for Schedule K-1.

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DISPOSITION OF IRC §179 PROPERTY A partnership reports a sale or other disposition of property for which the §179 deduction was previously passed through to the partners in box 20 (“other information”) of Schedule K-1 using Code L.122 A partnership must also provide its partners with detailed information about the disposition of the asset so the partners can properly report the disposition on their individual Forms 4797, Sales of Business Property. Each partner calculates their portion of depreciation allowed or allowable for the asset using the following formula.123

Depreciation allowed or allowable (as reported by the partnership to the partner) + The §179 deduction (as reported by the partnership to the partner) − Any of the partner’s unused carryover of the §179 deduction for this property Depreciation allowed or allowable to report on Form 4797

Note. These rules are consistent with the rules applicable to S corporation shareholders. See the 2016 University of Illinois Federal Tax Workbook, Volume A, Chapter 2: S Corporation Shareholder Issues. Examples 23 and 24 show how a passive partner should treat the disposition of §179 property.

LOANS BY A PARTNER

LOANS TO BUY AN OWNERSHIP INTEREST124 IRS guidance on allocating and deducting interest expense on debt-financed acquisitions of interests in S corporations and partnerships is based on Temp. Treas. Reg. §1.163-8T, which applies to individual taxpayers. The tracing and ordering rules discussed in this section of the chapter apply to all interest expense deductions for individuals, not just the deductions related to acquisitions of S corporation and partnership interests.

Allocation of Loan Proceeds A taxpayer who borrows money to buy into a partnership must allocate the loan proceeds into the appropriate classes in order to determine which set of rules apply. The first consideration when making this allocation is whether a taxpayer purchased the partnership interest from the partnership or another partner. If a taxpayer purchases their partnership interest directly from the partnership (e.g., makes a capital contribution to the partnership in exchange for their partnership interest), the interest expense is allocated using any reasonable method, including the following. • Methods based on the assets owned by the partnership • Methods based on the use of the contributed capital by the partnership under the tracing rules If a taxpayer purchases their partnership interest from another partner, the interest expense is allocated according to any reasonable method that is based on the assets of the partnership. Such methods may include pro-rata allocation based on an asset’s FMV, book value, or adjusted basis, reduced by any debt of the pass-through entity or the owner allocated to such assets.125 Use of a method based on anything other than the assets is not allowed.

122. Ibid. 123. Ibid. 124. IRS Notice 89-35, 1989-1 CB 675. 125. See Ltr. Rul. 9116008 (Jan. 10, 1991) and Ltr. Rul. 9441025 (Jul. 11, 1994) for IRS examples of allocations based on assets when the partnership interest was acquired from another partner.

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Example 19. Marty Jones purchases a 25% interest in the Healthy Home LLC, a multi-member LLC taxed as a partnership, for $150,000. Marty borrows the necessary funds on an unsecured line of credit at his local bank at an interest rate of 10%. The FMV and adjusted tax basis of Healthy Home LLC’s assets follow.

FMV Adjusted Tax Basis Business equipment $600,000 $300,000 Accumulated depreciation 0 (200,000) Loan payable on equipment (200,000) 0 Net value/basis of equipment $400,000 $100,000 Cash in bank 200,000 200,000 4 Total assets $600,000 $300,000

If Marty allocates the interest expense paid on his $150,000 note using the FMV of the partnership’s assets, 2 1 then /3 ($400,000 ÷ $600,000) of the interest expense will be allocated to business equipment and /3 ($200,000 ÷ $600,000) of the interest expense will be allocated to investment assets. Therefore, Marty’s 2 1 interest expense is allocated /3 to business interest expense and /3 to investment interest expense.

1 If Marty allocates the interest expense using the adjusted tax basis of the partnership’s assets, then only /3 of 2 the interest will be business interest ($100,000 ÷ $300,000) and the remaining /3 ($200,000 ÷ $300,000) will be investment interest. 126

Observation. IRS Notice 89-35126 requires debt to be allocated among all assets of a pass-through entity (unless the tracing approach is properly used). The phrase “all assets” includes bank accounts (classified as investments), physical assets, and intangible assets. Self-created intangible assets, such as self-created goodwill and customer base, and equipment depreciated under accelerated methods generally have little or no basis or book value. Therefore, taxpayers may want to use FMV for debt allocations in an entity conducting an active trade or business. This usually results in owners receiving a larger business interest deduction and minimizing that portion of debt allocable to investment or other nonbusiness assets.

The facts and circumstances determine whether an allocation method is reasonable. One significant factor is whether a taxpayer consistently applies the method from year to year. Accordingly, if the debt proceeds are allocated based on the partnership assets, the proceeds must be reallocated as the values or bases of an entity’s assets change or the use of such assets change. If the debt proceeds are allocated based on tracing rules, the debt proceeds must be reallocated under the following circumstances.127 1. The asset to which the debt was allocated is sold and the proceeds are used for another expenditure. 2. The use of the asset changes. 3. The proceeds that were held in the borrower’s account are used for another expenditure. Tracing Rules.128 In general, under the tracing rules, debt is allocated to expenditures according to how the debt proceeds are used. The allocation is not affected by the property used to secure the repayment of the debt unless the debt is qualified debt secured by the taxpayer’s residence.

126. IRS Notice 89-35, 1989-1 CB 675. 127. See Temp. Treas. Reg. §1.163-8T(c)(4) and (j). 128. Temp. Treas. Reg. §1.163-8T(c).

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Loan proceeds that are held in a taxpayer’s account are treated as property held for investment until the proceeds are spent. Generally, debt proceeds are treated as being used before either of the following. 1. Any unborrowed amounts held in the account at the time the debt proceeds are deposited 2. Any amounts that are deposited into the account after the debt proceeds are deposited Despite these rules, the taxpayer may treat any expenditure made from any account of the taxpayer within 30 days before or after debt proceeds are deposited as made from the debt proceeds.129 In addition, interest earned on an account consisting solely of the deposited debt may be treated as being spent before the loan proceeds.130 Qualified Residence Interest. If debt is secured by a qualified residence and otherwise satisfies the requirements for treatment as home equity debt, it is home equity debt regardless of the use of the debt.131 A qualified residence is the taxpayer’s principal residence plus any second residence elected by the taxpayer.132 The interest therefore must be deducted as mortgage interest on Schedule A. The tracing rules are disregarded for purposes of determining home equity debt.133 It may not always be desirable to deduct interest on home equity debt on Schedule A. Because lenders often require a lien on a residence to secure a business loan, the borrower may be better off treating that debt as business debt rather than as home equity debt. Example 20. Claire has a single qualified residence in which she has $40,000 of equity. She takes out a $30,000 business loan secured by a recorded lien on the residence. The loan must be treated as home-equity debt and the interest is deductible only on Schedule A. To avoid problems like this, the regulations allow a taxpayer to elect to treat any debt secured by a qualified residence as not secured by the residence.134 This permits a taxpayer to avoid treating business debt as home-equity debt simply because it was secured by a qualified residence. Example 21. By electing to treat the $30,000 debt in Example 20 as not secured by the residence, the debt no longer qualifies as home-equity debt. The tracing rules therefore apply, resulting in Claire treating the debt as business debt. The election can be made any year, not just in the year the debt is incurred. Once the election is made, it is irrevocable without the IRS’s consent.135 There is no form prescribed in the regulations or other published IRS guidance to make the election. The Tax Court has stated that when there is no guidance on the manner of making an election, the taxpayer must “clearly notify the Commissioner of the taxpayer’s intent to do so.”136 The following statement attached to the taxpayer’s return for a tax year should be sufficient for making the election. I hereby elect in accordance with Temporary Regulation § 1.163-10T(o)(5)(i) to treat debt in the amount of $[amount] under promissory note dated [date] to [Name of lender] as not being secured by my residence. 137

Note. The regulations state that “any debt” is eligible for this election.137 They do not affirmatively state that a portion of a debt can be elected, but it also does not say that the election applies only to the entire debt. The use of the term “any debt” also seems to indicate that the election is made on the basis of individual indebtedness rather than constituting a method of accounting that must thereafter be used for all such indebtedness.

129. IRS Notice 89-35, 1989-1 CB 675. (See Section VI) 130. Temp. Treas. Reg. §1.163-8T(c)(4)(iii)(c). 131. Temp. Treas. Reg. §1.163-8T(m)(3). 132. Temp. Treas. Reg. §1.163-10T(p). 133. Temp. Treas. Reg. §1.163-8T(m)(3). 134. Temp. Treas. Reg. §1.163-10T-(o)(5). 135. Ibid. 136. See, e.g., Kosonen v. Comm’r, TC Memo 2000-107 (Mar. 28, 2000). 137. Temp. Treas. Reg. §1.163-10T(o)(5).

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Debt Repayment Ordering Rule138 Once the debt has been allocated to multiple expenditures, repayments of the debt must be applied in the following order. 1. Personal expenditures 2. Investment expenditures and passive activity expenditures other than those specified in item #3. 3. Passive activity expenditures in connection with a rental real estate activity with respect to which the taxpayer actively participates (within the meaning of §469(i)) 4. Former passive activity expenditures 5. Amounts allocated to trade or business expenditures 4 Reporting Rules139 Individuals report interest expense paid or incurred in connection with debt-financed acquisitions on either Schedule E or Schedule A, Itemized Deductions, depending on the type of expenditure to which the interest expense is allocated. Based on the allocations made, interest expense is deducted on Form 1040 according to the following rules. 1. Interest expense allocated to a trade or business is reported in part II of Schedule E. This interest expense should be identified on a separate line as “business interest” followed by the name of the pass-through entity to which the interest expense relates. The amount of the interest expense should be entered in column (h). This interest expense is deductible without limitation if the partner is a nonpassive participant in the partnership.140 2. Interest expense allocated to a passive activity is reported on Form 8582 as a deduction from the activity in which such expenditure was made. The deductible amount141 (if any) of the interest expense should be reported on part II of Schedule E. This interest expense should be identified on a separate line in column (a) as “passive interest” followed by the name of the pass-through entity to which the interest expense relates, and the amount of such interest expense should be entered in column (f).142 3. Interest expense allocated to an investment is entered on Form 4952, Investment Interest Expense Deduction. The deductible amount (if any) of such interest expense carries to line 14 (investment interest)143 of Schedule A if the partner is a passive participant in the activity. However, if the partner is a nonpassive participant, the expense is reported on part II of Schedule E based on rule 1 or 2 above, as applicable. The Schedule E deduction is identified as “investment interest.” 4. Interest expense allocated to personal expenses other than qualified home mortgage interest is not deductible.144

Note. See IRS Notices 88-37145 and 89-35146 for information on allocating and deducting interest expense on debt-financed distributions.

145 146

138. Temp. Treas. Reg. §1.163-8T(d)(1). 139. IRS Notice 88-37, 1988-1 CB 522. 140. See Temp. Treas. Reg. §1.163-8T(b)(7). 141. As determined under Temp. Treas. Reg. §1.469-1T(f)(2)(ii). 142. Instructions for Schedule E. 143. Instructions for Form 4952. 144. IRC §163(h). 145. IRS Notice 88-37, 1988-1 CB 522. 146. IRS Notice 89-35, 1989-1 CB 675.

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LOANS INCURRED BY A PARTNER FOR PARTNERSHIP PURPOSES147 If a partner borrows money and loans it to the partnership, the interest the partner pays is treated as investment interest. The partner generally reports the interest paid on Form 4952. However, if the partner’s share of the corresponding interest expense deduction passed through from the partnership is treated as a passive activity deduction to the lending partner, some or all of the interest received by the partner may be recharacterized as passive income under the self-charged interest rules.148 If the partner borrows money and makes a capital contribution to the partnership, the interest is subject to the tracing rules, depending on how the partnership uses the money.

149 INCOME FROM DISCHARGE OF INDEBTEDNESS 149

Cancellation of debt (COD) income is includable in gross income except when excludable under IRC §108 (those rules are not within the scope of these materials).150 Although a canceled debt may be a partnership debt, the COD rules are applied at the individual partner level, not at the partnership level.151 For partnerships, therefore, any gross income arising from COD must be allocated among the partners, who receive an increase in their partnership bases equal to their share of the COD income. Because there is also a corresponding reduction in partnership-level liabilities, the partners simultaneously are treated as receiving a constructive cash distribution for their respective shares of the liability reduction. These generally offset each other unless profits and losses are not shared in the same ratios. (Each partner will then determine whether their individual share of the COD income must be included in gross income or can be excluded under §108.) This means some partners may be able to exclude COD income, while others cannot. Example 22. AB, LLC has two 50% members, Ashley and Barbara, who have equal allocations. The LLC has $100,000 of COD income. Each of the members is therefore allocated $50,000 of COD income and is simultaneously treated as receiving a $50,000 cash distribution attributable to the LLC’s reduction in liabilities. Each member’s partnership basis increases by $50,000 for the pass-through COD income and decreases by $50,000 for the reduction in liabilities. The net change is therefore zero.

147. IRS Pub. 550, Investment Income and Expenses. 148. Treas. Reg. §1.469-7. 149. IRC §§61(a)(12) and 108. See also Rev. Rul. 2012-14, 2012-24 IRB 1012. 150. IRC §61(a)(12). 151. Rev. Rul. 2012-14, 2012-24 IRB 1012.

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152 NET INVESTMENT INCOME TAX 152

The net investment income tax (NIIT) applies to investment income above certain thresholds. Income from partnerships is subject to this tax if the income is from a passive activity.153 Income from Schedule K-1 is generally included on line 4a of Form 8960, Net Investment Income Tax – Individuals, Estates, and Trusts. Income from dispositions of property that are reported on Schedule K-1 is included on line 5a. If the taxpayer materially participates in the trade or business of a partnership, an adjustment must be made on lines 4b and 5b to subtract the pass-through income that is not subject to the NIIT. Example 23. Sarah is a general partner in Newton Publishing, a general partnership. She works full time 4 promoting its publications. Her 2016 Schedule K-1 showed ordinary income of $990,000 and a net IRC §1231 gain of $50,000 from the disposition of business assets. These were reported on lines 4a and 5a of Form 8960, respectively. To show that these items of income were not subject to the NIIT, these amounts were reported on lines 4b and 5b and subtracted from the corresponding income. The relevant portion of Sarah’s 2016 Form 8960 follows.

Note. A partnership may be engaged in multiple activities. Some of those activities may be considered passive by definition (e.g., real estate rentals). In addition, a partner might materially participate in only one of multiple business activities engaged in by the partnership and may not have made a grouping election with respect to these activities. In these situations, a separate accounting of active and passive income is necessary for NIIT purposes. For more information about the grouping election, see the 2014 University of Illinois Federal Tax Workbook, Volume B, Chapter 4: Passive Activities. This can be found at uofi.tax/arc [taxschool.illinois.edu/taxbookarchive].

152. Instructions for Form 8960. 153. See IRC §469.

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DISPOSITION OF A PARTNERSHIP INTEREST

HOLDING PERIOD The selling partner’s holding period for determining whether the capital portion of the gain or loss resulting from the disposition of a partnership interest is long- or short-term is determined without reference to the holding periods of the partnership’s assets.154 It is determined by how long the partner held the partnership interest. However, if the interest in the partnership was acquired as a result of a contribution of property to the partnership, the partner’s holding period includes the holding period of the exchanged assets.155

GAIN OR LOSS ON SALE OR EXCHANGE The amount of gain or loss realized by the selling partner is equal to the difference between the amount realized and the selling partner’s adjusted basis in the partnership interest.156 The amount realized on the sale or exchange of a partnership interest is calculated as follows.

Money received + FMV of property received + Reduction in the partner’s share of partnership liabilities Amount realized on sale or exchange

Example 24. Mona has a basis in her partnership interest of $30,000, which includes her $20,000 share of partnership liabilities. She sells her entire partnership interest to Luann, an unrelated taxpayer, for $15,000. The amount realized from the sale is calculated as follows.

Money received $15,000 Liabilities assumed by purchaser 20,000 Amount realized from the sale $35,000

In general, when a sale or exchange of a partnership interest occurs, any gain or loss must be recognized and treated as a capital gain or loss,157 including proper application of the rates attributable to the portion of the gain from collectibles and unrecaptured IRC §1250 gains. However, if the partnership has any IRC §751 assets (unrealized receivables and substantially appreciated inventory) the sale must be reported as two sales: the §751 assets and the partnership interest. IRC §751 assets are treated as ordinary income based on the difference between the amount realized from the §751 assets and the selling partner’s inside share of the bases of those assets.158 The portion of the sales price allocated to §751 assets may be specified in the agreement between the seller and purchaser. If no allocation is made, the relative FMV of the partnership’s property is used.159

154. Comm’r v. Lehman, 165 F.2d 383 (2d Cir. 1948); Thornley v. Comm’r, 147 F.2d 416 (3d Cir. 1945). See also Comm’r v. Smith, 173 F.2d 471 (5th Cir.1949); Kessler v. U.S., 124 F.2d 152 (3d Cir. 1941). 155. IRC §1223(1). 156. IRC §1001. See also Rev. Rul. 84-53, 1984-1 CB 159. 157. IRC §741. 158. Treas. Reg. §1.751-1(a)(2); and Rev. Rul. 75-323,1975-2 CB 346. 159. Ibid.

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The term unrealized receivables includes income not previously recognized under the method of accounting used by the partnership for sales of inventory and services including contractual obligations for future sales.160 The partnership’s basis in the unrealized receivables includes all costs attributable to the income that have not been previously taken into account under the partnership’s method of accounting.161 The provisions regarding substantially appreciated inventory apply if at the time of the sale or distribution, the total FMV of all the inventory items of the partnership exceeds 120% of the aggregate adjusted basis for such property (without regard to any special basis adjustment of any partner).162 The selling partner’s basis in the assets is an amount equal to what the selling partner would have if their share of the properties was received in a current distribution immediately before the sale.163 The basis includes any special adjustments available to the selling partner under IRC §§734(b) or 743(b). 4

Note. For more information on adjustments under IRC§§734(b) and 743(b), see the 2017 University of Illinois Federal Tax Workbook, Volume B, Chapter 5: Partnership Issues.

INSTALLMENT SALE METHOD A sale of a partner’s interest qualifies as an installment sale if at least one payment is received after the close of the tax year. When the partnership has §751 assets, the installment sale is more complicated. The portion of the sale allocated to §751 assets is ineligible for installment sale reporting and therefore must be reported in the year of sale.164

Note. For more information on the installment sale method, see the 2017 University of Illinois Federal Tax Workbook, Volume B, Chapter 1: Installment Sales. For more information on the installment sale method as applied to liquidations, see the 2017 University of Illinois Federal Tax Workbook, Volume B, Chapter 5: Partnership Issues.

FAMILY GIFT OF A PARTNERSHIP INTEREST Background165 Family partnerships are subject to special rules to prevent income-shifting from high-income family partners to low- income family partners. The IRS may reallocate the income between the partners without regard to their respective capital interests if the partnership does not meet certain tests. The applicable tests depend on whether capital is a material income-producing factor in the business. The determination that capital is the source of a material portion of the partnership’s income is made based on the facts and circumstances related to the business. In general, capital is usually a material income-producing factor if the operation of the business requires substantial inventories or a substantial investment in land, plant, machinery, or other equipment. Farming is a business in which capital is a material income-producing factor.166 Capital is not a significant factor if the income of the business consists principally of fees, commissions, or other compensation for services.

160. IRC §751(c). See also Wolcott v. Comm’r, 39 TC 538 (1962). 161. Treas. Reg. §1.751-1(c). 162. Treas. Reg. §1.751-1(d). 163. Treas. Reg. §1.751-1(a)(2); and Rev. Rul. 75-323,1975-2 CB 346. 164. Rev. Rul. 89-108, 1989-2 CB 100. 165. IRC §704(e). See also Treas. Reg. §1.704-1(e). 166. Leo A. Woodbury et al. v. Comm’r, 49 TC 180 (1967).

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If capital is a material income-producing factor, the facts and circumstances must support the following. 1. The partners acquired their capital interests in a bona fide transaction (which includes gifts). 2. The partners actually own their purported interests. 3. The partners have dominion and control over their respective interests. Additional rules apply when the partnership interest is gifted or sold to a family partner. Under these rules, the distributive share of partnership income is subject to both of the following restrictions. • The distributable income must be reduced by reasonable compensation for services that the donor renders to the partnership. • The distributive share of income allocated to the recipient of the gifted interest must not be proportionately greater than the donor’s distributive share attributable to the donor’s capital.

Note. The presence or absence of a tax-avoidance motive is one of many factors to be considered in determining the ownership in a partnership interest acquired by gift.

If capital is not a material income-producing factor, the facts and circumstances must support the conclusion that the partners joined together in good faith to conduct a business. It is extremely important that any family partners performing significant services for the partnership receive adequate guaranteed payments in return.

Gifted Interests In general, there is no gain or loss on the transfer of a partnership interest by gift. The gift recipient’s basis in the partnership interest is the donor’s basis, subject to the usual adjustments for gifts.167 The holding period for the donor carries over to the donee.168 For gift and estate tax purposes, the value of the gift is the FMV of the transferred partner interest and not the basis of the transferred interest.169 However, if a gift of the partnership interest releases the donor from partnership liabilities, the gift is treated as a disposition.170 The amount realized from the disposition includes the liabilities from which the donor was released.171 If the amount realized is greater than the partner’s basis, the result is a taxable gain.172 However, if the amount realized is less than the partner’s basis, the loss is not deductible.173

Note. This could also trigger a §743(b) basis adjustment of the partnership property for the gift recipient.

If only a portion of the partner interest is transferred, the reduction in the partner’s share of partnership liabilities is treated as a cash distribution rather than as an amount received from a sale.174 Therefore, the transferred liability reduces the donor’s basis immediately before the gift.

167. IRC §1015. 168. IRC §1223(2). 169. William H. Gross v. Comm’r, 7 TC 837 (1946); acq., 1946-2 CB 2. 170. Treas. Reg. §1.1001-2(a)(4)(iii). 171. Treas. Reg. §1.1001-2(a)(1). 172. See Treas. Reg. §1.1001-2(c), Example 4. 173. Ibid. 174. Treas. Reg. §1.1001-1(c); IRC §752(b).

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Valuation of a Gifted Partnership Interest The value of a partnership interest is the price a willing buyer would pay a willing seller in an arms-length transaction. The FMV of an interest may reflect marketability and minority discounts.175 176

Note. In August 2016, the IRS proposed significant changes176 to the regulations governing these valuation discounts. The IRS received substantial push-back from commentators and Congress concerning the changes. As of August 14 , 2017, no action has been taken on the proposals.

ABANDONMENT OF A PARTNERSHIP INTEREST When a partner abandons their interest and their portion of the liabilities is assumed by the remaining partners, the 4 abandoner is deemed to sell their interest for their share of the liabilities.177 This may result in either a capital gain or a loss. Example 25. Travis is a general partner of Travis and Sons, LLP. He owns 75% of the partnership interests. Travis made the initial capital contribution to start the partnership, but his sons have been performing all the work. The partnership has shown continual losses, eroding Travis’s entire basis. In addition, the partnership has a $100,000 liability as the result of a bank loan. Travis is willing to give up his 75% ownership interest in order to avoid incurring additional losses and to be released from any liability for the bank loan. Travis must report $75,000 ($100,000 × 75%) of income in the year of abandonment because he has no basis remaining in his ownership interest. Observations for Example 25 1. Travis’s 75% share of the $100,000 liability increased his basis, which has since been eroded. Because he previously received a tax benefit from claiming the losses, he must essentially reclaim those losses due to the release of the liability.178 2. The release of liabilities is treated as a distribution of money to the partner.179 Accordingly, the tax consequences are determined under the rules applicable to distributions. Other types of abandonment of a partnership interest are not a sale or exchange. If the abandonment results in a loss, it may be eligible for ordinary loss treatment.180 A loss is considered ordinary only if there is neither an actual nor a deemed distribution to the partner.181 Therefore, in a limited partnership in which all recourse liabilities are allocated to the general partners and there are no nonrecourse liabilities, a limited partner can abandon their interest and have an ordinary loss rather than a capital loss. This is not true for a general partner to whom recourse liabilities are allocated because giving up a recourse liability is treated as a deemed distribution.182

175. Rev. Rul. 93-12, 1993-1 CB 202. 176. Prop. Treas. Regs. §§25.2704-2 and 25.2704-4. 177. IRS Pub. 541, Partnerships. 178. See, e.g. Comm’r v. Tufts, 461 U.S. 300 (1983). 179. IRC §752(b). 180. Citron v. Comm’r, 97 TC 200 (Aug. 5, 1991). 181. Rev. Rul. 93-80, 1993-2 CB 239. 182. Ibid.

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B212 2017 Volume B — Chapter 4: Partner Issues Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook Chapter 5: Partnership Issues

The Nature of Partnerships ...... B215 Minor Discrepancies...... B228 Defining Partnerships ...... B216 Adjustments when Guidance Is Lacking..... B228 Co-Tenancies ...... B217 Tax Basis vs. Book Accounting...... B229 Electing Out of Subchapter K ...... B218 Liabilities...... B230 Rental Real Estate Partnerships Definition of Liability ...... B231 and Electing Out ...... B219 Recourse Liabilities ...... B232 Effect of Electing Out ...... B220 Nonrecourse Liabilities ...... B234 Making the Election...... B222 IRC §754 Election ...... B238 Capital Accounts...... B223 5 Without §754 Election ...... B238 Liabilities ...... B224 With §754 Election...... B239 Fair Market Value...... B224 Allocations...... B242 Promissory Notes ...... B224 Substantial Economic Effect IRC §704(c) Considerations...... B225 Requirement ...... B243 Distributed Property...... B225 IRC §704(c) Allocations ...... B252 Special Adjustments to Distributions, Dispositions, and Terminations ....B254 Reflect Book Value...... B226 Distributions...... B254 Nondeductible Expenditures...... B226 Dispositions of Partnership Interests...... B258 Depletion...... B226 Collapsible Provisions ...... B264 Transfers of Partnership Interest...... B226 Holding Period and Character Optional Basis Adjustments...... B227 of Distributed Property ...... B267 Partnership Level Characterization...... B227 Death of Partner ...... B268 Guaranteed Payments ...... B228 Termination of Partnership ...... B268

About the Author Kenneth Wright has a law degree and a Master of Laws in Taxation from the University of Florida. He has been in private practice and has taught continuing education courses for the University of Missouri, the IRS, the AICPA, and the American Bar Association among others. Ken has served as Vice Chair of the Taxpayer Advocacy Panel, a Federal Advisory Group to the IRS, and was the first non-IRS recipient of the National Taxpayer Advocate Award for his work with the IRS on cancellation of indebtedness income and individual bankruptcy tax issues.

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Chapter Summary

A partnership results when two or more persons participate in a common business activity. State laws and subchapter K of the Code regulate partnerships and LLCs. These rules govern relationships between the partners of the partnership and its relationship with the outside world. The partnership makes certain tax elections and files an information return reporting collective income and expenses and each partner’s share of the same. Partners report their share of partnership income and expenses on their personal tax returns. Certain unincorporated organizations can elect exclusion from subchapter K. An electing organization may nevertheless be subject to certain partnership regulations. Most partnerships maintain capital accounts to determine each partner’s economic investment in a partnership. The main distinction between capital and tax accounts concerns contributed assets, for which FMV is used for capital accounting purposes and basis is used for tax purposes. For tax purposes, a partnership is treated as owning its assets as a separate entity, with its partners owning interests in that entity. Partners’ outside bases in their partnership interest are determined separately from the partnership’s inside basis in its assets. At initial formation, the total inside bases of the partnership plus its liabilities equals the sum of the partners’ outside bases. Differences between inside and outside bases can be eliminated by making a partnership election under IRC §754. Generally, partners allocate items in proportion to their ownership interests. Special allocations that depart from this standard must have substantial economic effect. The determination of whether an allocation has substantial economic effect involves a 2-part analysis. When there is a variation between the adjusted tax basis of contributed property and its FMV at the time of contribution, IRC §704(c) requires a partnership to specially allocate subsequent income, gain, loss, and deductions of the property entirely to the contributing partner until the difference is accounted for. Generally, neither gain nor loss is recognized by the partnership or by the partners with respect to distributions. However, this may not apply to certain cash and property distributions, payments to a retired partner, and certain liquidating distributions. A partnership normally terminates for federal tax purposes when it winds up its affairs and ceases conducting any business. However, a technical termination occurs when there is a 50% or more change in ownership in both partnership capital and partnership profits within a 12-month period. The tax consequences of partnership terminations are discussed.

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[T]here can be little doubt that the attempt to achieve “simplicity” [in partnership taxation] has resulted in utter failure.1 1

THE NATURE OF PARTNERSHIPS

As a concept, a partnership is nothing more than two or more persons who have agreed to engage in a common business activity. Such an arrangement, however, results in two sets of relationships. 1. The relationship of the persons to each other within their common activity 2. The relationship of the activity to the rest of the world Consequently, rules that determine the nature of each of these relationships are required. For purposes of state law, the rules are in statutes governing partnerships and limited liability companies (LLCs); for federal tax purposes, they are in subchapter K of the Code. 5 Under state law, the statutory rules governing the internal relationships of the partners to each other are default rules. They are applicable in the absence of an agreement by the partners. Therefore, stating that “there is no partnership because there is no partnership agreement” is incorrect. If a relationship looks and acts like a partnership under state law, it is a partnership. The absence of a specific partnership agreement among the partners means only that state law controls their internal relationship both for state law purposes2 and for tax purposes.3 The external relationship of the partnership or LLC to the rest of the world is a different matter. Under traditional partnership law, each general partner has full, unlimited liability for any wrong or injury committed by the partnership, even if the general partner had nothing to do with that act. Each general partner is liable for payment of the full amount of any partnership liability to third parties, not just the share attributable to their partnership interest. The LLC entity structure eliminates the unlimited liability exposure general partners have. Each member of an LLC has liability exposure only for harm done by that member. This is the same liability protection shareholders of a corporation have in their capacity as shareholders. At the same time, LLC members enjoy the flexibility of partnerships to privately agree what rules govern their internal relationship. Corporations are much more limited in this respect. For federal tax purposes, there is no distinction between partnerships and LLCs that are taxed as partnerships under the classification regulations.4 Both are subject to the partnership tax provisions of subchapter K. In this chapter, both partnership partners and LLC members are generally referred to as “partners.”

Note. The default tax status of a multiple-member LLC is a partnership. A single-member LLC is generally taxed as if the sole member owns the assets directly. However, an LLC may elect to be taxed as a corporation.

1. The Tax Court commenting on Congress’s attempt in 1954 to achieve simplicity in partnership taxation through enacting Subchapter K. Foxman, et al. v. Comm’r, 41 TC 535 (1964), aff’d 352 F.2d 736 (3rd Cir. 1965), acq. 1966-2 CB 4. 2. Uniform Partnership Act (1997) National Conference of Commissioners on Uniform State Laws. [www.uniformlaws.org/shared/docs/ partnership/upa_final_97.pdf] Accessed on Jun. 6, 2017. 3. Treas. Reg. §1.761-1(c). 4. Treas. Reg. §301.7701-3.

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DEFINING PARTNERSHIPS

The Uniform Partnership Act defines a partnership as “an association of two or more persons to carry on as co-owners a business for profit. . . ”5 The Code defines a partnership to include “a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation.”6 Whether an entity is a partnership for income tax purposes is determined under federal tax law, which may be broader than comparable state law. The tax rules applicable to partnerships may be described as “aggregate” or “entity.”7 The aggregate theory of partnership taxation is that of the collective sole proprietorship. That is why it is impossible to have an income tax liability at the partnership level. Instead, each partner is required to report their share of the collective income and expenses on their own individual Form 1040, U.S. Individual Income Tax Return, as if each of them had individually earned the income or made the expenditures. In fact, the Form 1065, U.S. Return of Partnership Income, is not an income tax return; instead, it is an information return.8 Because each partner must report their share of all partnership items and because the partnership’s internal operation is determined internally on the basis of the partners’ agreement among themselves, the partners have the ability to use their agreement to determine how income tax items, such as depreciation deductions, are allocated among the partners. Much of the complexity of the partnership tax rules, therefore, comes from efforts by Congress and the IRS to prevent partnerships from using their freedom of contract to make allocations among partners that are based on tax avoidance. This is the purpose, for example, of the requirement that special allocations have substantial economic effect.9 Under the entity theory, partnerships are treated as entities for tax purposes. This is generally done for purposes of administrative convenience or to ensure consistency among the partners. Thus, tax elections (e.g., whether to expense under §179) must be made at the partnership level. Because of the lack of a precise definition of partnerships and the often informal partnership arrangements, the determination of whether an arrangement is a partnership may require a facts-and-circumstances analysis. The classification regulations may treat an arrangement of two or more persons as a separate entity if the participants carry on a trade, business, financial operation, or venture and divide the profits from that activity.10 Courts have considered the following factors, none of which is conclusive. 11 • The agreement of the parties and their conduct in executing its terms • The contributions, if any, that each party makes to the venture • Parties’ control over income and capital and the right of each to make withdrawals • Whether each party is a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving contingent compensation for services in the form of a percentage of income • Whether business was conducted in the joint names of the parties

5. Uniform Partnership Act (1997). National Conference of Commissioners on Uniform State Laws. [www.uniformlaws.org/shared/docs/ partnership/upa_final_97.pdf] Accessed on Jun. 6, 2017. 6. IRC §7701(a)(2). 7. See. e.g., Holiday Village Shopping Center, Inc. v. U.S., 773 F.2d 276 (Fed. Cir. 1985). 8. IRC §6031 requiring partnership returns is found in the Code under Information Returns at Subtitle F, Chapter 61, Subchapter A, Part III. 9. Treas. Reg. §1.704-1(b)(2). 10. Treas. Reg. §301.7701-1(a)(2). 11. Luna v. Comm’r, 42 TC 1067 (1964).

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• Whether the parties filed federal partnership returns or otherwise represented themselves as partners to the IRS or to other people with whom they dealt • Whether separate books of account were maintained for the venture • Whether the parties exercised mutual control over and assumed mutual responsibilities for the enterprise In cases and rulings concerning whether an arrangement constitutes a partnership, the principal focus has been on whether the parties operated under an arrangement in which there was a division of profits from the venture. Nevertheless, as one court stated, “the sharing of profits is a necessary, but not sufficient, condition for a finding that a joint venture exists.”12 In that case, the court determined that a sharing of gross receipts from vending machines with the owners of establishments in which the machines were located was not a partnership because a sharing of gross receipts alone was not the sharing of profits. The term “profit” requires a sharing of both receipts and expenses.

CO-TENANCIES Mere co-ownership of property or cost-sharing arrangements does not create an entity for classification purposes.13 5 Instead, the joint ownership or arrangement must be for purposes of using the co-owned property or other arrangement to carry on a trade, business, financial operation, or venture, and dividing the profits from that activity. Even if an arrangement is not treated as an entity for classification purposes, if the participants in the arrangement nevertheless file partnership returns (which they are not prohibited from doing), they generally are prohibited from denying they are a partnership. In one letter ruling, for example, filing partnership returns evidenced intent to form a partnership. This prevented individual co-owners from engaging in like-kind exchanges of tenancies in common because the IRC §1031 like-kind exchange rules apply at the partnership level.14 The fact that services may be provided to tenants of the property is an issue only if provided by the co-owners. In one case, for example, two co-owners of apartment units provided customary tenant services to tenants of the apartments through a third-party manager. The manager also provided additional services, such as attendant parking, cabanas, gas, electricity, and other utilities. This was done independently by the manager, however, who kept all of the fees earned for such services. Because the services were provided independently of apartment rentals by the co-owners, the agent’s activities were found not to be sufficiently extensive to cause the co-ownership to be considered a partnership.15 Although a division of profits is normally thought of as a division of cash profits, courts have held that in-kind divisions of a product of an arrangement is within the scope of division of profits. In one leading case, a utility owned an interest in a nuclear power plant as a tenant in common with two other utilities and the two utilities shared the power generated. This was held to be a partnership, not a co-tenancy.16 If an arrangement is not an entity required to be classified as a partnership, the individual co-owners each report their proportionate share of income and expenses on their respective individual returns. In the case of individual co-owners, for example, each would report their share of income and expenses on Schedule E, Supplemental Income and Loss.

12. ACME Music Company, Inc. v. IRS, 196 BR 925 (BR WD Pa 1996). 13. Treas. Reg. §301.7701-1(a)(2). 14. Ltr. Rul. 9741017 (July 10, 1997). 15. Rev. Rul. 75-374, 1975-2 CB 261. 16. Madison Gas and Electric Company v. Comm’r, 633 F.2d 512 (7th Cir 1980), aff’g 72 TC 521 (1979).

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Effect of Holding Real Estate in an LLC In order for the co-ownership exception to the creation of a partnership to apply, it is the IRS’s position that real estate must be titled in the names of the individual co-owners either directly or indirectly through a disregarded entity. Title to the property as a whole may not be held by an entity recognized under local law if it has more than one member.17 Thus, if rental real estate is titled in the name of an LLC with more than one member, the IRS treats the activity as a partnership requiring the filing of a partnership return. There is nothing in the classification regulations or — with one exception — in anything issued by the IRS that permits a husband-wife LLC to be treated as a disregarded entity on a joint return. The one exception is applicable only to spouses in community property states when all the interests in an LLC are owned solely by the husband and wife as community property. In those cases, the spouses may choose to treat the LLC either as a disregarded entity or as a partnership (and file partnership returns). The IRS accepts that choice.18

ELECTING OUT OF SUBCHAPTER K

IRC §§701–777 comprise subchapter K and generally govern the tax treatment of partnerships (although §§771–777 apply to electing large partnerships and generally do not affect practitioners). IRC §761(a) gives the IRS authority to issue regulations permitting members of an unincorporated organization to be excluded from all or part of subchapter K. The income of the organization’s members must be capable of being adequately determined without the need for computing partnership taxable income.19 The following organizations are eligible for this treatment.20 1. Those formed for investment purposes only and not for the active conduct of a business 2. Those formed for the joint production, extraction, or use of property, but not for the purpose of selling services or property produced or extracted 3. Those formed by dealers in securities for a short period for the purpose of underwriting, selling, or distributing a particular issue of securities The first type of organization is the one most commonly encountered by practitioners. The second is intended primarily for public utilities. The regulations have the following requirements for an investment partnership to elect exclusion from subchapter K.21 1. The participants must be involved in the joint purchase, retention, sale, or exchange of investment property. 2. They must own the property as co-owners. 3. Each participant must reserve the separate right to take or dispose of their shares of any property acquired or retained. 4. The participants must not actively conduct business or irrevocably authorize some person or persons as representatives to purchase, sell, or exchange the investment property. However, participants may delegate authority to purchase, sell, or exchange their share of any investment property for a period of not more than one year.

17. See, e.g., Rev. Proc. 2002-22, 2002-1 CB 733 (§6.01). 18. Rev. Proc. 2002-69, 2002-2 CB 831. 19. Treas. Reg. §1.761-2(a)(1). 20. IRC §761(a). 21. Treas. Reg. §1.761-2(a)(2).

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5. The organization must make an affirmative election to be excluded or must be deemed to have made an election to be excluded.

RENTAL REAL ESTATE PARTNERSHIPS AND ELECTING OUT Although it may be common for rental real estate partnerships to file elections under §761 to be excluded from subchapter K, it is doubtful that many such elections are valid, especially in the case of LLCs. As stated above, two requirements for the election are co-ownership of the property and the right of each participant to take or dispose separately of their share of the property. If the property is titled in the name of an entity, it is not co-owned directly by the co-owners. Instead, they own an interest in the entity. The only authority in this area comes from a few letter rulings. In one field service advice (FSA), the IRS considered whether rental real estate held in a limited partnership was eligible for exclusion under §761.22 The IRS stated that the determination of co-ownership must be made under state law by reference to each party’s rights in the property as specified by a lease or other contract between the parties. Limited partners are treated under state law as owning partnership interests in a limited partnership, which is treated as 5 personal property. They do not directly own property and cannot separately take or dispose of assets owned by the limited partnership itself. A limited partnership is therefore not eligible to elect exclusion from subchapter K. This result is not affected by any statement in the limited partnership agreement purporting to characterize the partnership as an investment partnership electing to be excluded under §761. Although not addressed in the FSA, the same principle is applicable to LLCs or any other state-law form of partnership holding separate title to rental real estate. In a private letter ruling, the IRS ruled that investment real estate owned by tenants in common was a partnership not eligible for exclusion under §761.23 Property owned by the co-owners was desired by several potential purchasers. The owners did the following. • They entered into an agreement with a third-party agent to act for them in selling or otherwise disposing of the property. • They required any actions relating to the property to be approved by majority vote of the total undivided interests in the property. • Transfers of interests in the property were restricted to certain listed related parties, with any other transfers requiring prior written consent of all of the other owners. • Partition of the property was prohibited during the term of the agreement. The IRS ruled that the effect of the agreement was a surrender by the parties of their rights to take and separately sell their respective shares of the property so that the venture became more than mere co-ownership of property and was therefore properly classified as a partnership.

22. FSA 200216005 (Jan. 10, 2002). 23. Ltr. Rul. 8002111 (Oct. 22, 1979).

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EFFECT OF ELECTING OUT The IRS has the authority to exclude an electing partnership from the provisions of all or a portion of subchapter K.24 The IRS stated in two revenue rulings that the election out does not apply to §704(d) for purposes of prohibiting partners from deducting losses in excess of their basis in the partnership.25 In addition, the election out does not eliminate the need to establish a business purpose under §706(b) for adoption of a tax year for the partnership different from that of its principal partners.26 When an organization elects out of subchapter K pursuant to §761, it is generally not treated as a partnership only for purposes of those partnership rules specifically found in subchapter K. This means, for example, that a participant who sells their interest in an organization that has elected out is not treated as having sold a partnership interest, which would be considered the sale of a capital asset. This sale is also not subject to ordinary income recharacterization under §751 for certain items, such as cash-basis receivables. Instead, the participant is treated as having sold a proportionate interest in each asset held by the organization and is required to characterize and report gain or loss accordingly.27 It has long been the IRS’s position, as sustained by the courts, that the election out of subchapter K means only that those provisions are not applicable to the electing organization. However, for all other purposes of the Code, the organization is still a partnership to the extent required for proper application of the tax laws. As the Tax Court stated in Bryant v. Comm’r: The election under section 761(a) does not operate to change the nature of the entity. A partnership remains a partnership; the exclusion simply prevents the application of subchapter K. The partnership remains intact and other sections of the Code are applicable as if no exclusion existed.28 28 Consequently, in applying provisions not contained in subchapter K to an electing partnership, there must be some other basis for asserting that the entity is not a partnership. For example, partnership interests are not eligible for like- kind exchange nonrecognition treatment under IRC §1031. If an investment partnership holding real estate does not elect out of subchapter K, it is still treated as a partnership under §1031. This means that only the entity can accomplish the like-kind exchange because no individual partner can accomplish a like-kind exchange of the partner’s outside interest. IRC §1031(a)(2) provides, however, that “For purposes of this section, an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership.” Whether the organization should be treated as a partnership under other Code provisions is determined, according to the IRS, by whether the other provision and the provisions of subchapter K are “interdependent.” If there is interdependency, the organization is treated as a partnership; if not, each partner is treated as directly owning an interest in the assets. The IRS discussed interdependence in a General Counsel Memorandum (GCM), stating that: Merely because a partnership elects not to be subject to the provisions of subchapter K, does not mean that the partnership can escape limitations generally applicable to partnerships if those limitations can be applied despite the fact that income and deductions are computed at the partner rather than the partnership level. The question in each instance is whether the limitation or rule outside of subchapter K can be applied without doing violence to the concept of electing out of subchapter K and computing income and deductions at the partner level.29 29

24. IRC §761(a). 25. Rev. Rul. 58-465, 1958-2 CB 376. 26. Rev. Rul. 57-215, 1957-1 CB 208. 27. TAM 9214011 (Dec. 26, 1991). 28. Bryant v. Comm’r, 46 TC 848 (1966), aff’d 399 F.2d 800 (5th Cir. 1968). 29. GCM 39043 (Oct. 5, 1983).

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The discussion in the GCM expressly rejected a position in a proposed revenue ruling that interdependence exists only when a provision outside of subchapter K imposes a procedural or substantive rule specifically applicable to partnership entities. The GCM unhelpfully concluded that “Perhaps at this point, however, it is unnecessary to get involved in explaining the concept of interdependence.” Despite this lack of clear definition, no case or ruling has used interdependence in the absence of a particular Code provision intended to apply at the partnership level. For example, the Tax Court in Bryant v. Comm’r held that individual partners of a partnership that elected out of subchapter K were not each entitled to $50,000 of investment tax credit. Instead, the partners must share proportionately in the single $50,000 investment tax credit permitted partnerships with respect to partnership assets.30 Existing cases and rulings have addressed interdependency in the following situations involving an election out of subchapter K. • Partners are still required to treat their distributive share of partnership business income as net earnings from self-employment to the extent required under IRC §1402.31 • Individual partners may elect separately to treat their share of mine development costs as currently deductible 5 or as deferred expenses under IRC §616(b) if the partnership elected out of subchapter K.32 • The partnership unified audit (under the Tax Equity and Fiscal Responsibility Act) procedures of IRC §6231 are not applicable to partnerships that properly elect out of subchapter K. Any audit involving such an organization must be based upon the books and records of each individual partner, who must substantiate their share of the items reported for income tax purposes.33

Note. Presumably, the same principle will continue to apply under the new partnership audit rules effective beginning January 1, 2018.

• Partners of an electing partnership are treated as directly owning undivided interests in the partnership assets for purposes of determining the depreciation method to be used for its interest. The anti-churning rules are applicable at the individual partner level.34 • A partner of an electing partnership is entitled to an IRC §165 abandonment loss when it abandons its proportionate interest in property of the partnership rather than when the partnership abandons the property.35 • For purposes of extensions of time for payment of estate tax under §6166A, an interest in a partnership that has elected out of subchapter K is still considered an interest in a partnership that is a closely held business and not an interest in the assets themselves.36

30. Bryant v. Comm’r, 46 TC 848 (1966), aff’d 399 F.2d 800 (5th Cir. 1968). 31. Cokes v. Comm’r, 91 TC 222 (1988). 32. Rev. Rul. 83-129, 1983-2 CB 105. 33. FSA 001917 (Jan. 31, 2004). 34. TAM 9504001 (Jun. 10, 1994). 35. TAM 9214011 (Dec. 26, 1991). 36. TAM 8042011 (July 1, 1980).

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There is no direct guidance addressing the impact on §179 expensing of an election out of subchapter K. IRC §179(d)(8) states that the dollar limitation (amount that can be expensed) and taxable income limitation (taxpayer income against which expensed amounts are deductible) are applied at the entity level for partnerships. This is similar to the situation in the Bryant case (mentioned previously), in which the Tax Court applied the investment tax credit limitation at the partnership level for an electing organization. Because there is a specific limitation applicable to partnerships, partners in an organization electing out of subchapter K are limited to their proportionate shares of any dollar amount that can be expensed by the partnership. How the taxable income limitation applies is not clear. Presumably, any aggregate amount expensed by the partners in excess of the partnership taxable income carries forward at the partnership level to be used in future years under the partnership rules, notwithstanding the election out of subchapter K.

MAKING THE ELECTION The regulations generally require an affirmative election under §761(a).37 The election must be filed no later than the due date (including extension) of the partnership return for the first year for which the exclusion is desired. Thus, it can be filed even for an entity that has been filing partnership returns. Once made, the election is irrevocable without the IRS’s consent. The election is made by filing a Form 1065 partnership return at the proper IRS Service Center. The return should include only the following. • The name or other identification and the address of the organization • A statement attached to the return showing the names, addresses, and taxpayer identification numbers of all the members of the organization • A statement that the organization qualifies for exclusion under one of the categories of IRC §761(a) • A statement that all members of the organization elect to be excluded from subchapter K • A statement indicating where a copy of the agreement under which the organization operates is available or, if the agreement is oral, from whom the provisions of the agreement may be obtained The regulations also permit a deemed election in the event no affirmative election is filed. This is available if it can be shown from all relevant facts and circumstances that it was the intention of the members of the organization at the time of its formation to be excluded from subchapter K beginning with the first tax year of the organization. The regulations list the following two nonexclusive factors that may indicate the requisite intent.38 1. At the time of formation, there is an agreement among the members that the organization will be excluded from subchapter K beginning with its first tax year. 2. The members of the organization owning substantially all of the capital interests report their respective shares of the income, deductions, and credits of the organization on their returns, making such elections as to individual items as may be appropriate, in a manner consistent with the exclusion of the organization from subchapter K beginning with the organization’s first tax year. If it is found that an election out of subchapter K was not proper, the consequences may be unpleasant. One field service advice states that “If the entity did not properly elect out of subchapter K, then it is still required to file partnership returns [emphasis added].”39 Presumably, the partnership is then required to file late partnership returns, which could subject the partners to significant penalties unless the IRS can be convinced there is reasonable cause for abatement.

37. Treas. Reg. §1.761-2(b). 38. Treas. Reg. §1.761-2(b)(2)(ii). 39. FSA 001917 (Oct. 8, 1996).

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CAPITAL ACCOUNTS

Capital accounts are used to measure a partner’s economic investment in a partnership as opposed to tax investment. Capital accounts are commonly referred to as “book” accounts to distinguish them from tax capital accounts. The principal difference between the two is that book capital accounts are based on the fair market value (FMV) of contributed assets,40 while tax accounts use the basis of contributed assets.41 In this section, the term “capital account” refers to “book” unless stated otherwise. Although the maintenance of capital accounts is intended to track the partners’ economic interests in a partnership, these accounts are generally adjusted with respect to tax items, rather than through the use of normal financial accounting rules. This is because the fundamental rule of partnership allocations is that tax allocations must follow book allocations.42 In addition, special rules are provided under IRC §704(c) (described in the section entitled “IRC §704(c) Allocations”) for contributions of property with a book value that differs from its tax basis because, in these instances, tax allocations and book allocations necessarily differ. 5 Each partner’s book capital account begins at zero and, in general, is increased by the following items.43 • The amount of money contributed by the partner to the partnership • The FMV of property contributed by the partner to the partnership, net of liabilities secured by such contributed property that the partnership is considered to assume or take under IRC §752 • Allocations to the partner of partnership income and gain, including tax-exempt income and certain special allocations required by the regulations The following items decrease book capital accounts.44 • The amount of money distributed to a partner by the partnership • The FMV of property distributed to the partner net of liabilities secured by the distributed property that the partner is considered to assume or take under §752 • Allocations to the partner of nondeductible, noncapital expenditures of the partnership • Allocations of partnership loss and deductions A partner who has more than one interest in a partnership is required to have a single book capital account that combines all interests of the partner in the partnership.45 Many rules must be followed in maintaining book capital accounts. These are generally found in Treas. Reg. §§1.704- 1(b)(2)(iv)(c)–(q). The rules are briefly described in the following material (noncompensatory options are omitted). A summary of the changes to a partner’s capital account is reported on Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., in box L. Method used to calculate these amounts are described separately. Box M of Schedule K-1 indicates if the partner contributed property with a built-in gain or loss subject to IRC §704(c). The relevant portion of the Schedule K-1 is shown next.

40. See, e.g., Treas. Reg. §§1.704-1(b)(2)(iv)(b) and 1.704-1(b)(2)(iv)(g). 41. IRC §722. 42. Treas. Reg. §1.704-1(b)(2)(ii). 43. Treas. Reg. §1.704-1(b)(2)(iv)(b). 44. Ibid. 45. Ibid.

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LIABILITIES46 For book purposes, money contributed by a partner to a partnership includes the amount of any partnership liabilities assumed by the partner other than liabilities assumed by a distributee-partner in connection with distributed property. Money distributed to a partner by a partnership includes the amount of the partner’s individual liabilities that are assumed by the partnership other than liabilities secured by contributed property. Liabilities are considered assumed only to the extent: • The assuming party is subjected to personal liability, • The obligee is aware of the assumption and can directly enforce the assuming party’s obligation, and • The assuming party is ultimately liable (rather than the party from whom the liability is assumed). Liabilities do not include constructive cash distributions and partner contributions resulting from liability shifts occurring as a result of contributions and distributions of encumbered property.

FAIR MARKET VALUE47 The FMV assigned to property by the partners is generally accepted for book purposes as long as the value is reasonably agreed to among the partners in arm’s-length negotiations and the partners have sufficiently adverse interests. If these conditions are not satisfied and the property values are overstated or understated by more than an insignificant amount, the partners’ capital accounts are not considered to satisfy the economic effect requirement (other than economic equivalence).48 FMV is determined without taking into account the §7701(g) requirement that the FMV of property securing a nonrecourse liability is not treated as less than the amount of the nonrecourse liability.

PROMISSORY NOTES A partner’s contribution of a promissory note does not result in any increase in the partner’s book account unless the partnership disposes of the note in a taxable transaction or payments are actually made against the note principal by the contributing partner.49 If the note is readily tradable on an established securities market, however, this limitation is not applicable.50 Similarly, a partner’s capital account is not decreased for distribution of a partnership’s note to a partner unless there is a taxable disposition of the note by the partner or the partnership makes principal payments.51

46. Treas. Reg. §1.704-1(b)(2)(iv)(c). 47. Treas. Reg. §1.704-1(b)(2)(iv)(h)(1). 48. Ibid. 49. Treas. Reg. §1.704-1(b)(2)(iv)(d)(2). 50. Ibid. 51. Treas. Reg. §1.704-1(b)(2)(iv)(e)(2).

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IRC §704(c) CONSIDERATIONS The partnership agreement must require that the partners’ capital accounts be adjusted to reflect differences between book value and tax basis with respect to contributed property subject to a §704(c) special allocation for precontribution gain or loss.52 The capital accounts are not adjusted, however, to reflect the actual tax allocations required under §704(c).53

DISTRIBUTED PROPERTY A partner’s capital account is decreased by the FMV of property distributed to the partner. In doing so, the capital accounts of all the partners first must be adjusted to reflect the manner in which the unrealized income, gain, loss, and deduction inherent in the property that has not previously been reflected in capital accounts would be allocated among the partners if there were a taxable disposition of the property for its FMV.54 For this purpose, the excess of nonrecourse liabilities over FMV is taken into account.55 Revaluations of Partnership Property 5 A partnership agreement may increase or decrease the capital accounts of the partners to reflect a revaluation of partnership property on the partnership’s books, including intangible assets such as goodwill.56 For revaluations to be acceptable, they must be made principally for a substantial nontax business purpose such as any of the following.57 • The admission of a new partner • Contributions by existing partners • The liquidation of the partnership or a distribution of money or other property to a retiring or continuing partner as consideration for an interest in the partnership • Issuance of a partnership interest to an existing or new partner in exchange for services performed to the partnership • In connection with the issuance by the partnership of a noncompensatory option • Under generally accepted industry accounting practices, if substantially all the partnership’s property is readily tradable stock, securities, etc. In addition, the partnership agreement must generally require that the capital accounts be adjusted to reflect the manner in which the unrealized income, gain, loss, and deduction inherent in the property would be allocated among the partners under §704(c) special allocation principles if there were a taxable disposition of the property for FMV on the date of distribution.58

52. Treas. Reg. §1.704-1(b)(2)(iv)(d)(3). 53. Ibid. 54. Treas. Reg. §1.704-1(b)(2)(iv)(e)(1). 55. Ibid. 56. Treas. Reg. §1.704-1(b)(2)(iv)(f). 57. Treas. Reg. §§1.704-1(b)(2)(iv)(f)(5)(i)–(v). 58. Treas. Reg. §§1.704-1(b)(2)(iv)(f)(1)–(4).

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SPECIAL ADJUSTMENTS TO REFLECT BOOK VALUE One of the goals of the substantial economic effect test (discussed in the section entitled “Substantial Economic Effect Requirement”) is to apply economic rules to a partnership’s bookkeeping that will, over time, eliminate the differences between the partnership’s tax values (basis) and its book values (FMV). This is also a purpose of the mandatory §704(c) special allocations with respect to precontribution gain or loss. Allocations to the partners of depreciation, depletion, amortization, and gain or loss for book purposes must therefore be made for the book value of the property using the same ratio as the corresponding tax item over the tax basis of the property.59 For depreciation and other amortization purposes, if the property has a zero tax basis, the corresponding book deduction may be determined under any reasonable method selected by the partnership.60 Example 1. A partner contributes property with an FMV of $90 and an adjusted basis of $60 to a partnership. The depreciation deduction for the first year following the contribution is $20, which is one-third of the adjusted basis of the property. For purposes of book accounting, the partnership is therefore required to depreciate one-third of the $90 book value, or $30.

NONDEDUCTIBLE EXPENDITURES61 Nondeductible, noncapital expenditures of the partnership (e.g., the 50% disallowance of meal and entertainment expenses) reduce a partner’s book account. Unless an election is made under IRC §709(b) to amortize organizational expenditures, they are treated as nondeductible, noncapital expenses. Losses that are disallowed under IRC §§267 or 707(b) for sales or exchanges of partnership property to related parties are also treated as such expenditures.

DEPLETION Depletion deductions are separately stated items for income tax purposes. For book accounting, however, the regulations require that “simulated” depletion be determined at the partnership level and be used to adjust book value without regard to the tax limitations that apply at the individual partner level. Alternatively, each partner’s actual depletion deduction can be used. 62

TRANSFERS OF PARTNERSHIP INTEREST Upon the transfer of all or a part of an interest in the partnership, the capital account of the transferor that is attributable to the transferred interest must carry over to the transferee-partner. If the transfer of an interest in a partnership causes a termination of the partnership under IRC §708, the capital account of the transferee-partner and the capital accounts of the other partners of the terminated partnership carry over to the new partnership that results from termination of the prior partnership. Moreover, the deemed contribution of assets and liabilities by the terminated partnership to a new partnership and the deemed liquidation of the terminated partnership that occur as a result of the change in ownership are disregarded for purposes of book accounting.63

59. Treas. Reg. §§1.704-1(b)(2)(iv)(g)(1) and (3). 60. Treas. Reg. §1.704-1(b)(2)(iv)(g)(3). 61. Treas. Reg. §1.704-1(b)(2)(iv)(i). 62. Treas. Reg. §1.704-1(b)(2)(iv)(k). 63. Treas. Reg. §1.704-1(b)(2)(iv)(l).

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OPTIONAL BASIS ADJUSTMENTS A partnership that has an IRC §754 election in effect is generally not permitted to adjust the book account of a transferee-partner or of the partnership in the case of an IRC §743 adjustment under which a transferee-partner adjusts the partner’s share of inside tax basis to reflect the outside tax basis.64 This does not apply, however, to the extent the basis adjustment is allocated to the common basis of partnership property.65 IRC §732(d) adjustments for partnerships that do not have a §754 election in effect are treated in the same manner.66

Note. IRC §754 elections and §743 adjustments are discussed later in the chapter.

If there is an adjustment under IRC §734 (discussed later) as a result of gain or loss being recognized by a distributee- partner upon distribution of property from the partnership, the partner receiving the distribution giving rise to the adjustment is required to have a corresponding adjustment made to their book account.67 If the distribution is made other than in liquidation of the partner’s interest, however, the capital accounts of all partners are adjusted. The adjustment should be made in the manner in which the unrealized income and gain that is displaced by the adjustment 5 would have been shared if the property whose basis is adjusted were sold immediately prior to the adjustment for its recomputed adjusted tax basis.68 A partner’s capital account may be adjusted for IRC §§732, 734, and 743 basis adjustments to partnership property but only to the extent that such basis adjustments are permitted to partnership property under IRC §755 and result in a change in the amount for such property on the partnership’s balance sheet for book purposes.69

PARTNERSHIP LEVEL CHARACTERIZATION Except as otherwise required for depletion, the book capital accounts of partners must be determined by applying federal tax rules at the partnership level without regard to how items would be required to be treated at the individual partner level. In other words, book accounting treats the partnership as an entity rather than as an aggregate.70

64. Treas. Reg. §1.704-1(b)(2)(iv)(m)(2). 65. Ibid. 66. Treas. Reg. §1.704-1(b)(2)(iv)(m)(3). 67. Treas. Reg. §1.704-1(b)(2)(iv)(m)(4). 68. Ibid. 69. Treas. Reg. §1.704-1(b)(2)(iv)(m)(5). 70. Treas. Reg. §1.704-1(b)(2)(iv)(n).

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GUARANTEED PAYMENTS Guaranteed payments to a partner under IRC §707(c) cause the capital account of the recipient partner to be adjusted only to the extent of the partner’s distributive share of any partnership deduction, loss, or other downward capital account adjustment resulting from such payment.71 Example 2. ABC Partnership has three partners. All partnership items are allocated in accordance with the partners’ percentage interests. The partners have the following ownership interests, tax bases, and capital accounts.

o Partner Percentage Basis Capital Account Avery 80 $80,000 $80,000 Basil 15 15,000 15,000 Carlita 5 5,000 5,000

Carlita receives a $10,000 guaranteed payment. Each partner is allocated their respective share of deduction for the guaranteed payment, which reduces their capital accounts accordingly.

Partner Percentage Deduction Capital Account Avery 80 $8,000 $72,000 Basil 15 1,500 13,500 Carlita 5 500 4,500

Thus, Carlita receives $10,000 but her capital account is reduced by only her $500 share of the partnership’s deduction for the payment.

MINOR DISCREPANCIES Minor discrepancies between the actual balances in the capital accounts of the partners and the balances that would have existed had the book accounting rules been properly followed are not treated as violating the substantial economic effect requirement as long as they are attributable to good faith error by the partnership.72

ADJUSTMENTS WHEN GUIDANCE IS LACKING If the regulations fail to provide guidance on how adjustments to capital accounts should be made with respect to particular items, then adjustments must be made in a manner that:73 1. Maintains equality between the aggregate governing capital accounts of the partners and the amount of partnership capital reflected on the partnership’s balance sheet, as computed for book purposes; 2. Is consistent with the underlying economic arrangement of the partners; and 3. Is based, whenever practicable, on federal tax accounting principles.

71. Treas. Reg. §1.704-1(b)(2)(iv)(o). 72. Treas. Reg. §1.704-1(b)(2)(iv)(p). 73. Treas. Reg. §1.704-1(b)(2)(iv)(q).

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TAX BASIS VS. BOOK ACCOUNTING Is it possible simply to use tax basis accounting for a partnership and skip capital accounts? The short answer is yes. In fact, many small partnerships do not maintain capital accounts and there may be no need for them to do so. Regardless of whether capital accounts are maintained, tax basis accounting is required. The fundamental purpose of using both capital accounting and tax accounting is to enable partners to track any differences between their economic and tax investments in a partnership. This may become important when the two differ because of the possibility of creating undesirable tax issues. Take, for example, the rules governing contributions of property with built-in gain or loss under §704(c) (discussed in the “IRC §704(c) Allocations” section). If a partner contributes property with built-in gain, it is mandatory that the built-in gain be specially allocated to the contributing partner if the property is sold or exchanged in a taxable transaction, with only post-contribution appreciation in value allocated among all the partners. This ensures that a contributing partner cannot avoid paying tax on appreciated property by contributing it to a partnership. Even if the property is not sold, there are complicated regulations requiring the book-tax disparity to be eliminated as quickly as 5 possible. Maintaining capital accounts helps identify such situations and avoid problems. Example 3. Ava and Brian form an equal partnership. Ava contributes $100 cash and Brian contributes property with an FMV of $100 and an adjusted basis of $40. Each has a $100 capital account, because Brian’s capital account is equal to the property’s FMV. Ava has $100 of partnership basis and Brian has $40 of partnership basis. If the property is sold for $120, the first $60 of gain must be allocated to Brian and the remaining $20 of gain will be divided equally between the two partners. The $60 of §704(c) built-in gain ($100 FMV at time of contribution – $40 adjusted basis) increases Brian’s basis but it does not increase his capital account, however. Following the sale, each partner will have a capital account of $110 ($100 beginning capital account + $10 allocated gain) and each will have a partnership basis of $110. A liquidating distribution of $110 to each will be nontaxable. Example 4. Use the same facts as Example 3, except the special allocation requirement of §704(c) is ignored and the entire $80 of gain is divided equally between the two partners. Accordingly, Ava and Brian each report $40 of the gain. Ava has a capital account of $140 and a basis of $140, and Brian has a capital account of $140 and basis of $80 ($40 beginning basis + $40 allocated gain). If the partnership is then liquidated and the $220 of assets is divided equally between the two, each will receive $110. Ava will then have a $30 capital loss ($110 distribution – $140 basis) and Brian will have a $30 capital gain ($110 distribution – $80 basis). The sum of the gain and the loss (treating it as positive) effectively represents the $60 built-in gain. The result of failing to maintain capital accounts as well as tax basis accounts can therefore be that one partner is able to defer taxation while another partner pays unnecessary tax. Furthermore, it can have the effect of converting tax on ordinary income into a capital loss. This would have been the case if gain on the property contributed by Brian in the preceding example had been ordinary income property.

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LIABILITIES

Liabilities play an important role in the taxation of partnerships and partners. As discussed in the following section, they are included in determining partners’ outside bases in their partnership interests and, in the case of nonrecourse debt, they affect allocations. Each partner’s share of liabilities is reported on the partner’s Schedule K-1 in part II, item K. Practitioners must therefore be familiar with the rules for allocating liabilities in order to prepare Schedule K-1 correctly. Partnership and partner liabilities are governed by IRC §752. For purposes of determining partners’ outside bases, a partner’s assumption of partnership debt is treated as a cash contribution. This is because entity-level debt of general partnerships is, under both state law and federal income tax law, nothing more than the collective individual debts of all the partners. An individual who purchases an asset with borrowed money is entitled to immediate basis rather than acquiring basis only as the liability is paid off. The only difference between an individual’s debt and a partnership’s debt is the collective nature of partnership debt. The individual partners in a general partnership each have direct liability within the partnership for their proportionate shares of the partnership’s borrowing. Thus, partners can increase their outside bases in the partnership for their proportionate shares of the partnership’s liabilities as if they had used the debt to purchase that portion of their partnership interest. This manner of treating partners as simply a collection of individuals is an application of the aggregate theory of partnership taxation (as opposed to the entity approach, which treats the partnership as a separate entity).74 Example 5. Alan and Brandy are each 50% members of AB, LLC, and share all allocations equally. Each has $50 of basis in their membership interest. The LLC borrows $200 and constructs a building with it. The partnership’s inside basis in its assets increases by $200. Similarly, Alan and Brandy are each allocated $100 of the increase in liabilities. Each has an increase of $100 in their basis in the LLC without regard to whether they each have personally guaranteed the LLC’s loan. Debt relief is generally treated as the receipt of cash for income tax purposes. For partnership purposes, the partner is treated as receiving a cash distribution to the extent the partner is relieved of or has a decrease in the partner’s share of partnership debt. If this constructive distribution is in excess of the partner’s outside basis in the partnership, the excess is taxable as a sale or exchange of the partnership interest75 resulting in long- or short-term capital gain based on the partner’s holding period in the interest.76 Although debt of an LLC is more like corporate debt than partnership debt, the partnership rules are still applicable. The members are therefore able to use the basis resulting from the LLC’s debt for purposes of deducting pass-through losses from the LLC and receiving nontaxable distributions from the LLC. As discussed later, however, if the partnership is formed as an LLC (or other limited liability partnership form), complications may arise based on differences between allocation of recourse debt and nonrecourse debt.

74. See. e.g., Holiday Village Shopping Center, Inc. v. U.S., 773 F.2d 276 (Fed. Cir. 1985). 75. IRC §731(a). 76. Treas. Reg. §1.1223-3.

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DEFINITION OF LIABILITY A partnership liability is an obligation that:77 • Creates or increases the basis of any of the partnership’s assets, including cash; • Gives rise to an immediate deduction to the partnership; or, • Gives rise to an expense that is not deductible in computing the partnership’s taxable income and is not properly chargeable to capital. An obligation is more broadly defined than a liability. Obligations may include, but are not limited to, debt obligations, environmental obligations, tort obligations, pension obligations, obligations under a short sale, and obligations under derivative financial instruments, such as options, forward contracts, and futures contracts.78 Thus, a partnership may have an obligation, but it may not currently give rise to the existence of a liability for basis purposes. Example 6. An accrual basis LLC is subject to a products liability suit. The suit results in a structured settlement under which the LLC will pay out damages to the plaintiff over a period of 10 years. Although the 5 LLC has incurred an obligation, the obligation is not a liability. In the preceding example, the obligation has not created or increased the basis of any of the LLC’s assets and has not given rise to an expense that is not deductible in computing its taxable income or which is not properly chargeable to capital.79 Finally, although the LLC is an accrual basis taxpayer and the all-events test80 has been satisfied, the obligation does not give rise to an immediate deduction because of the economic performance limitation of IRC §461(h), which permits the LLC to take deductions in such cases only as payments are actually made to the plaintiff. Partnership liabilities also do not include accrued but unpaid expenses or accounts payable of a cash basis partnership except to the extent of basis created in the assets.81 The term “assets” includes capitalized items allocable to future periods82 (e.g., organizational and start-up expenses) because such items have amortizable bases. Applying the principles discussed above, a partner’s share of liabilities, and therefore the partner’s outside basis, can change as a result of any of the following. • Contributions or distributions of debt-encumbered property to or from the partnership that increase or decrease the partnership’s liabilities Example 7. Donald contributes property to ABC Partnership in exchange for a one-fourth partnership interest. The property has an FMV of $120, an adjusted basis of $60, and is subject to $80 of liabilities, which the partnership agrees to assume. The partnership has no other liabilities. The one-fourth partnership interest received by Donald has an initial basis of $60, Donald’s basis in the contributed property. The $80 of liabilities assumed by the partnership is treated as cash distributed to Donald with respect to Donald’s partnership interest. Finally, Donald is treated as having assumed one-fourth of the $80 of partnership liabilities, or $20. This assumption of $20 of partnership liabilities is treated as an additional cash contribution by Donald. The net effect of all these transactions is that Donald recognizes no income as a result of the transfer of the encumbered property, but he has a partnership basis of zero ($60 basis in property – $80 liabilities assumed by the partnership + $20 liabilities assumed by Donald = $0). The remaining partners of the partnership are treated as having contributed a total of $60 of cash to the partnership for their assumption of $60 of the liabilities and receive corresponding increases in bases.

77. Treas. Reg. §1.752-1(a)(4)(i). 78. Treas. Reg. §1.752-1(a)(4)(ii). 79. Treas. Reg. §1.752-1(a)(4)(i). 80. See Treas. Reg. §1.446-1(c)(1)(ii). 81. HR Rep. No. 98-861 (Conf. Rep.), 1984-3 CB 2 at 110-111. 82. IRS Pub. 541, Partnerships.

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Example 8. Use the same facts as Example 7, except that Donald has only $40 of basis in the contributed property. Donald is now treated as having received a cash distribution in excess of basis of $20 and is required to recognize gain. This is because Donald has $20 of net liability relief in excess of basis ($40 basis in property – $80 liabilities assumed by partnership + $20 of liabilities assumed by Donald = ($20)). Because partners cannot have a negative partnership basis, any cash distribution in excess of basis is taxable as a sale of the partnership interest. The consequences to the other partners remain the same. • Admission of a new partner or termination of a partner’s interest that results in a decrease or increase in the partners’ shares of partnership liabilities Example 9. ABC, LLC, has $36 of existing liabilities when Donyetta is brought into the LLC as a new, one-fourth member. The other members have personally guaranteed the debt and Donyetta is also required by the LLC’s lender to execute a personal guarantee. Donyetta is therefore treated as having made a $9 cash contribution for the one-fourth of the liability assumed and receives a basis increase of $9. Each of the other members also holds a one-fourth interest, and each is treated as having received a $3 cash distribution for their share of the $9 of liability assumed by Donyetta. • The partnership incurs a new liability or pays off an existing liability resulting in an increase or decrease in partnership liabilities • Cancellation of debt resulting in a decrease in partnership liabilities Partners are entitled to take into account in their outside bases their shares of both recourse and nonrecourse partnership debt.83 Recourse debt means simply that individual partners have personal liability for repayment to the creditor if the partnership is unable to repay the debt.84 Nonrecourse debt means the individual partners have no personal legal obligation to the creditor.85 The only action the creditor can take with respect to nonrecourse debt is to foreclose upon the property that secures the debt. If the value of the property is not sufficient to pay off the debt, the lender loses. Thus, with recourse debt, the partners bear the ultimate economic risk of loss. With nonrecourse debt, the lender bears the ultimate risk of loss. However, partners are permitted to increase their outside bases for both types of debt.86 It is therefore necessary to distinguish between recourse and nonrecourse debt because different rules are used to determine how the two different types of debt are allocated among the partners.

RECOURSE LIABILITIES A partner’s share of a partnership’s recourse liabilities is that portion of a liability for which the partner or a related person bears the economic risk of loss. Whether there is an economic risk of loss is determined under a constructive liquidation test.87 This is a worst-case scenario that determines how much the partner would be obligated to pay to any creditor of the partnership or contribute to the partnership because a liability becomes due and payable and the partner who has to make payment is not entitled to reimbursement from anyone else.

83. Treas. Regs. §§1.752-2 and 1.752-3. 84. Treas. Reg. §1.752-1(a)(1). 85. Treas. Reg. §1.752-1(a)(2). 86. Treas. Regs. §§1.752-2 and 1.752-3. 87. Treas. Reg. §1.752-2(b)(1).

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Under the constructive liquidation approach, all of the following events are deemed to occur simultaneously.88 • All of the partnership’s liabilities become payable in full. • With the exception of property contributed to secure a partnership liability,89 all of the partnership’s assets, including cash, have a value of zero. • The partnership disposes of all of its property in a fully taxable transaction for no consideration except relief from nonrecourse liabilities in which the creditor’s right to reimbursement is limited solely to partnership assets. • All items of income, gain, loss, or deduction are allocated among the partners. • The partnership liquidates. After all these events, it is necessary to determine which partners are liable for repayment and for how much. That is the extent to which each partner bears the economic risk of loss and is therefore the extent to which each partner is allocated recourse debt of the partnership. 5 The regulations contain a number of rules that must be applied in determining a partner’s share of recourse debt. Following is a summary of those rules.90 • Contingent obligations are ignored if the obligation is subject to contingencies that make it unlikely that the obligation will ever be paid. If the obligation will arise at a future time after the occurrence of an event that is not determinable with reasonable certainty, the obligation is ignored until the event occurs. • It is assumed that all partners who have obligations to make payments actually perform those obligations irrespective of their actual net worth. • A partner bears the economic risk of loss for a partnership liability to the extent the partner makes a nonrecourse loan to the partnership and no risk of loss for the liability is borne by any other partner. This rule does not apply in the case of a qualified nonrecourse loan to a partnership by a partner whose interest in all partnership items is 10% or less. • If a partnership liability is owed to a partner but that liability is wrapped around (i.e., includes) a nonrecourse liability that encumbers partnership property and which is owed to a third party, the partnership liability is treated as two separate liabilities. The portion of the partnership liability relating to the wrapped debt is treated as owed to the third party, and the rest is owed to the partner. • If payment by a partner is not required before the later of the end of the year in which the partner’s interest is liquidated or 90 days after the liquidation, the obligation to make payment is recognized only to the extent of the present value of the obligation unless it bears interest at least equal to the applicable federal rate (AFR). • A partner’s promissory note does not satisfy a partnership obligation unless the note is readily tradeable on an established securities market. • A partner bears the risk of loss for a partnership liability to the extent of the FMV of any of the partner’s separate property (other than an interest in the partnership) that is pledged as security for the partnership liability. • A partner bears the risk of loss for a partnership liability to the extent of the FMV of any property the partner contributes to the partnership solely for the purpose of securing a partnership liability. All tax items attributable to the property must be allocated to the contributing partner, however, and this allocation must generally be greater than the partner’s share of other significant partnership items.

88. Ibid. 89. The contributing partners are treated as bearing the economic risk of loss of the property if the requirements of Treas. Reg. §1.752-2(h)(2) are satisfied. 90. Treas. Reg. §1.752-2.

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Example 10. Alphonso and Brady form a general partnership, with each contributing $10,000 in cash. The partnership purchases an office building on leased land for $100,000 from an unrelated seller for which it pays $20,000 in cash and executes a note to the seller for the balance of $80,000. The note is a general obligation of the partnership (i.e., no partner has been relieved from personal liability). The partnership agreement provides that all items are allocated equally except that tax losses are specially allocated 90% to Alphonso and 10% to Brady and that capital accounts will be maintained in accordance with the regulations under IRC §704(b) (discussed later), including a deficit restoration obligation (DRO) on liquidation (discussed later). In a constructive liquidation, the $80,000 liability becomes due and payable. All of the partnership’s assets, including the building, are deemed worthless. The building is deemed sold for a value of zero. Capital accounts are adjusted to reflect the loss on the disposition, as follows.

Alphonso Brady Initial contribution $10,000 $10,000 Loss on sale (90,000) (10,000) Capital account ($80,000) $ 0

Other than the partners’ obligation to fund negative capital accounts on liquidation, there are no other contractual or statutory payment obligations existing between the partners, the partnership, and the lender. Therefore, the $80,000 partnership liability is classified as a recourse liability because one or more partners bear the economic risk of loss for nonpayment. Brady has no share of the liability because the constructive liquidation produces no payment obligations for Brady. Alphonso’s share of the partnership liability is $80,000 because he would have an obligation in that amount to make a contribution to the partnership.

NONRECOURSE LIABILITIES If a partnership has nonrecourse liabilities, allocations to partners of tax items based on those liabilities cannot have economic effect. This is because, with nonrecourse liabilities, it is the creditor who bears the economic risk of loss, not the partners. With nonrecourse liabilities, the creditor’s only remedy is against assets that secure the liability. To the extent the value of assets is not sufficient to satisfy the liability, the creditor has no recourse against the partners and therefore is the one who suffers the economic loss.91 Notwithstanding their lack of economic risk, partners have traditionally been permitted to use nonrecourse liabilities in determining basis for allocations and distributions. The regulations contain the following rules for allocations based on nonrecourse liabilities which, if they are satisfied, result in those allocations being deemed in accordance with the partners’ interests in the partnership.92 1. Throughout the full term of the partnership, capital accounts are maintained in accordance with Treas. Reg. §1.704-1(b)(2)(iv) and liquidating distributions are required to be made in accordance with positive capital account balances. Partners with deficit capital accounts have an unconditional deficit restoration obligation or agree to a qualified income offset. 2. Beginning in the first tax year of the partnership in which there are nonrecourse deductions and thereafter throughout the full term of the partnership, the partnership agreement provides for allocations of nonrecourse deductions in a manner that is reasonably consistent with allocations that have substantial economic effect of some other significant partnership item attributable to the property securing the nonrecourse liabilities (e.g., depreciation of the asset securing the nonrecourse debt).

91. Treas. Reg. §1.704-2(b)(1). 92. Treas. Reg. §§1.704-2(e)(1)–(4).

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3. Beginning in the first tax year of the partnership in which it has nonrecourse deductions or makes a distribution of proceeds of a nonrecourse liability that are allocable to an increase in partnership minimum gain, and thereafter throughout the full term of the partnership, the partnership agreement contains a provision that complies with the minimum gain chargeback requirement of the regulations (described later). 4. All other material allocations and capital account adjustments under the partnership agreement are recognized under Treas. Reg. §1.704-1(b). Although the regulations under IRC §752 briefly address the allocation of nonrecourse liabilities,93 the substantive application of those regulations is found under the allocation regulations of IRC §§704(b) and (c). The regulations provide that a partner’s allocation of a deduction generated from nonrecourse liabilities must be matched by an allocation of the nonrecourse liability in order to permit the partner to take the deduction. For example, a partner who is allocated a $100 loss attributable to property subject to a nonrecourse liability is also allocated a $100 share of the nonrecourse debt. The allocation of the $100 liability to the partner is a basis increase in the partner’s partnership interest, which then permits the $100 loss to be deducted.94 93 94 5 A partner’s share of the nonrecourse liabilities of a partnership is the sum of the following.95 1. The partner’s share of partnership minimum gain determined in accordance with the rules of IRC §704(b) and the regulations thereunder 2. The amount of any taxable gain that would be allocated to the partner under §704(c) (built-in-gain on contribution of an asset to the partnership or revaluation of partnership property) if the partnership disposed of all its properties (in a taxable transaction) subject to nonrecourse liabilities in full satisfaction of the liabilities and for no other consideration 3. The partner’s share of all other nonrecourse liabilities not otherwise allocated under the first two steps, allocated in accordance with the partner’s share of partnership profits (See Treas. Reg. §1.752-3(a)(3) for further information on these allocations.) The reason for the first two allocations from the preceding list is that these are income items that must be allocated to a particular partner. As will become evident from the discussion of minimum gain and minimum gain chargeback in connection with allocations, partners who are allocated basis from nonrecourse partnership liabilities and who take deductions against that basis are always required to pay those deductions back if the property securing the nonrecourse debt is disposed of.

Note. The following is a simplified discussion of minimum gain and minimum gain chargeback, which is intended to explain basic concepts. Practitioners must consult Treas. Reg. §1.704-2 for detailed information.

93. Treas. Reg. §1.752-3. 94. Treas. Reg. §1.704-2. 95. Treas. Reg. §1.752-3(a).

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Partnership Minimum Gain Deductions based on nonrecourse liabilities are allocated among partners to the extent of partnership minimum gain.96 Partnership minimum gain represents the minimum taxable gain a partnership would have if it disposed of property subject to nonrecourse liabilities solely in satisfaction of those liabilities.97 For this purpose, the minimum gain of each property subject to a nonrecourse liability is determined separately, then totaled.98 Any property for which a disposition would result in a loss (because the associated nonrecourse liability is less than the adjusted basis) is ignored and does not reduce partnership minimum gain because only gains are taken into account.99 Partnership minimum gain must be calculated annually and will increase or decrease each year in which the difference between nonrecourse debt and the basis of the property securing the debt fluctuates due to such things as payments on principal or depreciation.100 96 97 98 99 100 Example 11. An LLC has three properties that secure nonrecourse liabilities. The partnership minimum gain is calculated as follows.

Nonrecourse Minimum Liability Basis Gain Property 1 $100 $80 $20 Property 2 60 50 10 Property 3 40 50 0 Partnership minimum gain $30

Nonrecourse deductions can be allocated among the partners to the extent of $30. Nonrecourse deductions for a year equal the net increase in partnership minimum gain for the year reduced, but not below zero, by aggregate distributions made during the year of proceeds of nonrecourse borrowing that are treated as distributions of partnership minimum gain.101 Once the amount of nonrecourse deductions is determined, they are allocated as nonrecourse deductions in accordance with ordering rules found at Treas. Reg. §1.704-2(j) (not covered in these materials). Minimum Gain Chargeback. The purpose of the partnership minimum gain provisions is to ensure that there are no unintended tax benefits from permitting partners to take nonrecourse deductions based on minimum gain. This is true because any taxable disposition of property securing nonrecourse debt results in a sale for income tax purposes for an amount realized that is at least equal to the nonrecourse debt regardless of the FMV of the property.102 Example 12. Use the same facts at Example 11. Property 1 has an FMV of $90 and the creditor forecloses on the property. The partnership is taxed as if it sold the property for the amount of the nonrecourse debt, $100, and not its $90 FMV. The partnership is therefore required to recognize $20 of gain. Furthermore, any decrease in the partnership minimum gain from the previous year’s minimum gain requires repayment of prior nonrecourse deductions to the extent of the amount of the decrease. This is minimum gain chargeback.103 These rules ensure that a partner who has been allocated nonrecourse deductions is also allocated a proportionate share of income and gain from property that secures the nonrecourse debt in any year that a net decrease in partnership minimum gain occurs. 103

96. Treas. Reg. §1.704-2(c). 97. Treas. Reg. §1.704-2(d)(1). 98. See, e.g., Treas. Reg. §1.704-2(m), Example 2. 99. Treas. Reg. §1.704-2(d)(1). 100. Ibid. 101. Treas. Reg. §1.704-2(c). 102. Tufts v Comm’r, 461 U.S. 300 (1983). 103. Treas. Reg. §1.704-2(b)(2).

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Example 13. Use the same facts as Example 12. There was a $20 decrease in the partnership minimum gain because of the foreclosure on Property 1. The partners to whom nonrecourse deductions were allocated based on the $20 of minimum gain of Property 1 must “pay back” those deductions based on their share of the net decrease in partnership minimum gain. Minimum gain chargeback is accomplished by allocating income to partners subject to the chargeback. Under the ordering rules, this consists first of gains recognized from the disposition of property securing nonrecourse liabilities or discharge of indebtedness relating to nonrecourse liabilities and then, if necessary, from a pro rata share of all the partnership’s other items of income and gain for that year. If the amount of chargeback exceeds the total partnership income for the year, the excess chargeback carries over to the next year.104 The allocation of gain and income required for a minimum gain chargeback is made before any other allocation of partnership items.105 Practical Impact. It is common for boilerplate partnership and operating agreements to contain the necessary minimum gain provisions to comply with the regulations. Realistically, however, one must consider the extent to which the minimum gain rules are even applicable to a typical operating LLC (or other partnership form) that is not engaged in a traditional nonrecourse real estate lending activity. 5 First, debt guaranteed by any partner of the partnership or for which any partner otherwise incurs liability is not nonrecourse debt. Instead, the debt is recourse with respect to the partner or partners who have personal liability for it if the partnership fails to pay the debt. Second, if allocations of profits and losses are consistent with each partner’s interest in the partnership and there are no special allocations of deductions (other than mandated allocations such as under IRC §704(c)), there is no difference between allocations based on nonrecourse debt and allocations based on recourse debt. All partners will always be allocated offsetting income items in proportion to prior losses.

Effect of LLC on Allocation of Liabilities An LLC, like a corporation, is an entity separate from its members for liability purposes. Thus, if an LLC borrows money, the members who own the LLC have no liability for the debt except to the extent they personally guarantee it. If, however, property that is subject to an existing liability is transferred to an LLC, those persons who borrowed the money remain fully liable under state law106 for repayment of the debt, even though the LLC agrees to assume the debt unless the lender agrees otherwise. In fact, states with statutes permitting direct conversions from a partnership to an LLC provide that, if a partnership converts to an LLC, both the LLC and the partners of the former partnership remain fully liable for all the partnership’s debts.107 106 107 If the LLC does agree to assume a liability, the rules concerning transfers of encumbered property in exchange for partnership interests apply. Here, however, there may be a significant difference. Unless the creditor releases the contributing member from the obligation, the contributing member remains fully liable for repayment of the debt assumed by the LLC. The LLC also is liable for repayment. The other members of the LLC, however, have no personal liability for repayment of the debt unless they give personal guarantees to the lender. This means the debt is nonrecourse for those other members but fully recourse for the contributing member, who then is allocated the entire liability basis as partner recourse debt. This is partner nonrecourse debt.108 If the lender agreed to release a contributing member from liability and to look only to the LLC for repayment, the debt would be treated as nonrecourse with respect to all members. 108

104. Treas. Reg. §1.704-2(f)(6). 105. Treas. Reg. §1.704-2(j). 106. See, e.g., §347.125.4, Revised Statutes of Missouri. 107. Ibid. 108. Treas. Reg. §1.704-2(b)(4).

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Example 14. Delta contributes encumbered property to an LLC in exchange for a one-fourth membership interest. The property has an FMV of $120, an adjusted basis of $60, and is subject to $80 of liabilities. The LLC agrees to assume the debt, but none of the other members execute personal guarantees. The lender does not agree to release Delta from liability. Because Delta remains liable for repayment of the entire $80 debt, it is treated as recourse with respect to her and as nonrecourse with respect to the remaining members. Thus, the entire liability is allocated to Delta under the partnership rules. As a result, Delta is not treated as receiving a constructive distribution of cash because of the assumption of the obligation by the LLC. She receives no outside basis attributable to the assumption of any portion of the $80 liability, and she has a basis in the outside interest of $60, the adjusted basis of the contributed property. If this were a general partnership instead of an LLC or the other members personally guaranteed the debt, it would be recourse to all of them. Delta would therefore have $80 of liability relief from the assumption of the debt that is treated as a cash distribution, but she would also take a $20 share of the liability that is treated as a cash contribution. Delta would have a net cash distribution of $60 from liability relief that is nontaxable. This would reduce Delta’s basis from $60 to zero. The remaining partners are each allocated $20 of the assumed liability, which is treated as cash contributions. These partners’ bases increase by the same amount.109

110 IRC §754 ELECTION

Note. The following is a brief description of basis adjustment elections under §754. The manner in which basis allocations must be made can be complex and is beyond the scope of these materials. Practitioners making §754 elections must consult the appropriate regulations.110

WITHOUT §754 ELECTION Inside and outside bases can become unequal when events such as the following occur. • A taxpayer buys a partnership interest for an amount that differs from the selling partner’s basis in the interest. • A partner dies and the IRC §1014 FMV basis is different from the deceased partner’s partnership basis. • A partnership distributes cash or property with a basis in excess of the recipient partner’s basis in the partnership interest. If there is a change to an individual partner’s outside basis through purchase or inheritance, there is no effect on the partnership’s inside basis in its assets. The effect is therefore to delay the acquiring partner’s ability to recover the higher outside basis until termination of the partnership interest or of the partnership.

109. Treas. Reg. §1.722-1. 110. Treas. Reg. §§1.734-1 and 1.734-2 (adjustments to partnership’s inside basis based on distributions to partners); Treas. Reg. §1.743-1 (adjustments to partner’s outside basis and share of partnership’s inside basis); Treas. Reg. §1.755-1 (allocation of bases among partnership assets for adjustments under IRC §§734 and 743).

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Example 15. Derek and Erin own a 40% and 60% interest in partnership DE, respectively, with an FMV of $100 and an adjusted basis of $50. Derek sells his interest to Farrell for $100. The partnership has a depreciable asset with an FMV of $200 and an adjusted basis of $100, of which Derek’s share of inside basis is $40. After the sale, Farrell has a partnership interest with an outside basis of $100 based on the purchase price. Under the entity approach, however, Farrell continues to have the same $40 inside basis share that Derek had. After the partnership fully depreciates the asset, Farrell’s outside basis is reduced from $100 to $60 and Erin’s outside basis is reduced from $60 to $0. If the asset is then sold for $200, the gain is $200, which is divided 60/40 between Erin and Farrell, leaving Farrell with an outside partnership basis of $140 and Erin with a partnership basis of $120. If the $200 cash is then distributed 60/40 between the two partners in liquidation of the partnership, Erin receives the $120 tax- free and her basis is reduced to zero. Farrell receives the $80 tax-free but his basis is reduced to $60, leaving him with a $60 capital loss ($80 – $140 basis). 5 WITH §754 ELECTION Differences between inside and outside bases can be eliminated if the partnership made or makes an election under IRC §754 for the tax year in which the difference arises. This election permits the inside bases of partnership assets to be adjusted in accordance with the following Code sections. • IRC §743(b) and its regulations111 for transfers of partnership interests • IRC §734(b) and its regulations112 for distributions in a manner that restores equality between inside and outside basis In addition, guidance is provided under the following Code sections. • IRC §755 and its regulations113 provide the actual manner in which allocations are made. • IRC §754 and its regulations114 provide the manner in which the election is made (see the “Making the Election” section later).

Partner Adjustments Under IRC §743(b) Under §743, the partnership adjusts its basis of inside assets to reflect the outside increase or decrease of basis for a transfer of a partnership interest. The total amount of adjustment is the difference between the acquiring partner’s basis in the partnership interest and that partner’s share of the partnership’s basis for its assets, including liabilities but excluding cash. Example 16. Use the same facts as Example 15, except the DE partnership made a §754 election. Farrell can increase the inside basis he has in the asset by $60, the excess of his outside basis ($100) over his share of the partnership’s inside basis ($40). Farrell now has a $100 inside basis in the partnership asset to equal his $100 outside basis. When the asset with an adjusted basis of $100 is fully depreciated, Erin will have taken $60 of depreciation and reduced her outside basis to zero. Farrell will have taken $100 of depreciation because depreciation on the $60 increase in basis he receives under §743 will be specially allocated to him. His basis will therefore also be zero. If the asset is sold for $200, the partnership will have $200 of gain ($200 amount realized – $0 adjusted basis) and each partner will be allocated $100 of the gain. Their outside bases will increase by the $100 of gain and a distribution to each of their $100 share of the proceeds will be nontaxable.

111. Treas. Reg. §1.743-1. 112. Treas. Regs. §§1.734-1 and 1.734-2. 113. Treas. Reg. §1.755-1. 114. Treas. Reg. §1.754-1.

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The special adjustment under IRC §743(b) can only be used by the acquiring partner. Furthermore, the partnership must now keep two sets of books, one for the acquiring partner and one for the remaining partners. Partnership items adjusted under IRC §743(b) are specially allocated to the acquiring partner. Adjustments may be either positive or negative. Negative adjustments do not affect the other partners under IRC §743, but they do under IRC §734 (as explained in the next section). Thus, a partnership may be somewhat reluctant to make an IRC §754 election because of the possibility of future adverse adjustments. Under IRC §755, the IRC §743(b) special adjustment is made only among assets that were owned by the partnership at the time of acquisition. The bases of assets acquired later are generally not affected unless there is insufficient property or adjusted basis for such property, in which case an IRC §734(b) adjustment (discussed in the next section) is applied to subsequently acquired property of a like character.115 The assets are required to be divided into two classes — ordinary income assets and capital gain assets. Because the IRC §743(b) special adjustment can only be used to reduce the difference between the basis of an asset and its FMV, it is next necessary to determine the net appreciation or depreciation in value of each class (total FMV of the class less total adjusted basis). Allocations are also required to be made to IRC §197 intangibles (such as goodwill) using the principles of IRC §1060 that apply in the case of applicable asset acquisitions (not covered in this chapter).116 To the extent a positive IRC §743(b) adjustment is made to a depreciable asset, it is treated as a separate asset placed in service in the year of adjustment for depreciation purposes.117 This is not true for purposes of expensing under §179 because that election must be made at the partnership level and the adjustment to the basis of partnership property under §743 has no effect on the partnership’s computation of any item of partnership income or deduction.118 A negative adjustment reduces subsequent depreciation deductions.119 Adjustments are also taken into account for purposes of subsequent sales and distributions by the partnership, including the “collapsible” provisions of IRC §751.120 The special allocation is personal to the acquiring partner and cannot be transferred to any other partner.121 However, if property in which there is a special basis adjustment is distributed to a different partner, the adjustment is reallocated to another like-kind partnership asset.122

Observation. The amount of the §743(b) adjustment to a depreciable asset is not eligible for the §179 deduction because the adjustment is merely a recharacterization of the partnership interest under the §754 election.

115. Treas. Reg. §1.755-1(c)(4). 116. Treas. Reg. §1.755-1(a)(2). 117. Treas. Reg. §1.743-1(j)(4)(i). 118. Treas. Reg. §1.743-1(j)(1). 119. Treas. Reg. §1.743-1(j)(4)(ii). 120. Treas. Reg. §1.751-1(c)(6). 121. Treas. Reg. §1.743-1(g)(2)(i). 122. Treas. Reg. §1.743-1(g)(2)(ii).

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Partnership Adjustments Under IRC §734 IRC §734 special basis adjustments prevent distortions from occurring inside the partnership with respect to other partners because of gain or loss reported by a partner receiving a distribution or in the event that a partner’s basis in an asset differs from the partnership’s basis in that asset. Example 17. Alice, Brandon, and Charlotte are equal partners in a partnership. The partnership’s basis and book values and the partners’ bases and FMVs are as follows.

Partnership’s Assets Basis Book Cash $2,000 $2,000 Capital asset 1,000 1,000 Total $3,000 $3,000 5 Partners’ Interests Basis FMV Alice $1,000 $2,000 Brandon 1,000 2,000 Charlotte 1,000 2,000 Total $3,000 $6,000

The capital asset has an FMV of $4,000. Alice receives a liquidating distribution of $2,000 in cash and therefore recognizes $1,000 of gain ($2,000 cash – $1,000 basis). With no §754 election in effect, the partnership’s basis and book values and the partners’ bases and FMVs following the distribution are as follows.

Partnership’s Assets Basis Book Cash $0 $0 Capital asset 1,000 1,000 Total $1,000 $1,000

Partners’ Interests Basis FMV Brandon $1,000 $2,000 Charlotte 1,000 2,000 Total $2,000 $4,000

If the partnership sells the capital asset for its $4,000 value, the partnership has a $3,000 gain, which is split between Brandon and Charlotte, the remaining partners. Thus, Alice, Brandon, and Charlotte will have reported $4,000 in gains, when there was only $3,000 of appreciation in the partnership assets. However, Brandon and Charlotte each receive increases in their bases of $1,500 for the gain they reported. Thus, they each have $2,500 of basis following the sale of the asset. A liquidating distribution of $2,000 to each of them is received tax-free and results in a $500 capital loss to each ($2,000 distribution – $2,500 basis) but only after the liquidating distribution is made. Thus, the net taxable amount for all three partners is only $3,000 but the lack of an IRC §754 election results in a distortion. With an IRC §754 election in effect, under IRC §734 the partnership’s basis in the asset would be increased by the $1,000 of gain recognized by Alice, resulting in only $2,000 of gain on the sale of the asset. Therefore, the distortion is avoided.

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If an IRC §754 election is in effect, IRC §734 uses the amount of gain or loss to the distributee partner and the basis differential between the partnership’s basis and the distributee’s basis to make the adjustment to the bases of inside assets to prevent the distortion. Assets are divided into capital gain and ordinary income groups, as is the case with IRC §743 adjustments. If the adjustment is a result of the recognition of gain or loss by the distributee, it is applied only to the capital gain group. If it is a result of a basis differential, it is applied to partnership assets of the same category that the distributed property belonged to. Once it is determined which group the adjustment applies to, the same allocation rules apply as for IRC §743 regarding which appreciated or depreciated assets the adjustments are actually applied to. If there are no assets in a group, the adjustment is held in abeyance until it can be applied. Special basis increases can be allocated to a class only if the class has appreciated in value; decreases can be allocated only if a class has depreciated in value. If both classes are the same, the increase or decrease is allocated between them based on the relative appreciation or depreciation of each class. Allocations to specific assets within each group follow the same rules.123

Making the Election The partnership must elect under IRC §754 to have the special basis allocation rules of IRC §§734 and 743 apply for the year in which a qualifying distribution or transfer occurs.124 It is not necessary to make the election the first year this happens. However, if the election is made, it is irrevocable without the IRS’s consent. Once the election is made, it applies to the partnership with respect to distributions of properties to partners under IRC §734 and to partners who acquire their interests through transfers by sale, exchange, or death under IRC §743. The actual method of allocation is set forth at IRC §755. This is a partnership election and, if the partnership refuses to make it, an individual partner cannot adjust their inside basis. In the event a partnership fails to make a timely election, IRS regulations provide an automatic extension of 12 months to make the election.125 If the partnership does not extend its return, the 12-month period is measured from the unextended due date of the partnership return for the year for which the election should have been made. If the partnership extends its return, the 12-month period is measured from the extended due date. The regulations provide the manner in which the extended election must be made.

ALLOCATIONS

The general rule of partnership taxation under subchapter K is that a partner’s distributive share of income, gain, loss, deduction, or credit is determined by the partnership agreement.126 Partners are usually able to allocate these items under the partnership agreement in any manner they choose unless allocations lack substantial economic effect.127 The most basic form of allocation is simply to allocate all items among the partners in proportion to their partnership ownership interest. Whenever allocations depart from this standard, they are generally referred to as special allocations. The classic example of special allocations is to allocate initial limited partnership losses to the limited partners. The fact that there is a special allocation does not necessarily mean it is abusive, however. The attractive feature of special allocations is that they give the partners the ability to change various aspects of allocations in order to more accurately reflect the economic relationship they have or to enhance that relationship through the addition of tax benefits.

123. Treas. Reg. §1.755-1(c)(2). 124. Treas. Reg. §1.754-1(b)(1). 125. Treas. Reg. §1.9100-2. 126. IRC §704(a). 127. IRC §704(b)(2).

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The downside of special allocations is that they significantly increase the complexity of partnership tax rules. The IRS published extensive regulations under IRC §704 intended to permit partnerships to make special allocations while simultaneously attempting to control the potential for abuse. These regulations are some of the most complex provisions of partnership tax under subchapter K.

SUBSTANTIAL ECONOMIC EFFECT REQUIREMENT 128 129 A special allocation is an allocation of a partnership item that is disproportionate to the partners’ capital contributions or to their ratio for sharing other partnership items. For special allocations to be respected, the regulations require that they have substantial economic effect.128 This means the income tax consequences of an allocation must be assigned to the partner who receives the benefit or bears the burden of the economic consequences.129 For example, a partner who is allocated a disproportionately large share of depreciation must also be assigned the same disproportionately large reduction in the economic value of the partner’s partnership interest. Thus, tax allocations must be matched by economic allocations. If an allocation is found not to have substantial economic effect, the offending allocation is required to be reallocated among the partners in proportion to their interests in the partnership.130 This is based on the manner in which the 5 partners have agreed to share the economic benefit (income) or burden (deduction), if any, corresponding to the item that is specially allocated. It is a facts-and-circumstances determination, with no set rules. In determining a partner’s interest in the partnership, the regulations list the following factors as being among those that are considered.131 130 131 • The partner’s relative contributions to the partnership • The interests of the partners in economic profits and losses if different from their interests in taxable income or loss • The interests of the partners in cash flow and other nonliquidating distributions • The rights of the partners to distributions of capital upon liquidation The determination of whether an allocation has substantial economic effect involves a 2-part analysis that is made at the end of the partnership tax year to which the allocation relates.132 1. The allocation must have economic effect. 2. The economic effect of the allocation must be substantial. Economic Effect In order to ensure allocations have the necessary economic effect, the regulations require that, throughout the full term of the partnership, the partnership agreement contain the following provisions.133 • The partners’ capital accounts are determined and maintained throughout the full term of the partnership in accordance with the capital (book) accounting rules of Treas. Reg. §1.704-1(b)(2)(iv). • Liquidation proceeds are required (after certain capital account adjustments) to be distributed only in accordance with positive capital account balances by the later of the end of the tax year or 90 days after the date of liquidation. •There is a deficit restoration obligation (DRO) in the partnership agreement or under applicable state law. This is an unconditional obligation requiring a partner to restore to the partnership any negative balance in the partner’s capital account by the later of the end of the tax year or 90 days after the date of liquidation. This can also be satisfied by the partner giving a promissory note to the partnership (discussed later).

128. Treas. Reg. §1.704-1(b)(2)(i). 129. Treas. Reg. §1.704-1(b)(2)(ii)(a). 130. Treas. Reg. §1.704-1(b)(1)(i). 131. Treas. Reg. §1.704-1(b)(3)(ii). 132. Treas. Reg. §1.704-1(b)(2)(i). 133. Treas. Reg. §1.704-1(b)(2)(ii)(b).

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Example 18. Satisfaction of Economic Effect Test. Giselle and Marcus form an LLC with cash contributions of $40,000 each. This is used to purchase depreciable property for $80,000. The operating agreement provides that the members share income and losses equally except that all depreciation deductions are allocated to Giselle. The operating agreement further complies with the economic effect requirements, including a DRO. In the LLC’s first tax year, income and expenses are equal, and there is a depreciation deduction of $20,000 allocated entirely to Giselle. The LLC liquidates at the end of its first tax year and distributes assets in proportion to the members’ capital accounts.

Giselle Marcus Basis Book Basis Book Initial capital account $40,000 $40,000 $40,000 $40,000 Depreciation (20,000) (20,000) 0 0 Capital account end of Year 1 $20,000 $20,000 $40,000 $40,000

Upon liquidation of the LLC, Giselle is entitled to a distribution of only $20,000, reflecting the $20,000 of depreciation allocated to her. Marcus, who had no depreciation allocation and whose capital account remains unchanged, is entitled to a distribution of $40,000. Although members of an LLC do not have a DRO under state law, the operating agreement in the preceding example is presumed to have one for purposes of simplicity. In fact, an LLC will probably use the alternate economic effect test (qualified income offset, which is discussed in the next section). In the preceding example, the value of the asset is deemed to decline to the extent of the tax depreciation.134 Furthermore, the capital accounting rules do not permit revaluation of the asset to determine its true market value on the presumed liquidation date.135 This is in keeping with the requirement that value equals basis, which ensures that tax allocations have a dollar-for-dollar impact on a partner’s economic investment in the partnership. The following examples illustrate the effects of a failure to comply with the capital account distribution rules. Example 19. Failure of Liquidating Test. Use the same facts as Example 18, except that, upon liquidation, distributions are made equally between Giselle and Marcus without regard to capital accounts. Each member is therefore entitled to a distribution of $30,000. This fails to satisfy the economic effect test because Marcus’ cumulative economic investment in the LLC is $40,000, yet he receives only $30,000 in liquidation. Giselle, on the other hand, has a cumulative economic investment of only $20,000, but she receives a $30,000 distribution. In effect, Marcus pays for half of the depreciation deduction without being allocated any of it. This fails the economic effect test, and the depreciation deduction must be reallocated in accordance with the members’ equal interests in the LLC.

134. Treas. Reg. §1.704-1(b)(2)(iv)(g)(1). 135. Treas. Reg. §1.704-1(b)(2)(iv)(f).

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Example 20. Failure of DRO. Mitch and Rita form an LLC with contributions of $75,000 and $25,000, respectively. The operating agreement divides all items of income and loss equally between the two members and otherwise satisfies the requirements of the regulations except that there is no DRO and the alternate test is not satisfied. Therefore, the agreement does not satisfy the economic effect test, and the allocations will not be respected. The LLC has $20,000 of losses in each of its first three years. If the allocations in the operating agreement were honored and the partnership liquidated at the end of Year 3, the capital accounts would be as follows.

Mitch Rita Basis Book Basis Book Initial capital account $75,000 $75,000 $25,000 $25,000 Losses years 1, 2, 3 (30,000) (30,000) (30,000) (30,000) Capital account end of Year 3 $45,000 $45,000 ($ 5,000) ($ 5,000) 5

The value of the LLC’s assets were reduced from $100,000 to $40,000. In a liquidating distribution, Mitch should receive $45,000, but only receives $40,000. Thus, Mitch is suffering $5,000 of economic loss attributable to Rita’s deficit capital account. If the operating agreement contained a DRO (or satisfied the alternate test discussed later), the allocation would have been respected. With a DRO, Rita would be obligated to contribute $5,000 to the LLC to restore her deficit capital account to zero. The $5,000 would be distributable to Mitch, who would then have received the entire $45,000 to which he was entitled. The economic effect test is satisfied to the extent a partner has a DRO. Alternatively, a partner may provide a limited DRO, which satisfies the economic effect test to that extent. This may be accomplished by including a provision for a limited DRO in the operating agreement. If there is no express obligation for a DRO in the operating agreement, the partner can contribute a promissory note to the LLC. A promissory note constitutes a DRO to the extent of its outstanding principal balance as long as the partner is the maker of the note and meets the following requirements.136 1. The note is required to be satisfied no later than the end of the partnership year in which the partner’s interest is liquidated or, if later, within 90 days after the date of such liquidation. 2. If the promissory note is negotiable, the partnership agreement can provide that satisfaction under the preceding paragraph is not required, but the partnership will retain the note. The partner must contribute the excess of the outstanding principal of the note over its FMV at the time of liquidation. Example 21. Curative DRO. Use the same facts as Example 20, except Rita contributed a promissory note to the LLC with a face amount of $5,000. If the note satisfies the requirements of the regulations, Rita is treated as having a $5,000 limited DRO, and the allocation of the additional $5,000 loss to Mitch will be respected. A partner is permitted to reduce or eliminate an existing DRO as long as the reduction or elimination operates only prospectively and does not affect a DRO the partner may have for an existing deficit capital account.137

136. Treas. Reg. §1.704-1(b)(2)(ii)(c). 137. Treas. Reg. §1.704-1(b)(2)(ii)(f).

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A member’s guarantee of an LLC’s debt owed to a third party is not the same thing as a DRO. A DRO is essentially a debt owed to another partner in the partnership, not to third parties. The existence of guarantees by LLC members relates to whether the LLC’s debt is classified as recourse or nonrecourse for purposes of allocating basis among partners (discussed previously in the “Liabilities” section). Example 22. Guarantee of Third-Party Debt. Viola and Tom contribute $7,500 and $2,500, respectively, to an LLC taxed as a partnership. The LLC borrows $90,000, with each partner signing a full guarantee of the entire $90,000. Other income and expenses are equal and the depreciation deduction is in excess of those items. All tax items are divided between the partners based on their ownership percentages except depreciation, which is allocated equally between them. The operating agreement satisfies the requirements for the economic effect test except that there is no DRO (nor compliance with the alternate test). Because of the guarantees, the $90,000 of debt is treated as recourse. Viola is allocated $67,500 (75%) of the debt and Tom is allocated $22,500 (25%), based on their ownership percentages. The partnership buys a depreciable asset for $100,000. Each year, $10,000 of depreciation is allocated equally: $5,000 each to Viola and Tom. Based on this fact, the partnership agreement fails the economic effect test in the first year. At the end of year 2, the partnership liquidates. No principal payments were made on the loan. The property is sold for $80,000, which is equal to its basis, and the proceeds of the sale are used for loan repayment. Under their guarantees, Viola pays $7,500 to the lender and Tom pays $2,500. This is treated as a constructive contribution to the partnership, increasing their bases by the same amount. The following accounting shows why the economic effect test is not satisfied.

Viola Tom Basis Book Basis Book Initial capital account $ 7,500 $ 7,500 $ 2,500 $ 2,500 Allocated debt 67,500 22,500 Depreciation Years 1, 2 (10,000) (10,000) (10,000) (10,000) Interim capital account end of Year 2 $65,000 ($ 2,500) $15,000 ($ 7,500) Relief from partnership debt (constructive cash distribution) (67,500) 0 (22,500) 0 Constructive cash contribution for guarantee loan payments 7,500 7,500 2,500 2,500 Additional liability relief (7,500) (7,500) (2,500) (2,500) Ending capital accounts ($ 2,500) ($ 2,500) ($ 7,500) ($ 7,500)

The capital accounting rules do not take into account a partner’s allocated share of partnership-level liabilities. In addition, while the guarantee payments on the loan may be treated as constructive contributions, use of those funds to make actual debt payments does not reduce book capital accounts. Finally, liability relief is treated as a cash distribution reducing tax capital accounts and results in a constructive cash distribution to the partners in excess of basis (represented by the negative ending tax bases). Under the economic effect test, Viola is entitled to receive $2,500, but there are no partnership assets left with which to make distributions. Because the guarantees were only to the third-party lender and no DRO exists, the lender is paid but Viola cannot obtain the $2,500 owed her, and Tom has an extra $2,500 deduction. The economic effect test is not satisfied through the guarantees.

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Example 23. Curative Allocation. Because the depreciation allocations in Example 22 do not satisfy the economic effect test, they must be reallocated in accordance with the partners’ interests in the LLC. This requires $5,000 of depreciation in Years 1 and 2 to be reallocated to Viola (again ignoring the failure to satisfy the economic effect test in Year 1). This results in negative capital account balances for both partners and matching income tax losses in proportion to their interests in the LLC.

Viola Tom Basis Book Basis Book Initial capital account $ 7,500 $ 7,500 $ 2,500 $ 2,500 Allocated debt 67,500 22,500 Depreciation Years 1, 2 (15,000) (15,000) (5,000) (5,000) Interim capital account end of Year 2 $60,000 ($ 7,500) $20,000 ($ 2,500) Liability relief (67,500) 0 (22,500) 0 Constructive cash contribution for guarantee payments 7,500 7,500 2,500 2,500 Additional liability relief (7,500) (7,500) (2,500) (2,500) 5 Ending capital accounts ($ 7,500) ($ 7,500) ($ 2,500) ($ 2,500)

Alternate Economic Effect Test. The alternate economic effect test138 is classically used by LLPs and generally appears to be used for LLCs. The first two requirements for economic effect (maintenance of capital accounts and positive account liquidating distributions) must be satisfied.139 Instead of a DRO, however, the partnership agreement can provide for a qualified income offset (QIO).140 This is a provision in the partnership agreement that satisfies the following requirements. 138 139 140 • No allocation can be made to a partner with a QIO that causes or increases a deficit balance in that partner’s capital account as of the end of the partnership tax year to which the allocation relates.141 • The partnership agreement must provide that a partner who unexpectedly receives allocations or distributions resulting in a deficit capital account is allocated pro rata items of partnership income and gain in an amount and manner sufficient to eliminate the deficit balance as quickly as possible.142 In determining the capital account of a partner with a QIO at the end of a tax year for allocation purposes, the regulations require the capital account to be reduced first to reflect the following adjustments that are reasonably expected at the end of the year to be made in subsequent years.143 • Oil and gas depletion • Losses and deductions allocated to the partner under the family partnership rules, the rules governing retroactive allocations, and the rules governing disproportionate distributions of unrealized receivables and substantially appreciated inventory • Distributions the partner will receive that exceed reasonably expected increases in the partner’s capital account in the same year as the subsequent distribution 144

Observation. The income allocations are for both tax and capital account purposes, but distributions based on that income are still in accordance with the partnership agreement.144 This is because a partner with a deficit capital account has essentially borrowed from the other partners and is therefore required to pay them back.

138. Treas. Reg. §1.704-1(b)(2)(ii)(d). 139. Treas. Reg. §§1.704-1(b)(2)(ii)(d)(1) and (2). 140. Treas. Reg. §1.704-1(b)(2)(ii)(d)(3). 141. Ibid. 142. Treas. Reg. §1.704-1(b)(2)(ii)(d). 143. Ibid. 144. Treas. Reg. §§1.704-1(b)(2)(ii)(d)(3)–(6). 2017 Volume B — Chapter 5: Partnership Issues B247 Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook

The reason depletion and the other listed allocations are considered “unexpected” is that they are governed by rules that allocate them independently of the partnership agreement. Thus, the application of any one of these allocations for a partnership year creates unique, special allocations that are separate from or that override normal allocations for that year. Because these allocations occur without regard to their economic effect, special allocations are necessary to eliminate the deficits as quickly as possible. It is important to understand that “unexpected” does not include such events as an unforeseen loss from the normal business operations of the partnership. However, a partner subject to the alternate economic effect test and who has a zero or deficit capital account for any year is prevented from being allocated any of the “usual” partnership deductions and losses attributable to its normal operations, even if they are unexpected in an economic or business sense.145 The alternate economic effect test is applied on an annual basis.146 The test may therefore be satisfied in some years but not in others, or may be only partially satisfied in a year. To the extent the test is not satisfied in any year, special allocations are prohibited unless they satisfy the economic effect requirement in some other manner, such as economic effect equivalence (discussed later). 146 The following examples illustrate the alternate economic effect test. Example 24. Alternate Economic Effect Allocation. Waldo and Amy form an LLC organized as a partnership with cash contributions of $40,000 each. The LLC uses these funds to buy depreciable personal property for $80,000. All tax items are to be divided equally between Waldo and Amy except depreciation, which is allocated entirely to Waldo. Other income and expenses are equal and the depreciation deduction is in excess of those items. Assume the operating agreement satisfies the alternate economic effect test. Depreciation for the first year is $20,000 and the entire amount is allocated to Waldo. The allocation has economic effect.

Waldo Amy Basis Book Basis Book Initial capital account $40,000 $40,000 $40,000 $40,000 Depreciation (20,000) (20,000) 0 0 Capital account end of Year 1 $20,000 $20,000 $40,000 $40,000

145. Ibid. 146. Ibid.

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Example 25. Partial Alternate Economic Effect Allocation. Use the same facts as Example 24. The LLC has a $25,000 depreciation deduction in Year 2 allocated entirely to Waldo. Because this causes Waldo’s capital account to have a deficit of $5,000 ($20,000 capital account end of Year 1 – $25,000 depreciation), the allocation is valid only to the extent of $20,000. The remaining $5,000 of depreciation must be reallocated in accordance with the partners’ interest in the partnership. The regulations determine the partners’ interests in the partnership by assuming the property is sold at the end of Year 2 for $35,000, its adjusted basis. (This conforms to the value equals basis rule discussed later in the section entitled “Substantial Effect.”) The entire $35,000 is distributed to Amy, who has a $40,000 capital account, and none to Waldo, who would have a $5,000 deficit capital account if the entire amount of depreciation were allocated to him. Amy, not Waldo, would then bear the economic burden of $5,000 of the depreciation. This $5,000 depreciation is reallocated from Waldo to Amy. Waldo is allocated the remaining $20,000 of depreciation, bringing his capital account at the end of Year 2 to zero. If the LLC’s net income in Year 3 before depreciation is zero, no depreciation is allocated to Waldo in Year 3. 5 Waldo Amy Basis Book Basis Book Initial capital account $40,000 $40,000 $40,000 $40,000 Depreciation Years 1 and 2 (40,000) (40,000) (5,000) (5,000) Capital account end of Year 2 $ 0 $ 0 $35,000 $35,000

Example 26. Invalid Allocation under Alternate Economic Effect. Use the same facts as Example 25 except that the depreciation deduction for Year 2 is $20,000 instead of $25,000. In addition, the property is sold for $35,000 at the beginning of Year 3, which results in a $5,000 tax loss ($35,000 sales price – ($80,000 cost of property – $40,000 total depreciation for Years 1 and 2)), and the partnership is liquidated. Allocations in accordance with the partnership agreement result in the following capital accounts after the sale.

Waldo Amy Basis Book Basis Book Capital account beginning of Year 2 $20,000 $20,000 $40,000 $40,000 Depreciation Year 2 (20,000) (20,000) 0 0 Capital account end of Year 2 $ 0 $ 0 $40,000 $40,000 Loss on sale (2,500) (2,500) (2,500) (2,500) Interim capital account before liquidation ($ 2,500) ($ 2,500) $37,500 $37,500

The $35,000 of sale proceeds are distributable entirely to Amy because only she has a positive capital account. However, Amy is entitled to $37,500. The $2,500 loss allocated to Waldo is improper because it is Amy, not Waldo, who bears the economic loss attributable to that deduction. Therefore, the entire $5,000 loss must be allocated to Amy. In addition, Waldo is unable to use the deduction because he has zero basis. The revised capital accounts are as follows.

Waldo Amy Basis Book Basis Book Capital account beginning of Year 2 $20,000 $20,000 $40,000 $40,000 Depreciation Year 2 (20,000) (20,000) 0 0 Capital account end of Year 2 $ 0 $ 0 $40,000 $40,000 Loss on sale 0 0 (5,000) (5,000) Interim capital account before liquidation $ 0 $ 0 $35,000 $35,000

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Example 27. Qualified Income Offset. Use the same facts as Example 26. At the end of Year 2, Waldo’s capital account is zero and Amy’s is $40,000. In Year 3, the partnership borrows $20,000 (which is unforeseen at the end of Year 2) and distributes $10,000 each to Waldo and Amy. In addition, in Year 3, the partnership has income of $50,000, expenses (exclusive of depreciation) of $50,000, and depreciation of $20,000. Waldo’s capital account has unexpectedly become negative because of the $10,000 distribution. The QIO therefore requires that $10,000 of partnership gross income be allocated to Waldo to restore the deficit to zero. This allocation reduces the partnership’s gross receipts from $50,000 to $40,000, giving the partnership a $10,000 loss before the $20,000 depreciation deduction. The $10,000 gross income allocation restores Waldo’s deficit capital account to zero. However, no losses can be allocated to him because of the zero capital account. The $10,000 loss and $20,000 of depreciation must therefore be allocated entirely to Amy, who has a $30,000 capital account after the $10,000 distribution. After the $10,000 loss and $20,000 depreciation are allocated to Amy, her capital account is also zero at the end of Year 3. Example 28. Allocation in Accordance with Partners’ Interests in Partnership. Use the same facts as Example 27, except the partnership had $40,000 of gross income instead of $50,000 and $10,000 of the $40,000 is specially allocated to Waldo. Losses and deductions of the partnership for the year total $40,000. The first $30,000 is allocated entirely to Amy, reducing her capital account to zero. Because both partners now have a zero capital account, the remaining $10,000 of the loss must be allocated in accordance with the partners’ interests in the partnership. Based on their equal capital contributions and share of items other than depreciation, the $10,000 excess is allocated $5,000 to each partner. This leaves each partner with a $5,000 deficit capital account at the end of Year 3. Economic Effect Equivalence. Economic effect equivalence is sometimes referred to as “dumb but lucky.” It applies to allocations that fail the economic effect or alternate economic effect tests. As long as the partners can demonstrate that the economic effect of the allocation is equivalent to the results that would have occurred under either of the two tests, the allocation is accepted. This requires the partners to show that a liquidation of the partnership in the current or any future year would have the same economic effect as if the partnership agreement contained a requirement for capital accounts, liquidating distributions with respect to positive capital accounts, and a DRO.147

Substantial Effect To satisfy the substantial economic effect requirement, not only must special allocations have economic effect but the economic effect must be substantial.148 This is a separate requirement. An allocation that has economic effect may not have a substantial economic effect. An economic effect is substantial only if it has a substantial impact on the dollar amounts the partners will receive independently of tax consequences.149 148 149 For purposes of determining substantial effect, value generally equals basis. This means the FMV of assets is presumed to be equal to their adjusted bases. If book value differs from adjusted basis, however, book value is used instead.150 This rule is intended to prevent partnerships from attempting to justify special allocations based on anticipated increases in the value of partnership assets.151

147. Treas. Reg. §1.704-1(b)(2)(ii)(i). 148. Treas. Reg. §1.704-1(b)(2)(i). 149. Treas. Reg. §1.704-1(b)(2)(iii)(a). 150. Treas. Reg. §1.704-1(b)(2)(iii). 151. Ibid.

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The regulations describe three different types of allocations that lack substantial economic effect. • After-tax economic consequences. The allocation is not substantial if, at the time the allocation becomes part of the partnership agreement:  The after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to the consequences if the allocation was not contained in the partnership agreement; and  There is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished.152 • Shifting allocations. These are special allocations that occur within a tax year that have the same effect on partners’ capital accounts as if the special allocations had not been made but that result in a lower overall income tax liability for the partners than would have occurred without the allocations.153 • Transitory allocations. These are special allocations that occur over more than one tax year. At the end of this period, the partners’ capital accounts are substantially the same as they would have been without the special 5 allocations but the partners’ overall tax liability is less than it would have been without the allocations.154 In applying the substantial effect rules, the “nonpartner” individual tax attributes of a partner that are unrelated to their status as a partner must be taken into account.155 This includes such factors as whether a partner is subject to tax or is tax- exempt, is insolvent or in bankruptcy, or has a net operating loss carryover from an activity other than the partnership.

Note. There appears to be no legal means under the Code, however, for a partnership to force an individual partner to disclose such information.

Shifting Allocations. Shifting allocations are special allocations of tax items within a single tax year that have no different effect on the partners’ year-end capital accounts. This means that the partners’ capital accounts would have been the same without the special allocations. If this is the case, there is a strong presumption that the special allocations lack substantial economic effect. However, the partners can rebut the presumption by showing that facts and circumstances indicate that a strong likelihood of a shifting allocation did not exist at the time the provision for the allocation became part of the partnership agreement. To apply the shifting allocation test, the partners’ year-end capital accounts with the special allocation must be compared to what their capital accounts would have been without the allocation. If there is no substantial difference, the partners’ tax liabilities with and without the allocation must then be compared, taking into account each partner’s nonpartnership tax attributes.156

152. Treas. Reg. §1.704-1(b)(2)(iii)(a). 153. Treas. Reg. §1.704-1(b)(2)(iii)(b). 154. Treas. Reg. §1.704-1(b)(2)(iii)(c). 155. Treas. Reg. §1.704-1(b)(2)(iii). 156. Treas. Reg. §1.704-1(b)(2)(iii)(b).

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Example 29. Shifting Allocation. James and Sharon form a partnership and contribute equal amounts to its capital. The partnership agreement satisfies the requirements of the general economic effect test. The partnership agreement also provides that James and Sharon share equally in all items of partnership income and loss. The partnership invests equally in tax-exempt bonds and corporate stock. For its first year, James expects to be in a substantially higher marginal tax bracket than Sharon. The partnership agreement is modified for the first year to allocate the first $100,000 of tax-exempt interest for that year 90% to James and 10% to Sharon and to allocate the first $100,000 of corporate dividends 10% to James and 90% to Sharon. All other items are shared equally between the two. At the beginning of the tax year, when the agreement was modified, there was a strong likelihood there would be at least $100,000 each of tax-exempt interest and corporate dividends. Although these allocations would have economic effect, the economic effect is not substantial because there was a strong likelihood that the amendment would not alter the before-tax economic arrangements of the partners. However, the allocation would result in a lower total tax liability. Because the offsetting allocations occur in the same tax year, they are shifting allocations. Transitory Allocations. Transitory allocations occur over more than one tax year. Otherwise, they are analyzed in essentially the same manner as shifting allocations. There are two exceptions to the transitory allocation rules.157 1. An allocation is not considered transitory if there is a strong likelihood it will not be largely offset within five years (determined on a first-in, first-out basis). 2. An allocation is not considered transitory if the partnership activity is of a sufficiently risky nature that there is not a strong likelihood that there will be a future offsetting allocation. Example 30. Transitory Allocation. Use the same facts as Example 29, except the partnership owns depreciable real property generating $50,000 in annual depreciation deductions. Because James expects to be in a substantially higher marginal tax bracket than Sharon during the partnership’s first tax year, they agree to allocate the first year of depreciation deductions to James and the second year of depreciation deductions to Sharon. All other items are shared equally, and this allocation has economic effect. At the time the provision for the allocations of depreciation deductions was added to the agreement, there is a strong likelihood that the capital accounts of James and Sharon, after reflecting these allocations, would not differ substantially from what would have happened if the allocations were not made. Moreover, the overall tax liability of the two partners is reduced by such allocations. The allocations are therefore transitory because the offsetting allocations occur over a period of more than one tax year.

IRC §704(c) ALLOCATIONS The purpose of IRC §704(c) is to prevent the shifting of tax consequences among partners with respect to precontribution gain, loss, income, or deductions. Under §704(c)(1)(A), a partnership must allocate income, gain, loss, and deductions with respect to property contributed by a partner to the partnership back to the contributing partner. This is done to take into account any variation between the adjusted basis of the property and its FMV at the time of contribution. Such allocations must be made using a reasonable method that is consistent with the purpose of §704(c). These allocations are mandatory, whether they are contained in the partnership agreement or not.

157. Treas. Reg. §§1.704-1(b)(2)(iii)(c) and 1.704-1(b)(5), Example 3.

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The built-in gain on §704(c) property is the excess of the property’s book value over the contributing partner’s basis at the time of contribution. The built-in gain is thereafter reduced by decreases in the difference between the property’s book value and adjusted basis. The built-in loss on §704(c) property is the excess of the contributing partner’s basis over the property’s book value at the time of contribution. The built-in loss is thereafter reduced by decreases in the difference between the property’s adjusted basis and book value.158 Example 31. Willard contributes $100 of cash basis accounts receivable and $40 of accounts payable to a partnership in exchange for a partnership interest. His capital account is credited with $60, the net FMV. Willard’s basis, however, is zero. The $100 receivable has a built-in gain and the $40 payable has a built- in loss. Income resulting from collection of the $100 of receivables and deductions resulting from the $40 of payables existing on the contribution date must be specially allocated back to Willard. Collection of receivables and payment of payables arising after Willard’s contribution date are allocated among the partners in proportion to their interests. Example 32. Use the same facts as Example 31, except Willard contributes property with an FMV of $100 and an adjusted basis of $40. Therefore, the property has $60 of built-in gain. 5 If the property is later sold for $150, the first $60 of gain must be specially allocated to Willard. The remaining $50 of gain is allocated among the partners in proportion to their interests. If a partner transfers all or a portion of their partnership interest to another partner, IRC §704(c) built-in gains and losses of the transferor partner must be allocated to the transferee.159 If property with §704(c) gain or loss is disposed of in a nonrecognition transaction, the property acquired in the transaction substitutes for that property.160 Although no particular method is required by the Code or regulations, the regulations set out three methods for making the §704(c) allocations that generally are considered to be reasonable.161 The actual application of these rules is complicated and beyond the scope of these materials. What is most important to remember is that if the partnership sells §704(c) property and recognizes gain or loss, any built-in gain or loss on the property must be allocated to the contributing partner.162 In addition, a sale of a proportionate interest requires a proportionate allocation.

Observation. It is important to be able to recognize circumstances involving §704(c) assets because the existence of book-tax disparities has a significant effect on the proper maintenance of capital accounts and allocations of minimum gain under the nonrecourse debt rules. In addition, Schedule K-1 (Form 1065), part II, item M, asks whether the partner contributed property with a built-in gain or loss.

158. Treas. Reg. §1.704-3(a)(3)(ii). 159. Treas. Reg. §1.704-3(a)(7). 160. Treas. Reg. §1.704-3(a)(8)(i). 161. Treas. Reg. §§1.704-3(b)–(d). 162. Treas. Reg. §1.704-3(b)(1).

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DISTRIBUTIONS, DISPOSITIONS, AND TERMINATIONS

The general rule of partnership taxation is that neither gain nor loss is recognized by the partnership or by the partners with respect to distributions. Exceptions are provided in the following situations. • Distributions of contributed property with built-in gain or loss under IRC §704 • Distributions of cash in excess of basis under IRC §731 • Certain distributions of assets with pre-contribution built-in gain under IRC §737 • Payments to a retired partner under IRC §736 • Certain distributions of unrealized receivables under IRC §751 • Certain liquidating distributions under IRC §731 A partner’s partnership interest can be sold to a third party, including one or more other partners. This is generally treated as the sale or exchange of a capital asset rather than as a distribution but is subject to ordinary income recharacterization to the extent of the partner’s share of unrealized receivables under §751 (discussed later under “Collapsible Provisions”).163 A current distribution is one made to a partner who continues to be a partner following the distribution. A liquidating distribution is one that terminates a partner’s interest in the partnership. Although a current distribution may be made in connection with a reduction of a partner’s interest in the partnership, as long as the partner continues as a partner, it is treated as a current distribution. Payments made in liquidation of a partner’s interest in the partnership are between the partnership and the partner and are governed by §736 and are generally treated as distributions. The sale of a partnership interest is between the selling partner and a third party other than the partnership and falls under the provisions of §741. The tax treatment of liquidations and of sales may have important differences, which are discussed in the following material.

DISTRIBUTIONS Cash Distributions IRC §731(a) provides that distributions of money to partners (including liability relief) is tax-free to the extent of the partner’s outside basis in the partnership. For this purpose, the FMV of marketable securities distributed to the partner may be treated as money.164 The partner’s basis is reduced to the extent of the money distributed. Distributions of money in excess of basis are treated as gain from a constructive sale of the partnership interest. This results in short- or long-term capital gain except to the extent such distributions are governed by §§736, 737, and 751.165 If both money and property are distributed, the partner’s basis is always reduced first to the extent of money distributed.166 No loss can be recognized with respect to current (as opposed to liquidating) distributions.167 The partnership recognizes neither gain nor loss on a distribution.168

163. IRC §741. 164. IRC §731(c)(1). Certain exceptions are provided for securities distributed to the contributing partner and for investment partnerships. 165. IRC §731(d). 166. IRC §732(a)(2). 167. IRC §731(a)(2). 168. IRC §731(b).

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169 170 Note. Although money distributions in excess of a partner’s basis are treated as the sale or exchange of a capital asset,169 the look-through rule for capital gain rates (discussed later) does not apply to the “redemption” of the partnership interest.170 Although the term redemption is not specifically used under §736 to describe liquidation of a partner’s interest, the substance of those transactions should be treated as a redemption for this purpose.

Example 33. Doris has a partnership basis of $20,000, and she receives a cash distribution of $25,000. She has held the partnership interest more than one year. The first $20,000 of the distribution is tax-free, and Doris’s basis is reduced from $20,000 to zero. The remaining $5,000 of distribution is treated as though Doris received it in exchange for a sale of her partnership interest. This part of the distribution is long-term capital gain.

Property Distributions The manner in which nonrecognition of property distributions is achieved is typical of the tax treatment of 5 partnerships. IRC §732(a) provides that the basis of property other than money distributed as part of a current distribution is its adjusted basis to the partnership immediately prior to the distribution. However, this basis may not exceed the distributee-partner’s basis in the partnership immediately prior to the distribution and after the reduction for any money distributed. If the distributee-partner’s basis in the partnership is less than the bases in properties distributed (after reduction for money distributed), the partner’s basis is first allocated among unrealized receivables and inventory. Any remaining basis is allocated among other distributed property in proportion to the partnership’s bases in the properties. The partner is then left with a zero basis in the partnership. The point of the property distribution rules is to defer the taxation of any gain or loss on distributed property until the distributee-partner disposes of it.171 This is in contrast to property distributions from corporations, which are generally treated as being fully taxable to both the corporation and the distributee-shareholder.172 Example 34. Scott receives a current distribution from a partnership at a time when his basis in the partnership is $10,000. The distribution consists of $7,000 of cash and IRC §1231 property (property used in a trade or business and held for more than one year) with an adjusted basis of $5,000 and an FMV of $9,000. Scott recognizes no gain because the $7,000 cash received does not exceed his $10,000 basis in the partnership. Scott’s partnership basis is reduced from $10,000 to $3,000. His remaining $3,000 partnership basis is substituted as his basis in the §1231 property. If Scott were then to sell the property for its $9,000 FMV, he would recognize $6,000 of gain. This is because Scott originally received a distribution with a total value of $16,000 when he had only $10,000 of basis, but he was not taxed at that time for the distribution in excess of his basis.

169. IRC §731(a). 170. Treas. Reg. §§1.1(h)-1(b)(2)(ii) and (b)(3)(ii). 171. Treas. Reg. §1.731-1(a)(1)(i). 172. IRC §311.

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Example 35. Renee has a partnership basis of $15,000. She receives a distribution consisting of $5,000 of cash, inventory with an adjusted basis of $6,000, and two pieces of real property. Property A has a partnership basis of $6,000, and Property B has a partnership basis of $2,000. Renee’s basis in the partnership is first reduced from $15,000 to $10,000 by the cash distribution. Her remaining $10,000 basis is first allocated to the inventory, giving it a full carryover basis of $6,000. Her remaining $4,000 of basis is allocated between the two pieces of real property in proportion to their bases in the hands of the partnership prior to the distribution. Thus, Property A receives a basis of $3,000 ($4,000 remaining basis × ($6,000 Property A basis ÷ $8,000 total partnership basis for Properties A and B)). Property B receives a basis of $1,000 ($4,000 remaining basis × ($2,000 Property B basis ÷ $8,000 total partnership basis for Properties A and B)). If distributed property is subject to a liability assumed by the distributee-partner, the partner’s basis in the partnership is: 1. Increased by the liabilities assumed in connection with the distribution,173 2. Decreased by the partner’s resulting reduction in partnership liabilities,174 and 3. Decreased by the basis of the distributed property.175 Example 36. Ryan has a partnership basis of $3,000. He receives a current distribution of property with an FMV of $12,000. The property has an adjusted basis to the partnership of $5,000 and is subject to a liability of $10,000. At the time of distribution, $6,000 of the liability was included in Ryan’s basis. He receives a carryover basis of $5,000 in the distributed property and has a $2,000 basis remaining in the partnership ($3,000 initial basis + $10,000 of liabilities assumed – $6,000 decrease in partnership liabilities – $5,000 basis in distributed property). Ryan’s remaining $2,000 basis in the partnership interest is because his outside partnership basis cannot be allocated to the distributed property in excess of the partnership’s adjusted basis in the property.

173. IRC §752. 174. Ibid. 175. IRC §733(2).

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Basis Differences. Special allocation rules apply under §732(c) in situations in which the distributee-partner’s partnership basis required to be allocated among the distributed assets is greater (in the case of a liquidating distribution) or less (in the case of current or liquidating distributions) than the partnership’s aggregate bases in those assets. Step 1. These rules allocate a distributee partner’s basis adjustment among distributed assets first to unrealized receivables and inventory items in an amount equal to the partnership’s basis in each such property, as under the usual rules. Step 2. To the extent of any basis not allocated in accordance with step 1, basis is allocated first to the extent of each distributed property’s adjusted basis to the partnership. Any remaining basis adjustment, if an increase, is allocated among properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation (to the extent of each property’s appreciation), and then in proportion to their respective FMVs. Example 37. XYZ partnership has two assets, A and B, which are both distributed in liquidation to 5 Yolanda, whose basis in the partnership interest is $55. Neither asset consists of inventory or unrealized receivables. Asset A has a basis to the partnership of $5 and an FMV of $40. Asset B has a basis to the partnership of $10 and an FMV of $10. Yolanda’s basis in the partnership is first allocated $5 to asset A and $10 to asset B (their respective adjusted bases to the partnership). Yolanda’s remaining basis in the partnership is $40 ($55 original basis − $15 partnership’s total basis in distributed assets). This basis is then allocated to asset A in the amount of its unrealized appreciation of $35 ($5 partnership basis – $40 FMV). No allocation is attributable to asset B for unrealized appreciation because its FMV equals the partnership’s adjusted basis in it. The remaining basis adjustment of $5 is then allocated in the ratio of the assets’ FMVs. Therefore, the remaining basis is allocated $4 to asset A ($5 basis adjustment × ($40 FMV for asset A ÷ $50 FMV for both assets)) and $1 to asset B ($5 basis adjustment × ($10 FMV for asset B ÷ $50 FMV for both assets)). After these allocations, asset A has a total basis of $44 ($5 + $35 + $4), and asset B has a total basis of $11 ($10 + $1). Step 3. Any remaining basis adjustment that is a decrease arises when the partnership’s total adjusted basis in the distributed properties exceeds the amount of the partner’s basis in its partnership interest, and the latter amount is the basis to be allocated among the distributed properties (nonliquidating distributions). If the partner’s basis to be allocated is less than the sum of the adjusted bases of the properties in the hands of the partnership, then, to the extent a decrease is required to make the total adjusted bases of the properties equal to the basis to be allocated, the decrease is allocated in the following order. • Among properties with unrealized depreciation in proportion to their respective amounts of unrealized depreciation (to the extent of each property’s depreciation) • In proportion to their respective adjusted bases (taking into account the adjustments already made) Example 38. Omega partnership has two assets, D and E, which are both distributed in liquidation to Gavin, whose basis in the partnership interest is $20. Neither asset consists of inventory or unrealized receivables. Asset D has a basis to the partnership of $15 and an FMV of $15. Asset E has a basis to the partnership of $15 and an FMV of $5. Gavin’s $20 basis in the partnership is first allocated to asset D in the amount of $15 and to asset E in the amount of $15 (their respective adjusted bases to the partnership), for a total of $30. Because Gavin’s basis in the partnership interest is only $20, a reduction of $10 ($30 – $20) is required. The entire amount of the $10 decrease is allocated to property E. This is because asset E has unrealized depreciation of $10 ($15 partnership basis – $5 FMV). Asset D has no unrealized depreciation (i.e., its partnership basis is equal to its FMV). Thus, Gavin’s basis in asset D is $15, and his basis in asset E is $5 ($15 partnership basis – $10 decrease).

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DISPOSITIONS OF PARTNERSHIP INTERESTS Sale If a partner sells a partnership interest to a third party who then becomes a new partner, there is clearly a sale of a partnership interest. However, if the partner sells the interest to other partners in the partnership, it is important to distinguish an actual sale of the interest to another person from a liquidation of that interest by the partnership. A sale of a partnership interest is treated as the sale of a capital asset176 and generates capital gain except to the extent the gain is recharacterized as ordinary income under IRC §751 for the selling partner’s share of appreciation in unrealized receivables and inventory. These requirements are discussed later in the section entitled “Compliance — Sales and Exchanges of §751(a) Property.” Although the sale of a partnership interest held for more than one year is the sale of a capital asset, the rates applicable to any long-term capital gain must be determined on a look-through basis. Under this rule, the gain must be allocated to the selling partner’s proportionate interest in any partnership collectibles and unrecaptured §1250 gain,177 with the residual balance treated as long-term capital gain.178 Both the partnership and the partner are also required to report the partner’s share of collectibles gain and unrecaptured depreciation in a manner similar to reporting requirements for gain attributable to unrealized receivables and inventory under §751(a).179

Liquidation IRC §736 governs payments to a “retiring partner” or to the successor in interest of the deceased partner. However, such payments are in fact in liquidation of a partner’s or deceased partner’s interest in the partnership.180 A partner “retires” for purposes of subchapter K when they cease to be a partner under state law. The partnership provisions of subchapter K continue to apply to a retiring partner or the successor in interest or estate of a deceased partner, however, until the retiring or deceased partner’s interest has been entirely liquidated, unless the successor or estate actually becomes a continuing full partner under state law. IRC §736(a) Payments. Payments under §736(a) are taxable to the withdrawing partner as a distributive share of partnership income if they are payable with regard to partnership profit. They are treated as guaranteed payments under IRC §707(c) if payable without regard to partnership profit. In either event, §736(a) payments are taxable income to the withdrawing partner and either reduce the distributive share of the remaining partners (if distributions) or are deductible by the partnership (if guaranteed payments). If a partner receives deferred payments taxable under both §§736(a) and (b) (discussed later), any payment must be allocated proportionately between the two as described in the regulations or in such other manner as the partnership and retired partner or successors of a deceased partner may agree in writing.181

176. IRC §741. 177. Treas. Reg. §1.1(h)-1(b). 178. Treas. Reg. §1.1(h)-1(a). 179. Treas. Reg. §1.1(h)-1(e). 180. IRC §736(a). 181. Treas. Reg. §1.736-1(b)(5)(iii).

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Example 39. ABC is a personal service partnership in which capital is not a material income-producing factor. ABC’s balance sheet follows. Assets

Adjusted Basis FMV Cash $13,000 $13,000 Unrealized receivables 0 30,000 Capital assets and §1231 assets 20,000 23,000 Total $33,000 $66,000

Liabilities and Capital

Adjusted Basis FMV 5 Liabilities $ 3,000 $ 3,000 Capital: Alton 10,000 21,000 Brad 10,000 21,000 Carla 10,000 21,000 Total $33,000 $66,000

Alton retires from the partnership in accordance with an agreement under which his $1,000 share of liabilities is assumed by the other partners. In addition, Alton receives $9,000 the year that he retires plus $10,000 in each of the two succeeding years. Thus, the total that he receives is $30,000 ($29,000 in cash + $1,000 in liability relief). His basis is $10,000 plus a $1,000 share of liabilities. Under the agreement terminating Alton’s interest, the value of his interest in §736(b) partnership property is 1 $12,000 ( /3 × ($13,000 cash + $23,000 FMV of capital assets and §1231 assets). Alton’s share in unrealized receivables is not included in the interest in partnership property described in §736(b). Because the basis of Alton’s interest is $11,000, he realizes a capital gain of $1,000 ($12,000 – $11,000) from the disposition of his interest in partnership property. The remaining $18,000 ($30,000 total he receives – $12,000 for 736(b) property) constitutes payments under §736(a) that are taxable to Alton as guaranteed payments under §707(c) because they are fixed in amount and not dependent on partnership profit. The payment for the first year is $10,000 ($9,000 in cash + $1,000 liability relief). Thus, unless the partners agree to allocate annual payments otherwise, each annual payment of $10,000 is allocated as follows. • $6,000 ($18,000 payment under §736(a) ÷ $30,000 total payments) × $10,000) is a §736(a) ordinary income payment • $4,000 ($12,000 payments under §736(b) ÷ $30,000 total payments) × $10,000) is a payment for an interest in §736(b) partnership property. The partnership may deduct the $6,000 guaranteed payment made to Alton in each of the three years. The gain on the payments for partnership property is determined under §731 in the same manner as for any distribution. Therefore, Alton treats only $4,000 of each payment as a distribution in a series in liquidation of his entire interest. Under §731, Alton has a capital gain of $1,000 (($23,000 FMV of capital and §1231 assets – $20,000 adjusted basis) ÷ 3) when the last payment is made. However, if Alton elects, he may treat each $4,000 payment as follows. • $333 as capital gain (one-third of the total capital gain of $1,000) • $3,667 as a return of capital

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Example 40. Use the same facts as Example 39, except the agreement between the partners provides that payments to Alton for three years are a percentage of annual income instead of a fixed amount. All payments received by Alton up to $12,000 (his share of §736(b) property) are treated under §736(b) as payments for his interest in partnership property. Alton’s gain of $1,000 is taxed only after he receives his full basis under §731. Because the payments are not fixed in amount, the election to recover basis proportionately is not available. Any payments in excess of $12,000 are treated as a distributive share of partnership income to Alton under §736(a). Example 41. Use the same facts as Example 39, except capital is an income-producing factor, Alton is considered a general partner, and the partnership agreement provides that the payment for his interest in partnership property includes payment for his interest in partnership goodwill. At the time of Alton’s retirement, the partners determine the value of partnership goodwill is $9,000. 1 Therefore, the value of Alton’s interest in partnership property under §736(b) is $15,000 ( /3 × ($13,000 cash + $23,000 capital assets and §1231 assets + $9,000 goodwill)). From the disposition of Alton’s interest in partnership property, he realizes a capital gain of $4,000 ($15,000 value – $11,000 basis). The remaining payments of $15,000 ($30,000 total payments – $15,000) constitute ordinary income under §736(a), which are taxable to Alton as guaranteed payments under §707(c). IRC §736(b) Payments. Liquidating distributions to a partner for the partner’s interest in partnership property are subject to §736(b). This results in capital gain or loss. An exception is provided if there are unrealized receivables or inventory items. In that case, the partner is required to treat as ordinary income under §751 an amount equal to what the partner’s share of gain would have been if the partnership disposed of all of its receivables and inventory in a taxable sale at FMV.182 The partner therefore has ordinary income to the extent of that amount.183 The remainder of the §736(b) liquidating distribution is governed by the provisions of §731 (discussed previously).184 The constructive sale treatment is not applicable to distributions of §751 property contributed to the partnership by the distributee-partner or to distributions treated as distributive shares of partnership income or guaranteed payments under §736(a).185 Under §736(b), liquidating distributions to a partner are treated in the same manner as current distributions under §731. This means they are generally tax-free except to the extent the liquidated partner receives cash in excess of basis. Because a liquidating distribution is a termination of a partner’s interest, however, the distributee-partner is required to substitute the distributee’s outside basis in the partnership immediately before the distribution as the partner’s basis in the property distributed by the partnership.186 In contrast, a current distribution requires the distributee to take the carryover basis of the partnership.187 Although liquidating distributions use a substituted rather than a carryover basis, the actual basis allocation rules are the same for both liquidating and current distributions as discussed previously. In addition, unlike current distributions, a partner may be permitted to recognize a loss on a liquidating distribution if the distribution: 188 • Consists solely of money (for this purpose not including marketable securities), unrealized receivables, and inventory; and • The partner’s basis immediately before the distribution exceeds the money and the basis of the receivables and inventory distributed.

182. Treas. Reg. §1.751-1(a)(2). 183. Treas. Reg. §1.751-1(a)(1). 184. Treas. Reg. §1.736-1(b)(1). 185. IRC §751(b)(2). 186. IRC §732(b). 187. IRC §732(a). 188. IRC §731(a)(2).

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Example 42. David receives a liquidating distribution from a partnership at a time when his basis in the partnership is $10,000. The distribution consists of $7,000 of cash and §1231 property (property used in a trade or business and held for more than one year) with an adjusted basis of $5,000 and an FMV of $9,000. David recognizes no gain because the cash he received does not exceed his basis. His partnership basis is reduced from $10,000 to $3,000 and the $3,000 of remaining partnership basis is substituted as his basis in the §1231 property. If David were then to sell the property for its $9,000 FMV, he would recognize $6,000 of gain. This is because David originally received a distribution with a total value of $16,000 against only $10,000 of basis but was not taxed at that time. Unrealized receivables and partnership goodwill are specifically excluded from the scope of §736(b) unless an exception for goodwill applies (discussed later).189 Therefore, they are treated as a distributive share of partnership income if the amount paid depends on the partnership’s income or as a guaranteed payment if the amount is determined without regard to the partnership’s income.190 5 Sale versus Liquidation of Interest As discussed previously, the sale of a partnership’s interest is treated as the sale of a capital asset191 resulting in capital gain except to the extent the gain is recharacterized as ordinary income under IRC §751. Liquidation of the interest of a deceased or retiring partner is treated as a distribution and is governed by §736. If the partnership interest is liquidated for cash, it is generally only a matter of distinguishing between payments under §§736(a) and 736(b). The tax treatment of the two can differ significantly. A partner selling a partnership interest can report any capital gain under the installment rules of §453 (but not ordinary income attributable to unrealized receivables192 and inventory193 under §751). If there is a deferral of §736(b) payments, the rules generally provide that the withdrawing partner recover basis first and then report gain because the normal distribution rules of IRC §731 require this.194 However, the withdrawing partner can attach an election to their return for the first year payments are received to report the gain and basis recovery ratably over the period that payments are received.195 Such flexibility is not permitted if a partner sells an interest under §741 because it is a sale or exchange.196 In addition, an installment sale of a partnership interest may be subject to the imputed interest rules,197 while deferred payments for liquidation of a partnership interest are not because they are distributions under §731 and not the result of a sale or exchange.198

189. IRC §736(b)(2). 190. IRC §736(a). 191. IRC §741. 192. Mingo v. Comm’r, 773 F.3d 629 (5th Cir. 2014). 193. IRC §453(b)(2)(B). 194. Treas. Reg. §1.736-1(b)(6). 195. Ibid. 196. IRC §1001(a). 197. IRC §483. 198. Treas. Reg. §1.708-1(b)(2).

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A selling partner is required to recharacterize gain as ordinary income to the extent of the partner’s share of unrealized receivables.199 The remaining partners receive no benefit from such recharacterization, unless a §754 election is in effect, and then only the purchasing partner or partners receive a benefit (discussed previously in the section entitled “IRC §754 Election”). In a liquidation, a partner’s interest in unrealized receivables may be treated as a §736(a) payment for partnership property, thereby reducing ordinary income to the remaining partners because the payments reduce the distributive shares of the remaining partners or are deductible by the partnership as a guaranteed payment.200 If there is a sale or exchange of 50% or more of the total interests in partnership capital or profits within a 12-month period, a technical termination of the partnership occurs under IRC §708. Although the consequences of such an event are not as bad as they were in the past (discussed later), there are still certain tax issues associated with technical terminations. The liquidation of a partner’s interest under §736 is not a sale or exchange for purposes of §708, even if it involves 50% or more of the total partnership interests.201 Because of the differing tax consequences, it is important to be able to distinguish a sale from a liquidation of the interest. The general rule is that the partners are free to determine the form in which to cast the transaction because of their adverse tax interests. Courts generally accept an unambiguous agreement characterizing the transaction. If it is not clear, the transaction is examined for its substance under a facts-and-circumstances determination.202 Goodwill. The sale of a partnership interest to a third party under §741 may include an amount for the selling partner’s share of the partnership’s goodwill. This is treated as capital gain to the selling partner.203 If a §754 election is in place (discussed earlier), the purchaser may be treated as having a basis in partnership goodwill amortizable under IRC §197 to the extent basis is allocable to goodwill pursuant to that election.204 In a liquidation, goodwill may be treated under §736(a) as a distributive share of partnership income or as a guaranteed payment except to the extent the partners have agreed in the partnership agreement that it will be treated as a §736(b) payment for an interest in partnership property. This applies only if capital is a material income-producing factor in the partnership and the partner is considered a general partner.205 Thus, in a liquidation, the partners have the ability, if capital is as material income-producing factor, to make amounts received for goodwill either capital gain to the withdrawing partner and nondeductible by the partnership or distributive shares or guaranteed payments that reduce the distributive shares of the remaining partners or are deductible by the partnership.206 If a §754 election is in place, however, the partnership can adjust its inside bases to reflect certain tax consequences to the liquidated partner (discussed earlier). To the extent gain is recognized by that partner on partnership goodwill, the partnership may be able to allocate this to partnership goodwill as a §197 amortizable intangible. This is not the case in a partnership in which capital is not a material income-producing factor. Such partnerships are not eligible to treat goodwill as partnership property under §736(b) and must therefore always treat it as a §736(a) payment.

199. IRC §741. 200. IRC §736(a). 201. Treas. Reg. §1.708-1(b)(2). 202. See, e.g., Foxman, et al. v. Comm’r, 41 TC 535 (1964), aff’d 352 F.2d 736 (3rd Cir. 1965), acq. 1966-2 CB 4. 203. IRC §741. 204. Treas. Reg. §1.755-1(a)(5). 205. IRC §736(b)(3). 206. IRC §736(b)(2)(B).

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The IRS has not defined circumstances in which capital is not a material income-producing factor. However, the Conference Committee Report to the Revenue Reconciliation Act of 1993, which enacted §736(b)(3), states the following. For purposes of this provision, capital is not a material income-producing factor where substantially all the gross income of the business consists of fees, commissions, or other compensation for personal services performed by an individual. The practice of his or her profession by a doctor, dentist, lawyer, architect, or accountant will not, as such, be treated as a trade or business in which capital is a material income- producing factor even though the practitioner may have a substantial capital investment in professional equipment or in the physical plant constituting the office from which such individual conducts his or her practice so long as such capital investment is merely incidental to such professional practice.207 207

Compliance The instructions for box 19 (distributions) of Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., identify code A as showing distributions to a partner of cash and marketable securities required to be treated as cash. If distributions of money and the FMV of marketable securities exceeds the partner’s adjusted basis in their 5 partnership interest, the instructions say to treat this as the sale of a capital asset on the partner’s return. The instructions also say that cash or property distributed in exchange for any part of the partner’s partnership interest attributable to the partner’s share of unrealized receivables and inventory items is ordinary income (discussed next under “Collapsible Provisions”) but provide no directions for reporting these items on the partner’s individual return. Presumably, line 21 (other income) of Form 1040, U.S. Individual Income Tax Return, would be appropriate. Code C in box 19 of Schedule K-1 is used to report the partnership’s adjusted basis of property other than money distributed from the partnership to the partner. If there is more than one property, the partnership must report the adjusted basis and FMV of each. The Schedule K-1 instructions describe how the property’s basis is determined in the hands of the individual partner based upon whether it is a liquidating or nonliquidating distribution. Payments made to a retiring partner under §736(a), or the successor, or to the estate of a deceased partner are taxed as ordinary income. If payments are based on a share of partnership profit, the partnership issues a Schedule K-1 reflecting the partner’s distributive share of partnership items. If the payments are treated as guaranteed payments, the Schedule K-1 should reflect that. In either case, a retiring partner is subject to self-employment (SE) tax under the usual rules if the partner was a general partner, regardless of the fact that the partner is retired.208 It is possible to structure retirement payments to a retired partner under IRC §1402(a)(10) in such a manner that they will not be subject to SE tax. However, any such plan must comply strictly with the regulations and may not suit the needs of the partnership or retiring partner.209 If deferred §736(a) payments are made to a deceased partner’s successor, a Schedule K-1 must also be issued showing the payments as either a distributive share of partnership income or a guaranteed payment. The instructions for Form 1065 state that amounts should not be entered on line 14 of the Schedule K-1 for net earnings or loss from self- employment (code A) for any partner that is an estate, trust, corporation, exempt organization, or individual retirement arrangement. If an individual successor in interest to a deceased partner has not been admitted as a substitute partner, there should also be no entry on line 14 because that individual is not a partner210 and therefore has no SE income under IRC §1402(a) as a partner in the partnership.

207. HR Rep. No. 103-213 at 698 (1993) (Conf. Rep.). A footnote cites IRC §§401(c)(2) and 911(d) as references. 208. Treas. Reg. §§1.1402(a)-1(b) and 2(d). 209. Treas. Reg. §1.1402-17. 210. IRC §761(b).

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COLLAPSIBLE PROVISIONS Sale or Exchange Under §741, the sale of a partnership interest is considered the sale of a capital asset. However, rules under §751 recharacterize the gain related to unrealized receivables and inventory items as ordinary income. The intent of the recharacterization rule is to prevent partners from circumventing ordinary income treatment that would result from an entity-level sale of those assets by selling the outside partnership interests instead. In addition, nonliquidating disproportionate distributions that change a partner’s share of inventory or unrealized receivables can cause both the distributee-partner and the partnership to recognize gain or loss under IRC §751. IRC §751 is referred to as the “collapsible” partnership provision, and the types of assets that result in ordinary income are commonly called “hot assets.” Unrealized receivables are any rights to payment not already included in income for goods delivered or to be delivered to the extent that the payment would be treated as received for property other than a capital asset. They also include rights to payment for services rendered or to be rendered to the extent income arising from such rights to payment was not previously includable in income by the partnership.211 The rights to payment must have arisen under contracts or agreements in existence at the time of sale even though the partnership may not be able to enforce payment until a later time.212 Work in progress is an example of such income rights. Unrealized receivables also include any §1245 or §1250 depreciation recapture (as well as other less common forms of recapture) to the extent the partnership would be subject to it for the sale of any partnership asset on the date of transfer.213 Inventory items include the usual stock in trade and property held for sale to customers. Inventory also includes any other partnership property which, on a sale or exchange by the partnership, would be considered property other than a capital asset or §1231 property.214 Example 43. Claudia, Nancy, and Carey are each one-third partners in an accrual basis partnership. The partnership’s balance sheet follows.

Assets

Basis FMV Cash $ 10,000 $ 10,000 Accounts receivable 5,000 2,500 Trade notes receivable 2,000 2,100 Merchandise on hand 4,000 9,500 Land 80,100 100,100 Total assets $101,100 $124,200

211. IRC §751(c). 212. Treas. Reg. §1.751-1(c)(1)(ii). 213. IRC §751(c). 214. IRC §751(d).

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Capital

Basis FMV Claudia $ 33,700 $ 41,400 Nancy 33,700 41,400 Carey 33,700 41,400 Total capital $101,100 $124,200

The hot assets are the accounts receivable, trade notes receivable, and merchandise. They have a total adjusted basis of $11,000 and an FMV of $14,100. Claudia sells a one-third interest in the partnership to Wayne for $41,400. Claudia has a gain of $7,700 ($41,400 sale price – $33,700 basis). Her one-third share of the hot assets’ FMV is $4,700 and her share of their bases is $3,667. Therefore, Claudia is required to recognize $1,033 of ordinary income under §751 5 ($4,700 – $3,667). The $6,667 balance of Claudia’s gain ($7,700 – $1,033) is capital gain.

Disproportionate Distributions Disproportionate partnership distributions that change a partner’s share of substantially appreciated inventory or unrealized receivables can cause both the distributee-partner and the partnership to recognize gain or loss.215 Substantially appreciated inventory is inventory with an FMV that is more than 120% of its adjusted basis.216 Otherwise, the rules are generally the same as for distributions under IRC §731 (discussed earlier in the section entitled “Distributions”). Example 44. Scott, Don, and Alan each own a one-third interest in a partnership. The partnership has the following assets.

Basis FMV Cash $ 6,000 $ 6,000 Inventory 6,000 12,000 Land 9,000 18,000 $21,000 $36,000

Scott’s partnership interest has a basis of $7,000 ($21,000 ÷ 3). All inventory is distributed to Scott in liquidation of his partnership interest. Scott is treated as having exchanged a one-third interest in the cash and the land for a two-thirds increased interest in the inventory. Scott has a gain of $3,000 because he received 2 1 $8,000 ( /3 × $12,000) of inventory in exchange for assets with a basis to him of $5,000 ( /3 × ($6,000 cash + $9,000 land)). The $3,000 gain ($8,000 – $5,000) is capital gain if the land was a capital asset.

1 The partnership is treated as having received $8,000 (FMV of Scott’s /3 share of cash and land) in exchange for inventory with a basis of $4,000 (basis of inventory distributed in excess of Scott’s one-third share). Thus, the partnership recognizes ordinary income of $4,000.

215. IRC §751(b). 216. IRC §751(b)(3)(A).

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Compliance — Sales and Exchanges of §751(a) Property A transferor-partner selling or exchanging any part of an interest in a partnership that has §751(a) property (unrealized receivables and inventory) at the time of the sale or exchange must notify the partnership in writing of such transfer by the earlier of 30 days after the transfer or January 15 of the calendar year following the transfer.217 Failure to do so can result in imposition of a $50 penalty on the transferor.218 The written notification must include the following information. 1. Names and addresses of the transferor and transferee 2. Taxpayer identification numbers of the transferor and the transferee (if known) 3. Date of the transfer A partnership that has been notified of a §751(a) sale or exchange is required to issue a Form 8308, Report of a Sale or Exchange of Certain Partnership Interests, to the transferor and transferee. Form 8308 is not required to be issued if the sale or exchange is reported by a broker pursuant to IRC §6045. Form 8308 must be issued to the transferor and transferee by January 31 of the calendar year following the §751(a) transfer. A copy must also be included with the partnership’s Form 1065 by its due date, including extensions. Form 8308 follows.

217. Treas. Reg. §1.6050K-1(d)(1). The materials in this section are based on Treas. Reg. §1.6050K-1. 218. IRC §6723. Treas. Reg. §1.6050K-1(g)(1) and the instructions for Form 8308 incorrectly refer to IRC §6722. This section applies to failure to furnish correct payee statements. Information required to be furnished to the partnership by the transferor is not within the definition of the statement at IRC §6724(d)(2)(P).

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A partnership is not required to issue a Form 8308 until it is notified of the exchange. A partnership is notified of the exchange when either: 219 • A partner has notified it of a covered transfer, or • The partnership has knowledge that there has been a transfer of a partnership interest or any portion thereof at a time when the partnership had any §751 property. A partnership may rely on a written statement from the transferor that the transfer was not a §751(a) exchange in the absence of actual knowledge to the contrary.220 Transfers that are not sales or exchanges (such as gifts) are not reportable. A §751(a) sale or exchange is a sale or exchange under §741 between the transferor-partner and another person in which any portion of consideration received by the transferor is attributable to §751(a) property. It does not include distributions by partnerships to partners that are treated as sales or exchanges of unrealized receivables and inventory under §751(b). The definition of a §751(a) transfer in the regulations is inconsistent with that in the Form 8308 instructions. The regulations define §751 property for reporting purposes as unrealized receivables (§751(c)) and substantially 5 appreciated inventory (§751(d)).221 The instructions to Form 8308 define such property simply as unrealized receivables and inventory. The inconsistency is the result of a change in the definition of inventory in §751(a) eliminating the requirement that inventory be substantially appreciated. The regulations under §6050K have not yet been updated to reflect this change, although there are proposed regulations that would do so as well as require the partnership statement to the transferor to include the amount of any gain or loss required to be recognized with respect to §751 property.222 HOLDING PERIOD AND CHARACTER OF DISTRIBUTED PROPERTY In general, a distributee-partner tacks (adds) on the partnership’s holding period to the holding period of the distributee-partner.223 Example 45. Janelle receives a distribution of a capital asset from a partnership. The partnership held the asset for six months. If Janelle holds the asset for more than six months following distribution and then sells it, she will have a long-term capital gain because the partnership’s holding period is tacked on to her holding period. IRC §735(a) requires any gain or loss on a subsequent disposition of unrealized receivables by a distributee to be treated as ordinary regardless of when it is disposed of. In addition, any gain or loss on a disposition of inventory within five years of distribution must be treated as ordinary. For purposes of measuring the 5-year period, there is no tacking on to holding periods.224 Although this appears to be the same as the treatment accorded a sale of a partnership interest under §751, there are some important differences. • Unrealized receivables does not include depreciation recapture, as it does for purposes of §751. That is because the recapture potential carries over in the distributed property.225 • Inventory does not include §1231 property that is included within the definition of inventory for purposes of §751 solely because it has not been held for the requisite §1231 holding period.226

Note. In some cases, a partner may have a divided holding period in a partnership interest. See Treas. Reg. §1.1223-3 for determining and handling such cases.

219. Treas. Reg. §1.6050K-1(e). 220. Ibid. 221. Treas. Reg. §1.6050K-1(a)(4)(ii). 222. Prop. Treas. Reg. §§1.6050K-1(a)(4)(ii) and (c). 223. IRC §735(b). 224. Ibid. 225. Treas. Reg. §1.1245-3(a)(3). 226. IRC §735(c)(1).

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DEATH OF PARTNER Although the death of a partner may cause the dissolution of a general partnership under state law (but generally not an LLC), there usually is no termination of the partnership for federal income tax purposes.227 This is true even in the case of the death of one partner in a 2-partner partnership as long as any successor-in-interest of the deceased partner continues to receive payments from the partnership prior to a complete liquidation of the decedent’s interest.228 Payments for a deceased partner’s interest in the partnership are considered to be payments under §736 and are taxed accordingly. The death of a partner also results in a closing of the partnership’s tax year for the deceased partner.229 Any distributive share to that point is included on the decedent’s final return and any distributive share after death is reported on the successor’s return.230

TERMINATION OF PARTNERSHIP A partnership terminates for federal tax purposes when it winds up its affairs and ceases conducting any business or when there is a 50% or more change in ownership in both partnership capital and partnership profits within a 12-month period, even if the partnership’s business is thereafter continued by the new and remaining partners.231 Multiple sales of partnership interests are cumulated to determine whether the 50% threshold has been reached within any consecutive 12-month period.232 This is commonly referred to as a technical termination. Transactions that are not treated as sales for this purpose include distributions, gifts, transfers at death, and liquidations of partnership interests.233 Admissions of new partners causing shifts in partnership interests and contributions of property by an existing partner are nonrecognition events under IRC §721 and are therefore not sales or exchanges covered by IRC §708(b)(1)(B). 234

Note. While liquidating distributions to a partner under §736 are not treated as sales under §708, the purchase of a partnership interest by another partner under §741 is.234

If a partnership is terminated under §708 by a sale or exchange of an interest, the following is deemed to occur.235 1. The partnership contributes all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership. 2. Immediately thereafter, the terminated partnership distributes interests in the new partnership to the purchasing partner and other remaining partners in proportion to their respective interests in the terminated partnership in liquidation of the terminated partnership, either for the continuation of the business by the new partnership or for its dissolution and winding up. In the latter case, the new partnership terminates by virtue of winding up its affairs.

227. IRC §706(c)(1). 228. Treas. Reg. §1.708-1(b)(1)(i). 229. IRC §706(c)(2)(A). 230. Treas. Reg. §§1.706-1(c)(2)(i) and (ii). 231. IRC §708(b). 232. Treas. Reg. §1.708-1(b)(2). 233. Ibid. 234. Ibid. 235. Treas. Reg. §1.708-1(b)(4).

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The consequences of a technical termination include the following. • The new partnership continues to use the same employer identification number as the terminated partnership.236 • Separate short-year returns are filed for both the terminated and new partnership resulting from a technical termination.237 The return for the terminated partnership should be marked “final,” and the return of the new partnership should be marked “initial.” In both cases, the “technical termination” box (item G(6)) on Form 1065 should be checked. • Generally, no gain or loss is recognized as a result of the deemed contribution and distribution.238 • The tax year of the terminated partnership ends for all partners.239 • Capital accounts carry over and are not revalued.240 • Unless termination occurs on the last day of the partnership tax year, partners’ distributive shares of termination are reported on their returns for the year in which the termination occurs.241 Items are reported by 5 the terminated partnership through the date of the terminating event.242 • Unless otherwise provided, any elections by the terminated partnership end because the old partnership is treated as otherwise terminating and a new partnership comes into existence for tax purposes.243 The new partnership must therefore generally make all new elections (e.g., accounting method, §754 elections, inventory methods, and IRC §179 expensing). • The new partnership begins new depreciation periods for all the partnership’s depreciable tangible assets.244 This has the effect of stretching out the recovery period of such property beyond its original recovery period. However, the new partnership steps into the shoes of the terminated partnership and must continue amortizing §197 intangibles over the remainder of the terminated partnership’s amortization period.245 • Qualified bonus depreciation property acquired by the terminated partnership and contributed to the new partnership is not treated as acquired and disposed of in the same tax year solely as a result of a technical termination. The bonus depreciation deduction must be taken by the new partnership even if the property was placed in service by the terminated partnership.246 • Because the constructive contribution and distribution are treated as nonrecognition events,247 basis in partnership assets carries over from the terminated partnership to the new partnership.248 In addition, holding periods are tacked on for capital and §1231 assets (but not ordinary income assets).249

236. Treas. Reg. §301.6109-1(d)(2)(iii). 237. IRS Notice 2001-5, 2001-1 CB 327. 238. IRC §§721 and 731. 239. Treas. Reg. §1.706-1(c)(1). 240. Treas. Reg. §1.704-1(b)(2)(iv)(l). 241. Treas. Reg. §1.706-1(c)(1). 242. Treas. Reg. §1.708-1(b)(3). 243. Notice of Proposed Rulemaking PS-5-96, Preamble. 244. IRC §168(i)(7). 245. Treas. Reg. §§1.197-1(g)(2)(ii)(A) and (iv). 246. Treas. Reg. §1.168(k)-1(f)(1)(ii). 247. IRC §§721 and 731. 248. IRC §723. 249. IRC §1223(1).

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• Because the new partnership resulting from the termination is generally viewed as a new taxpayer and no exception is provided, it must adopt a proper tax year regardless of any previous correct use of a fiscal year.250 • If a partnership has in place an inside §754 basis adjustment under IRC §743, this is not affected even if the new partnership does not make a §754 election.251 • A §754 election in place on the date of termination is deemed to survive long enough to apply to an incoming partner.252 • The new partnership continues the terminated partnership’s election to amortize startup and organizational expenses in the same manner and over the same remaining period as the old partnership.253 • A technical termination does not affect the amount of built-in gain or loss property under IRC §704(c), but the new partnership is not required to use the same methods as the old partnership’s book-tax basis differences in such property.254 • A technical termination is not treated as a distribution of §704(c) property within seven years of contribution that triggers recognition of built-in gain or loss to the contributing partner.255 • A technical termination does not trigger §731(c) rules regarding distributions of marketable securities.256 • The 7-year holding period for determining recognition of precontribution gain on certain distributions under §737 is not affected.257

Observation. Some consequences of a technical termination may be undesirable. It may therefore be prudent for planning purposes to stagger changes in ownership so that there is a less than 50% ownership change in any 12-month period.

250. IRC §706(b)(1)(B). 251. Treas. Reg. §1.743-1(h)(1). 252. Treas. Reg. §1.708-1(b)(5). 253. Treas. Reg. §1.708-1(b)(6). 254. Treas. Reg. §1.704-3(a)(2). 255. Treas. Reg. §1.704-4(c)(3). 256. Treas. Reg. §1.731-2(g)(2). 257. Treas. Reg. §1.737-2(a).

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The following example from the regulations illustrates a technical termination.258 Example 46. Abigail and Bentley each contribute $10,000 cash to form AB, a general partnership, as equal partners. AB purchases depreciable Property X for $20,000. Property X increases in value to $30,000, at which time Abigail sells her entire 50% interest to Corinne for $15,000 in a transfer that terminates the partnership under IRC §708(b)(1)(B). At the time of the sale, Property X had an adjusted basis of $16,000 and a book value of $16,000 (original $20,000 basis and book value, reduced by $4,000 of depreciation). In addition, Abigail and Bentley each had a capital account balance of $8,000 (original $10,000 capital account reduced by $2,000 of depreciation allocations with respect to Property X). Following the deemed contribution of assets and liabilities by the terminated AB partnership to a new partnership (new AB) and the liquidation of the terminated AB partnership, the adjusted basis of Property X in the hands of new AB is $16,000. The book value of Property X in the hands of new partnership AB is also $16,000 (the book value of Property X immediately before the termination). In addition, Bentley and Corinne each have a capital account of $8,000 in new AB (the balance of their capital accounts in AB prior to the termination). The deemed contribution and liquidation with regard to the terminated partnership are 5 disregarded in determining the capital accounts of the partners and the books of the new partnership. Additionally, new AB retains the taxpayer identification number of the terminated AB partnership. In the preceding example, Property X was not IRC §704(c) property in the hands of terminated AB and is therefore not treated as IRC §704(c) property in the hands of new AB. This is true even though Property X is deemed contributed to new AB at a time when the FMV of Property X ($30,000) was different from its adjusted basis ($16,000). That is because property contributed to a new partnership under these termination rules is treated as IRC §704(c) property only to the extent that the property was IRC §704(c) property in the hands of the terminated partnership.

258. Treas. Reg. §1.708-1(b)(4).

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Overview...... B275 Return Filing and Selecting Tax Year...... B301 Pre-2013 Planning...... B275 Passive Activity Loss Limitations...... B303 Estate Tax Data ...... B276 Tax Rate Schedule...... B304 The Changed Landscape — Post-2012...... B277 Alternative Minimum Tax ...... B305 State-Level Impacts and Estimated Income Tax Payments ...... B305 Income Tax Ramifications...... B278 Basis Considerations for Estate Planning Post-2012...... B279 In-Kind Distributions...... B306 Transfer Tax Cost vs. Basis Step-Up...... B286 Specific Bequests...... B306 Basis Step-Up Benefits...... B287 Sale of A Decedent’s Personal Residence...... B307 Planning Techniques to Achieve Residence Held in Revocable Trust...... B308 Income Tax Basis Step-Up...... B289 Residence Sold by Estate or Trust...... B308 Transferee Liability...... B291 Termination of Estates and Trusts...... B308 6 IRS Guidance on Discharging Excess Deductions...... B308 Estate Tax Liens ...... B292 Net Operating Losses...... B310 Basis of Assets in Estates...... B293 Executor/Administrator Fees Received...... B312 Date of Death Valuation and Alternate Valuation...... B293 Valuation Discounting via Family Limited Partnerships ...... B312 Basis Consistency Rules ...... B294 Family Limited Partnerships Accuracy-Related Penalty...... B299 and IRC §2036 ...... B315 Practical Estate Planning...... B299 Use of Formula Clauses for Moderate-Wealth Taxpayers...... B299 Gifting/Transferring Assets ...... B315 High Net-Worth Taxpayers...... B300 The Life Estate/Remainder Transfer Strategy ....B318 Taxable Income of Trusts and Estates ...... B301 Creation of and Property Subject to a Life Estate ...... B318

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Chapter Summary

For 2017, the federal estate tax exclusion is at $5.49 million and only 18 states impose an estate tax or inheritance tax at death. Consequently, the focus has switched to tax planning for larger estates by, for example, “porting” the deceased spouse’s unused estate tax exemption to the surviving spouse’s estate. Most assets receive a step-up in basis to fair market value (FMV) at date of death, which can result in significant income tax savings on the subsequent disposition of appreciated property. In community property states, the surviving spouse may get this step-up in basis for all marital property upon the death of their spouse if at least half of the community property was included in the decedent’s gross estate for federal estate tax purposes. Additional planning is required to obtain similar treatment for common law property. A decedent’s estate is liable for the decedent’s tax deficiency at the time of death. Distributees are liable for the decedent's tax liabilities to the extent of the assets they received. An estate executor may elect to value estate assets using the FMV on the alternate valuation date (six months after the date of death). However, this election is only available if it lowers the overall estate value, lowers the estate tax, and is used for all assets in the estate. Estates required to file a federal estate tax return after July 31, 2015, must provide basis information to the IRS and estate beneficiaries. This ensures consistent use of basis for estate assets by all parties. An accuracy- related penalty is imposed on taxpayers who report a basis higher than the amount that the estate reported to the IRS on Form 8971. Wealthier taxpayers should consider moving to a state with either zero or low state income taxes and low property taxes. Business succession and retirement planning are also important. Bypass trust schemes are more suitable for states like Illinois that have a significant estate tax and a non-portable exemption. Generally, estates or trusts compute taxable income the same way as individuals, with certain modifications. There are also some unique applications of the passive loss limitations to estates and trusts. Income from a terminated estate or trust is taxable to the beneficiaries even if it has not been distributed to them. Excess deductions from the estate or trust’s last tax year flow to the beneficiaries, who can claim them as itemized deductions. Valuation discounts are important succession planning tools. Discounts from FMV of 30-45% are common in closely held entities. The life estate/remainder arrangement is a common estate and succession planning technique. It avoids probate because property automatically passes to the remainder-interest holder.

About the Author Roger McEowen, JD, is the Kansas Farm Bureau Professor of Agricultural Law and Taxation at Washburn University School of Law in Topeka, Kansas. He is a published author and prominent speaker, conducting more than 80 seminars annually across the United States for farmers, agricultural business professionals, lawyers, and tax professionals. He can also be heard on WIBW radio and RFD-TV. His writing can be found in national agriculture publications, a monthly publication, Kansas Farm and Estate Law, his two books, Principles of Agricultural Law and Agricultural Law in a Nutshell, as well as on www.washburnlaw.edu/waltr. He received a B.S. with distinction from Purdue University in Management in 1986, an M.S. in Agricultural Economics from Iowa State University in 1990, and a J.D. from the Drake University School of Law in 1991. He is a member of the Iowa and Kansas Bar Associations and is admitted to practice in Nebraska. He is also a past President of the American Agricultural Law Association.

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OVERVIEW

The year 2013 marked the beginning of major changes in estate planning and its impact on estates and beneficiaries. Significant changes were made to the transfer tax system before 2013, particularly within the provisions of the Economic Growth and Tax Relief Recovery Act of 2001 (EGTRRA). The EGTRRA changes expired after 10 years. Extensions of EGTRRA provisions were temporary until the enactment of the American Taxpayer Relief Act of 2012 (ATRA). ATRA increased taxes on the wealthiest taxpayers and increased the tax rates on capital gains, dividends, and transfer taxes. ATRA’s changes are permanent.

Note. For detailed information about ATRA, see the 2013 University of Illinois Federal Tax Workbook, Vol um e A, Chapter 1: New Legislation. This can be found at uofi.tax/arc [taxschool.illinois.edu/taxbookarchive].

Under ATRA, the transfer tax system was characterized by four key components beginning in 2013. • Permanency •Indexing • Unification of the estate and gift tax systems 6 • Portability of the unused portion of the applicable exclusion at the death of the first spouse Effective for tax years beginning after 2012, the Patient Protection and Affordable Care Act imposed an additional 3.8% tax on passive sources of income under IRC §1411. This has important implications for the structuring of business entities and succession planning, particularly for taxpayers with passive sources of income. PRE-2013 PLANNING Before the changes to the transfer tax system beginning in 2013, much of estate planning for moderate and high- wealth clients involved the use of lifetime asset transfers. Often, these asset transfers were accomplished through trusts that typically involved the use of life insurance. However, such a strategy came at a cost. A recipient of lifetime transfers does not receive a “stepped-up” basis under IRC §1014. That was often only a minor concern for the transferor because the strategy was to avoid estate tax for the transferor. The strategy made sense, particularly when the estate tax exemption was significantly lower than the 2017 amount of $5.49 million1 and estate tax rates were significantly higher than income tax rates. For example, before 2002, the top estate and gift tax rate was 55% and did not drop to 45% until 2007. Currently, the top income tax rate is 39.6%, with the potential for an additional 3.8% on passive sources of income (for a combined 43.4%), and the top estate tax rate is 40%.

1. Rev. Proc. 2016-55, 2016-45 IRB 707.

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The standard pre-2013 estate plan for many higher-wealth clients had the following common pattern. • A lifetime taxable gift uses the estate tax exemption equivalent, thereby removing all future appreciation attributable to that property from the decedent’s future estate tax base. In many instances, the gifted property was used to fund an intentionally defective grantor trust (IDGT). An IDGT is drafted to invoke the grantor trust rules with a deliberate flaw ensuring that the individual continues to pay income taxes (i.e., the grantor is treated as the owner of the trust for income tax purposes but not the owner of the assets for estate tax purposes). Thus, the grantor’s estate is decreased by the amount of the assets transferred to the trust. An IDGT is part of an estate “freeze” technique. In a typical sale to an IDGT, the grantor sells appreciating assets at their fair market value (FMV) to the trust in exchange for a note at a very low interest rate. The installment note is treated as full and adequate consideration if the minimum interest rate charged on the installment note is at least the applicable federal rate (AFR) and all the formalities of a loan are followed. The goal is to remove future asset appreciation, above the mandated interest rate, from the grantor’s estate.

Note. For more information about IDGTs, see the 2016 University of Illinois Federal Tax Workbook, Vo lu m e B , Chapter 5: Wealth Accumulation and Preservation.

• Using trusts (such as a “dynasty trust”) and other estate planning techniques avoids including assets in the gross estate for as long as possible. This is accomplished by leveraging the generation-skipping transfer tax (GSTT) and establishing a GSTT trust in a jurisdiction that has abolished the rule against perpetuities. If the trust was established in a state without an income tax, the trust income also avoids income taxation.

Observation. The typical pre-2013 estate plan deemphasized the income tax consequences of the plan. The emphasis focused on avoiding federal estate tax. Additionally, post-2010, the temporary nature of the transfer tax system and the lateness of legislation dealing with expiring transfer tax provisions persuaded many clients to make significant gifts late in the year based on the fear that the estate tax exemption would drop significantly. Moreover, the decedent’s and the beneficiaries’ states of residence at the time of the decedent’s death were typically of little concern because there was a large gap in the tax rates applicable to gifts and estates and those applicable to income at the state level.

ESTATE TAX DATA2 According to IRS data, the number of Forms 706, United States Estate (and Generation-Skipping Transfer) Tax Return, filed declined nearly 76% from 49,050 in 2006 to 11,917 in 2015. That reduction was the result of the gradual increase in the filing threshold from $2 million in 2006 to $5.43 million in 2015. In 2015, the total net estate tax reported on all estate tax returns filed for the year was $17.1 billion. California had the highest number of estate tax returns filed in 2015, followed by Florida, New York, Texas, and Illinois. Stock and real estate made up more than half of asset holdings for 2015 estate tax returns. Taxable estates for decedents with total assets of $20 million or more held a greater share of their portfolio in stocks (over 38%) and lesser shares in real estate and retirement assets than did decedents in other asset categories.

Note. The IRS statistics reveal that the estate tax is of particular concern to farm and ranch estates and other small businesses. It also reveals that the primary asset likely to be included in a generation-skipping (“dynasty”) trust is stock rather than agricultural land.

2. Estate Tax Returns Filed for Wealthy Decedents, 2006–2015. IRS. [www.irs.gov/pub/irs-soi/2015estatetaxonesheet.pdf] Accessed on May 15, 2017.

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THE CHANGED LANDSCAPE — POST-2012

The changes in estate planning beginning in 2013 are characterized by the following. • Continuing trend of states repealing taxes imposed at death 3

Note. As of the beginning of 2017, 18 states (and the District of Columbia) have some variation of an estate tax or inheritance tax imposed at death. Those states are as follows: Connecticut, Delaware, Hawaii, Illinois, Iowa, Kentucky, Maine, Maryland, Massachusetts, Minnesota, Nebraska, New Jersey, New York, Oregon, Pennsylvania, Rhode Island, Vermont, and Washington.3

• Increase in the amount of the applicable exclusion and indexing of the amount (With moderate inflation, the exclusion is anticipated to be approximately $6.5 million by 2023 and $9 million by 2033.) • Reunification of the estate and gift tax • Permanency of portability of the deceased spouse’s unused exclusion • Permanency of transfer taxes 6 Other changes that began in 2013 that influence estate planning include the following. • An increase in the top federal ordinary income tax rate to 39.6% • An increase in the highest federal long-term capital gain tax rate to 20% • An increase in the highest federal qualified dividend income tax rate to 20% • The 3.8% net investment income tax (NIIT) under §1411 4 5 6

Note. For agricultural estates, land values more than doubled from 2002 to 2012, and continued to increase post- 2010. From 2009–2013, the overall increase in agricultural land values was 31% ($2,090 in 2009 and $2,730 in 2013).4 In the “corn belt,” from 2006–2013, the average farm real estate value increased by 229.6%.5 During that same period, the applicable exclusion increased 262.5%. For the year ending June 1, 2016, corn-belt farm real estate values declined 0.9%.6 That decline is in response to lower farm earnings due to declines in crop and livestock revenue. It is anticipated that corn-belt farm real estate values will trend slightly downward in 2017. This all means that even with the increase in the applicable exemption to $5.49 million (for 2017) and subsequent adjustments for inflation, many agricultural estates still face potential estate tax issues.

3. State Death Tax Chart. Jul. 7, 2017. American College of Trust and Estate Counsel. [www.actec.org/resources/state-death-tax-chart/] Accessed on Jul. 17, 2017. 4. Land Values 2016 Summary. USDA. Aug. 2016. [usda.mannlib.cornell.edu/usda/current/AgriLandVa/AgriLandVa-08-05-2016.pdf] Accessed on Jul. 17, 2017. 5. Ibid. 6. Farmland Value. Apr. 10, 2017. USDA. [www.ers.usda.gov/topics/farm-economy/land-use-land-value-tenure/farmland-value/] Accessed on May 16, 2017.

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STATE-LEVEL IMPACTS AND INCOME TAX RAMIFICATIONS At the state level, the landscape has dramatically changed. At the time EGTRRA was enacted in 2001, almost every state imposed taxes at death that were tied to the federal state estate tax credit. Since that time, however, the federal state estate tax credit has been replaced with a federal estate tax deduction under IRC §2058. Currently, only 18 states (and the District of Columbia) impose some type of tax at death (a state estate tax or a state inheritance tax). In those jurisdictions, the size of the estate exempt from tax (in states with an estate tax) and the states with an inheritance tax have various statutory procedures that set forth the amount and type of bequests that are exempt from tax.7 The following table sets forth the various state estate tax exemptions and tax rates as of July 7, 2017.8

States Imposing an Estate Tax States Imposing an Inheritance Tax Exemption Maximum Exemption Maximum State Amount Tax Rate State Amount Tax Rate CT $2,000,000 12% IA Varies 15% DE 5,490,000 16% KY Varies 16% DC 2,000,000 16% MD $0 16% HI 5,490,000 16% NE Varies 18% IL 4,000,000 16% NJ 0 16% ME 5,490,000 12% PA 0 15% MD 3,000,000 16% MA 1,000,000 16% MN 2,100,000 16% NJ 2,000,000 16% NY 5,250,000 16% OR 1,000,000 16% RI 1,515,156 16% VT 2,750,000 16% WA 2,129,000 20%

Maryland and New York gradually will increase the exemption until it becomes equal to the federal estate tax exemption effective January 1, 2019. However, in New York, the exemption is phased out for estates with values exceeding 105% of the applicable exemption amount. The Minnesota exemption gradually increases until 2020, at which time it will be set at $3 million.9 10

Note. Connecticut is the only state that imposes a gift tax. The gift tax lifetime exclusion is $2 million (as of 2017).10

Seven states have no state income tax (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming). Tennessee and New Hampshire only tax dividend and interest income. Other states such as California, Hawaii, Minnesota, New Jersey, New York, and Oregon have a relatively high state income tax burden compared to other states with an income tax.11

7. State Death Tax Chart. Jul. 7, 2017. American College of Trust and Estate Counsel. [www.actec.org/resources/state-death-tax-chart/] Accessed on Jul. 17, 2017; Where Not to Die in 2017. Eberling, Ashlea. Oct. 25, 2016. Forbes. [www.forbes.com/sites/ashleaebeling/2016/ 10/25/where-not-to-die-in-2017/#5635e571e374] Accessed on Aug. 1, 2017. 8. Ibid. 9. Ibid. Qualified farms are exempt up to $5 million. 10. Estate, Inheritance, and Gift Taxes in Connecticut and Other States. Connecticut General Assembly, Office of Legislative Research. [www.cga.ct.gov/2016/rpt/pdf/2016-R-0224.pdf] Accessed on Jul. 19, 2017. 11. State Individual Income Tax Rates and Brackets for 2017. Scarboro, Morgan. Mar. 9, 2017. Tax Foundation. [taxfoundation.org/state- individual-income-tax-rates-brackets-2017/] Accessed on Jul. 17, 2017.

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Generally, post-2012 estate planning is characterized by lower transfer tax costs, higher income tax rates, and greater disparity among the states between transfer taxes and income taxes.

Note. Post-2012, income tax issues play a greater role in estate planning. Planners should consider whether it is possible for a client to minimize the overall tax burden for a particular client or family by moving to a state with a reduced or eliminated income tax and no transfer taxes. In general, planners with clients domiciled in relatively higher income tax states should place an emphasis on ensuring a basis step-up at death. For clients with family businesses, pre-death transition/succession planning is important.

ESTATE PLANNING POST-2012 The key issues for estate planning beginning in 2013 and later years appear to be the following. • The client’s life expectancy • The client’s lifestyle • The potential need for long-term health care and whether a plan is in place to deal with that possibility • The size of the potential gross estate 6 • The type of assets the decedent owns and their potential for appreciation in value • For farm estates, preserving the eligibility for the estate executor to make a special-use valuation election • For relatively illiquid estates (commonplace among agricultural estates and other estates for small business owners), preserving qualification for various liquidity planning techniques such as installment payment of federal estate tax and properly making the installment payment election on the estate tax return 12 13

Caution. IRC §6166(d) specifies that the installment payment election is made on a timely filed (including extensions) return in accordance with the regulations. The regulations12 are detailed, and require that the appropriate box on Form 706 be checked and a notice of election be attached to the return. The notice of election must contain certain information. In Estate of Woodbury v. Comm’r,13 the estate filed for an extension of time to file and included a letter that expressed the estate’s intent to make an installment payment election. It estimated that approximately $10 million in tax would be paid in installments. The estate made a subsequent request for an additional extension along with another letter containing some of the required information for a §6166 election. The IRS denied the second extension and informed the estate that it must file by the previously extended due date. The estate ultimately filed its estate tax return 2½ years late and attached a proper notice of election to pay the tax in installments. The IRS rejected the election for lack of timely filing, but the estate claimed that it substantially complied. The court determined that the estate’s letters did not contain all of the information required by the regulations to make the election, particularly valuation information to allow the IRS to determine if the percentage qualification tests were satisfied. Thus, the estate did not substantially comply with the regulations and the election was disallowed.

• Whether a basis increase at death will be beneficial/essential • Where the decedent resides at death • Where the beneficiaries reside at the time of the decedent’s death

12. Treas. Regs. §§20.6166-1 and 20.6166A-1; see instructions for Form 706. 13. Estate of Woodbury v. Comm’r, TC Memo 2014-66 (Apr. 14, 2014).

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• If the decedent has a business, whether succession planning is needed • Entity structuring and whether multiple entities are necessary • For agricultural clients, the impact of farm program eligibility rules on the business structure • Asset protection strategies, including the use of a spousal lifetime access trust (SLAT) • General economic conditions and predictions concerning the future (For agricultural clients, land values, commodity prices, and marketing strategies are important factors to monitor.) The uncertain future of the federal estate tax (and whether basis step-up will be retained) means that existing estate planning documents should be reviewed to make sure they are in accordance with the present exemption amount and the availability of portability (discussed later in this chapter). Existing estate plans should also be reviewed if the federal estate tax system is eliminated or modified and if the basis step-up rule is either modified or eliminated. For instance, formula clauses in existing documents should be examined. The classic bequest to a credit shelter trust of the maximum amount possible without incurring estate tax may result in the entire estate passing to the credit shelter trust if the estate tax is repealed. This may not conform to the original intent of the estate plan. In addition, formula general power of appointment (GPOA) clauses might be impacted if the federal estate tax is repealed. For example, if the GPOA ties its existence to not causing the estate to incur any estate tax to be paid by the holder of the power, federal estate tax repeal would trigger the operation of the power. In other words, repeal would trigger the application of the GPOA and cause inclusion of the property subject to the GPOA in the decedent’s estate. If the step-up basis rule is repealed along with the estate tax, the results would be even more adverse.

Impact of Coupling Because of the “coupled” nature of the estate and gift tax systems and the portability of the unused exclusion at the death of the first spouse, it is often desirable to use as little as possible of the applicable exclusion during an individual’s life to cover taxable gifts. For many taxpayers, the applicable exclusion shelters the entire value of their gross estate, and the inclusion of assets in the estate at death allows for an increased basis for the heirs. Thus, for most taxpayers, there is little or no transfer tax cost. This fact causes many taxpayers to place an emphasis on preserving the income tax basis step-up at death. If there are asset transfers pre-death, such transfers generally occur in the context of business succession/transition planning. However, for many taxpayers, gifting assets during life takes on diminished importance.

Portability An election can be made under which the amount of the estate tax applicable exclusion that is not used in the estate of the first spouse to die is available to be used in the estate of the surviving spouse. This process is referred to as “portability.” The amount available to be “ported” to the estate of the surviving spouse is the deceased spouse’s unused exclusion (DSUE).14 The DSUE amount is available to the surviving spouse as of the date of the deceased spouse’s death. It is applied to gifts and the estate of the surviving spouse before their own exemption is used. Accordingly, the surviving spouse may use the DSUE amount to shelter lifetime gifts from gift tax or to reduce the estate tax liability of the surviving spouse’s estate at death.15 Portability of the DSUE has become a key aspect of post-2012 estate planning. The Treasury Department issued proposed and temporary regulations addressing the DSUE under IRC §§2010(c)(2)(B) and 2010(c)(4) on June 15, 2012. The proposed regulations applied until June 15, 2015, and were then replaced with final Treas. Reg. §20.2010-2.

14. IRC §2010(c)(4); Treas. Reg. §20.2010-2. 15. Treas. Reg. §20.2010-3(b)(ii).

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The portability election must be made on a timely filed Form 706 for the first spouse to die.16 This also applies for nontaxable estates and the return is due by the same deadline (including extensions) as for taxable estates. The deadline for filing is nine months after the decedent’s date of death. The election is revocable until the deadline for filing the return expires. 16 While an affirmative election is required by statute, part 6 of Form 706 (which is entirely dedicated to the portability election, the DSUE calculation, and roll forward of the DSUE amount) provides that “a decedent with a surviving spouse elects portability of the DSUE amount, if any, by completing and timely-filing the Form 706. No further action is required to elect portability…”17 This election, therefore, is made by default if there is a DSUE amount and an estate tax return is filed. This is the case as long as the box in section A of part 6 is not checked. Checking the box affirmatively elects out of portability. In Rev. Proc. 2014-18,18 the IRS provided a simplified method for certain estates to obtain an extended time to make the portability election. The 2014 relief expired, and then it was extended by Rev. Proc. 2017-34.19 The portability election must be submitted with a complete and properly filed Form 706 by the later of January 2, 2018, or the second anniversary of the decedent’s death. After January 2, 2018, the extension is two years. The extension is only available to estates that are not otherwise required to file an estate tax return. Other estates can only obtain an extension under Treas. Reg. §301.9100-3. Form 706 must state at the top that the return is “FILED PURSUANT TO REV. PROC. 2017-34 TO ELECT PORTABILITY UNDER §2010(c)(5)(A).” 6

Caution. An estate that files late, but within the extended deadlines of Rev. Proc. 2017-34, cannot rely on the revenue procedure if it later learns that it should have filed a Form 706. If a valid late election is made and results in a refund of estate or gift taxes for the surviving spouse, the time period for filing for a refund is not extended from the normal statutory periods. In addition, a claim for a tax refund or credit is treated as a protective claim for a tax credit or refund if it is filed within the time period of §6511(a) by the surviving spouse or the surviving spouse’s estate in anticipation of Form 706 being filed to elect portability under Rev. Proc. 2017-34.

The regulations allow the surviving spouse to use the DSUE before the deceased spouse’s return is filed (and before the amount of the DSUE is established).20 However, the DSUE amount is subject to audit until the statute of limitations expires on the surviving spouse’s estate tax return.21 The regulations do not address whether a presumption of survivorship can be established. Thus, there is no guidance on what happens if both spouses die at the same time and the order of death cannot be determined. In that situation, the question remains as to whether the IRS would respect estate planning documents that include a provision for simultaneous deaths. If the IRS does not respect the will or trust language, guidance would be needed to determine which estate is allowed a DSUE amount. Example 1. Earl and Alice, a married couple, died in a plane crash. Their estate planning documents provide that Alice is presumed to have survived Earl. If the IRS respects the documents, Alice’s estate could add the DSUE amount from Earl’s estate to her exclusion amount. Also, if their estate plans established a qualified terminable interest property (QTIP) trust in favor of Alice’s children (Alice has children from a prior marriage), the ported-over DSUE from Earl would likewise be sheltered.

16. IRC §2010(c)(5)(A); Treas. Reg. §20.2010-2(a)(1). 17. See Form 706. 18. Rev. Proc. 2014-18, 2014-7 IRB 513. 19. Rev. Proc. 2017-34, 2017-26 IRB 1282. 20. Treas. Reg. §20.2010-3(ii). 21. Temp. Treas. Regs. §§20.2010-3T(c)(1) and 25.2505-2T(d)(1).

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Form 706 Requirements. Treas. Reg. §20.2010-2 requires that the DSUE election be made by filing a complete and properly prepared Form 706. Treas. Reg. §20.2010-2(a)(7)(ii)(A) permits the “appointed” executor who is not otherwise required to file an estate tax return to use the executor’s “best estimate” of the value of certain property and then report on Form 706 the gross amount in aggregate, rounded up to the nearest $250,000.22 Treas. Reg. §20.2010-2(a)(7)(ii) sets forth simplified reporting for particular assets on Form 706, which allows for good faith estimates. The simplified reporting rules apply to estates that do not otherwise have a filing requirement under IRC §6018(a). Consequently, if the gross estate exceeds the basic exclusion amount ($5.49 million in 2017), simplified reporting cannot be used. Simplified reporting is only available for marital and charitable deduction property (under IRC §§2056, 2056A, and 2055). It is not available for such property if any of the following conditions apply.23 • The value of the involved property relates to, affects, or is needed in order to determine the value passing from the decedent to another recipient. • The value of the property is needed to determine the estate’s eligibility for alternate valuation, special-use valuation, estate tax deferral, or other Code provisions. • Less than the entire value of an interest in property includible in the decedent’s gross estate is marital deduction property or charitable deduction property. • A partial QTIP election or a partial disclaimer is made with respect to the property that results in less than all of the involved property qualifying for the marital or charitable deduction (i.e, property passing outright to the surviving spouse or a charity). Assets reported under the simplified method are listed on the applicable Form 706 schedule without any value entered in the column for “Value at date of death.”24 The sum of the asset values included in the return under the simplified method are rounded up to the next $250,000 increment and reported on lines 10 and 23 of part 5 of Form 706 (as assets subject to the special rule of Treas. Reg. §20.2010-2(a)(7)(ii)). In addition to listing the assets on the appropriate schedules, the regulations require that the following must be provided for each asset.25 1. Property description 2. Evidence of ownership of the property (i.e., a copy of a deed or account statement) 3. Evidence of the beneficiary of the property (i.e., copy of beneficiary statement) 4. Information necessary to establish that the property qualifies for the marital or charitable deduction (i.e., copy of the trust or will)

Caution. These documentation requirements are not included in the Form 706 instructions, but the regulations require the reporting of these items. Example 1 under Treas. Reg. §20.2010-2(a)(7)(ii)(C) provides that a return is properly filed if it includes such documentation and proof of ownership. The question arises as to whether this means, at least by implication, that a return is not properly filed if it does not contain such documentation.

22. See Instructions for Form 706. 23. Treas. Reg. §20.2010-2(a)(7)(ii)(A). 24. See Instructions for Form 706. 25. Treas. Reg. §20.2010-2(a)(7)(ii)(A).

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The statute of limitations for assessing additional tax on the estate tax return is the later of three years from the date of filing or two years from the date the tax was paid. The IRS can examine the DSUE amount at any time during the period of the limitations as it applies to the estate of the deceased spouse. Treas. Reg. §20.2010-2(d) allows the IRS to examine the estate and gift tax returns of each of the decedent’s predeceased spouses. Any materials relevant to the calculation of the DSUE amount, including the estate tax (and gift tax) returns of each deceased spouse, can be examined. Consequently, a surviving spouse needs to retain appraisals, work papers, documentation supporting the good-faith estimate, and all intervening estate and gift tax returns to substantiate the DSUE amount.

Note. Because the election to utilize portability allows the IRS an extended timeframe to question valuations, the use of a bypass/credit shelter trust that accomplishes the same result for many clients may be a preferred approach.

Example 2. Herman and Miriam were married for 12 years when Herman died in February 2014. Their marriage was the second one for each of them. Herman and his first wife did not have any children, while Miriam has three children with her first husband. Miriam’s first husband was an executive with a large U.S. corporation and died with a significant investment portfolio, including shares of his employer. His estate was very well planned and his assets were allocated between Miriam and a standard bypass trust. Miriam’s assets (excluding assets in the bypass trust) are now valued at approximately $7 million. Herman died with 6 $630,000 in assets. Due to the recent rise in the stock market, Miriam realizes that her estate will likely be liable for federal estate tax. Her tax advisor suggested that Herman’s estate should have elected portability. Miriam, as executor of Herman's estate, may make a late election under the provisions of Rev. Proc. 2017-34. Herman’s will bequeathed his property to nieces and nephews due to Miriam's strong financial position. At death, the value of his assets are as follows.

Cash $200,000 Stocks and bonds 190,000 Condo at Lake of the Ozarks 240,000 Gross estate $630,000

Herman made no taxable gifts during his lifetime. The calculation of the DSUE is shown on part 6 of the following Form 706.

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For Example 2

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For Example 2

Role for Traditional Bypass/Credit Shelter Trusts. Portability, at least in theory, can allow the surviving spouse’s estate to benefit from a step-up in basis with little (and possibly zero) transfer tax cost. A traditional bypass/credit shelter trust approach can largely accomplish the same result. Under this approach, an amount tied to the applicable estate tax exclusion at the time of death is left to the surviving spouse in trust for life. The balance in the estate of the first spouse to die passes to the surviving spouse outright and qualifies for the marital deduction. The result is that the estate of the first spouse to die escapes estate tax. In addition, the property passing to the credit shelter trust is included in the estate of the first spouse to die and qualifies for a basis step-up in the hands of the surviving spouse. While traditional bypass/credit shelter trust estate plans still have merit, for many clients (married couples whose total net worth does not exceed twice the applicable exclusion), such trusts could result, over time as the applicable exclusion increases by inflation, in the underfunding of the marital trust. For wealthy clients with large estates that are above the applicable exclusion (or are expected to be at the time of death), one planning option might be to use the DSUE in the surviving spouse’s estate to fund a contribution to an IDGT. The DSUE is applied against a surviving spouse’s taxable gift first before reducing the surviving spouse’s applicable exclusion amount. Thus, an IDGT would provide the same estate tax benefits as the bypass trust but the assets would be taxed to the surviving spouse as a grantor trust. Therefore, the trust assets would appreciate outside of the surviving spouse’s estate.

Note. Portability planning is slightly less appealing to couples in community property states because, as discussed later, all community property gets a step-up in basis at the first spouse’s death.

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Multiple DSUEs. A surviving spouse can utilize multiple DSUEs by outliving multiple spouses when the DSUE election is made in each of those spouse’s estates. To accomplish this, the surviving spouse must make gifts and exhaust the DSUE of the last deceased spouse before the next spouse dies.26 Example 3. Harry died in 2011 and is survived by Wilma.27 Neither Harry nor Wilma made any taxable gifts during Harry’s lifetime. Harry’s executor elected portability of his DSUE amount. The DSUE amount as calculated on Harry’s estate tax return was $5 million. In 2012, Wilma made taxable gifts to her children valued at $2 million. She reported the gifts on a timely filed gift tax return. Wilma is considered to have applied $2 million of Harry’s DSUE amount to the 2012 taxable gifts. Therefore, Wilma owed no gift tax. Wilma has an applicable exclusion amount of $8.12 million ($3 million of Harry’s remaining DSUE + $5.12 million of Wilma’s 2012 exclusion amount). In 2013, Wilma married George. George died on June 30, 2015. George’s executor elected portability of the DSUE amount, which was properly computed on George’s estate tax return as $2 million. The DSUE amount included in determining the applicable exclusion amount available to Wilma for gifts during the second half of 2015 is $4 million. The amount is calculated by adding George’s $2 million DSUE amount and Harry’s $2 million DSUE amount that was applied by Wilma to her 2012 taxable gifts. Thus, Wilma’s applicable exclusion amount during the balance of 2015 is $9.43 million ($4 million DSUE + $5.43 million of Wilma’s basic exclusion amount for 2015).

TRANSFER TAX COST VS. BASIS STEP-UP

As noted previously, an initial estate planning step for many taxpayers is determining the potential transfer tax costs as compared to the income tax savings from a step-up in basis. The comparison is imperfect because the applicable exclusion will continue to be adjusted for inflation or deflation. The rate of inflation or deflation and the client’s remaining lifespan are uncontrollable variables. Additionally, as indicated previously, the tax structure of the state in which the decedent and beneficiaries are domiciled is a factor. Under current law, the majority of estates are not subject to federal estate tax at death. However, a basis increase under IRC §1014 for assets included in the gross estate is typically viewed as more important than avoiding federal estate tax. Under §1014, the basis of property in the hands of the person acquiring the property from a decedent or to whom the property passed from a decedent “shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be the fair market value of the property at the date of the decedent’s death.”28 The only exceptions to the FMV at date of death rule are for property subject to a special-use valuation election, an alternate valuation date election, or to the extent property is excluded from the gross estate by virtue of a qualified conservation easement.29 The federal estate tax and basis step-up are not necessarily connected. The federal income tax was enacted in 1913 and the federal estate tax was enacted in 1916. As originally enacted, neither the income tax nor the estate tax made any provision for the basis of assets received from a decedent’s estate. It was not until the Revenue Act of 1921 that there was a rule concerning the basis of assets passing at death. Later, Congress added various “string” provisions to the federal estate tax, and the basis rules began to track the estate tax. 30

26. Treas. Reg. §25.2505-2(c). 27. Example adapted from Treas. Reg. §25.2505-2(c). 28. IRC §1014(a)(1). 29. IRC §1014(a).

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Observation. It is possible that future legislation could eliminate the federal estate tax and retain basis step- up at death. In that case, ensuring a basis increase at death for the decedent’s assets will be of primary importance to heirs. However, while §1014(b)(9) covers all property included in a decedent’s gross estate under Chapter 11 and probate assets are covered by §1014(b)(1), Congress would have to clarify the type of nonprobate assets to which basis step-up applies.30

BASIS STEP-UP BENEFITS The only way to capture the income tax benefits of the stepped-up basis adjustment is for the recipients of those assets to dispose of them in a taxable transaction. This raises several questions that the estate planner must consider. • Is the asset of a type (such as a farm, ranch, or other closely held family business) that the heirs may never sell, or may sell in the very distant future? • Is the asset depreciable or subject to depletion? • Is the involved asset an interest in a pass-through entity such as a partnership or an S corporation? Exceptions to the Basis Step-Up Rule 6 As noted previously, there are exceptions to the general rule that basis is determined as of the date of death. • If the estate executor elects alternate valuation under IRC §2032, then basis is established as of the alternate valuation date. • If the estate executor elects special-use valuation under §2032A, the value of the elected property as reported on the federal estate tax return establishes the basis in the hands of the heirs. This is true even though the executor and the IRS agree to value the elected land at less than what would otherwise be allowed by statute (for deaths in 2017, the maximum statutory value reduction for elected land is $1.12 million).31 32

Caution. In Van Alen v. Comm’r,32 the petitioners were children of a decedent who died in 1994. They were beneficiaries of a residuary testamentary trust that received most of the decedent’s estate, including a 13/16 interest in a cattle ranch. The ranch value was reported on the estate tax return at substantially less than FMV, in accordance with §2032A. The petitioners signed a consent agreement agreeing to personal liability for any additional taxes imposed as a result of the sale of the elected property or cessation of qualified use. The IRS disputed the reported value, but the matter was settled. Years later, the trust sold an easement on the ranch that restricted development. The gain on the sale of the easement was reported with reference to the §2032A value. Schedules K-1, Beneficiary’s Share of Income, Deductions, Credits, etc., were issued showing that the proceeds were distributed to the beneficiaries. The beneficiaries did not report the gain as reflected on the Schedules K-1. They asserted that the ranch was undervalued on the estate tax return and that the gain reportable should be reduced by using a FMV tax basis. The court determined that the §2032A value establishes the basis of the elected property via §1014(a)(3). The court upheld the consent agreement. An accuracy-related penalty was imposed because tax advice was sought only after the petitioners failed to report any gain.

30. This includes assets in a revocable trust, assets subject to a general power of appointment by the decedent to appoint the assets to the decedent’s creditors or estate, and assets that would have been included in the estate by virtue of IRC §§2034–2042. Also, whether assets included in a QTIP trust would be entitled to a basis step-up at the time of the surviving spouse’s death would need to be clarified by an amendment to §1014(b). 31. Rev. Proc. 2016-55, 2016-45 IRB 707. 32. Van Alen v. Comm’r, TC Memo 2013-235 (Oct. 21, 2013).

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• A carryover basis applies to land subject to a qualified conservation easement that is excluded from the gross estate under IRC §2031(c).33 • Property that constitutes income in respect of a decedent (including unrecognized interest on U.S. savings bonds, accounts receivable for cash basis taxpayers, qualified retirement plan assets, and IRAs) does not receive a basis step-up. • There is also no basis step-up for appreciated property (determined on the date of the gift) that was gifted to the decedent within one year of death that is then transferred back to the original donor of such property (or the spouse of the donor). In this situation, the donor receiving the property back takes the basis that the decedent had in the property immediately before the date of death.34

Community Property Considerations Estates in community property states have an advantage over estates in separate property states. The ownership portion of a couple’s community property that is attributable to the surviving spouse by virtue of §1014(b)(6) gets a new basis when the first spouse dies if at least half of the community property is included in the decedent’s estate for federal estate tax purposes. This means that there is a basis adjustment of both the decedent’s and surviving spouse’s half of community property at death if at least half of the community property was included in the decedent’s gross estate for federal estate tax purposes. If future legislation repeals the federal estate tax, a question will arise as to whether the so-called “double basis step-up” for community property will survive. 35

Note. The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Two common-law property states, Alaska and Tennessee, allow couples to convert or elect to treat their property as community property.35 In these states, resident and nonresident couples can classify property as community property by transferring the property to a qualifying trust. For nonresidents, a qualifying trust requires at least one trustee who is a resident of the state or a company authorized to act as a fiduciary, and specific trust language declaring the trust asset as community property.

Currently, sixteen states (Alaska, Arkansas, Colorado, Connecticut, Florida, Hawaii, Kentucky, Michigan, Minnesota, Montana, New York, North Carolina, Oregon, Utah, Virginia, and Wyoming) have enacted the Uniform Disposition of Community Property Rights at Death Act (UDCPRDA).36 Under the UDCPRDA, when the first spouse dies, half of the community property is considered the property of the surviving spouse and the other half is considered to belong to the deceased spouse. However, a couple can change their interests in the property37 and can adopt an estate plan that controls the inheritance of their property. One drawback is that there are not any cases or IRS rulings on the impact of the UDCPRDA on basis step-up under IRC §1014(b)(6).38

Observation. Because the unlimited marital deduction under IRC §2056 essentially gives couples in community property states the ability to avoid transfer taxes on the first spouse’s death, this step-up in basis provides an immediate income tax savings for the surviving spouse’s benefit. This changes the planning dynamic as compared to similarly situated taxpayers in noncommunity property states.

33. IRC §1014(a)(4). 34. IRC §1014(e). 35. Marriage & Property Ownership: Who Owns What? NOLO. [www.nolo.com/legal-encyclopedia/marriage-property-ownership-who-owns- what-29841.html] Accessed on Aug. 1, 2017. 36. Legislative Fact Sheet – Disposition of Community Property Rights at Death Act (1971). Uniform Law Commission. [www.uniformlaws.orgLegislativeFactSheet.aspx?title=Disposition%20of%20Community%20Property%20Rights%20at%20Death%20A ct%20(1971)] Accessed on Jul. 18, 2017. 37. UDCPRDA, Sec. 8. 38. Preamble to Uniform Disposition of Community Property Rights at Death Act.

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Suggested Approach. The following is a suggested estate planning approach for married couples in community property states when the emphasis is on achieving a stepped-up basis. • There should be minimal gifting of assets during the lifetimes of both spouses so that the maximum value of assets is included in the estates, where they will be eligible for a basis increase under §1014(b)(6). • After the death of the first spouse, if the value of the survivor’s gross estate exceeds the available applicable exclusion, strategies should be utilized to reduce the potential estate tax in the survivor’s estate consistent with the surviving spouse’s goals. Such strategies may involve income tax planning, planning to avoid or at least take into account the NIIT, gifting, the use of entities to create minority interest and lack of marketability discounts, and discounts for built-in capital gain (applicable to S corporations).

PLANNING TECHNIQUES TO ACHIEVE INCOME TAX BASIS STEP-UP The disparate treatment of community and common law property has motivated estate planners to come up with techniques designed to achieve a basis step-up for the surviving spouse’s common law property at the death of the first spouse. These techniques are summarized as follows. • General power of appointment is given to each spouse over the other spouse’s property that causes, on the death of the first spouse, the deceased’s spouse’s property to be included in the decedent’s estate by virtue of IRC §2033 (if owned outright) and IRC §2038 (if owned in a revocable trust). The surviving spouse’s 6 property is also included in the decedent’s estate by virtue of IRC §2041. The power held by the first spouse to die terminates upon the first spouse’s death and is deemed to have passed at that time to the surviving spouse.39 • Both spouses contribute their property to a joint exempt step-up trust (JEST)40 that holds the assets as a common fund for the benefit of both spouses. Either spouse may terminate the trust while both are living, in which case the trustee distributes half of the assets back to each spouse. If there is no termination, the JEST becomes irrevocable upon the first spouse’s death. Upon the first spouse’s death, all assets are included in that spouse’s estate and assets equal in value to the first spouse’s unused exclusion are used to fund a bypass trust for the benefit of the surviving spouse and descendants. These bypass trust assets receive a stepped-up basis and are not included in the surviving spouse’s estate. Any asset in excess of the funding of the bypass trust goes into an electing QTIP trust. If the deceased spouse’s share of the trust is less than the available exclusion, then the surviving spouse’s share is used to fund a bypass credit shelter trust. These assets avoid estate taxation at the surviving spouse’s death. 41 42 43 44

39. The Optimal Basis Increase and Income Tax Efficiency Trust. Morrow III, Edwin P. Jan. 2016. [https://papers.ssrn.com/sol3/ papers.cfm?abstract_id=2436964] Accessed on Aug. 4, 2017. 40. Jest Offers Serious Estate Planning Plus for Spouses—Part 1. Gassman, Alan; Denicolo, Christopher; and Hohnadell, Kacie. Oct. 22, 2013. Gassman, Crotty, & Denicolo, PA. [http://gassmanlaw.com/wp-content/uploads/2013/10/JEST-Offers-Serious-Estate-Planning-Plus-for- Spouses.pdf] Accessed on Jun. 7, 2017.

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Note. IRC §1014(e) may operate to prevent the planning benefits of these techniques. Under §1014(e), property with an FMV that exceeds its basis at the time of the transfer may be ineligible for a basis step-up. The property is ineligible if the transferee dies within one year of the transfer and, as a result of the transferee’s death, the transferred property is “acquired from” the transferee by the original transferor or “passes from” the transferee to the original transferor under §1014(e). The primary question is whether §1014(e) applies to the GPOA held by a deceased spouse over the surviving spouse’s interest in trust property. The IRS ruled against this technique in a 1993 letter ruling.41 The IRS disallowed a basis increase to the surviving spouse’s half interest in a trust because §1014(e) requires relinquishment of dominion and control over the property transferred to the decedent at least one year before death. Because the surviving spouse (the donor) could revoke the joint revocable living trust at any time, the surviving spouse had dominion and control over the trust assets during the year before and up to the time of the decedent spouse’s death. The IRS ruled similarly in Ltr. Rul. 200101021.42 Although the 1993 letter ruling has been criticized,43 there is also support for the IRS’s position.44 Clearly, complex planning is required to achieve the desired result. The administration of trusts always requires care. The level of care is elevated for estate planning techniques designed to increase basis for common law property equivalent to community property.

• Many married couples have the traditional bypass/credit shelter trust estate planning arrangement. Many of those couples now have assets less than the estate tax exemption amounts. In a traditional bypass/credit shelter trust, the assets held in the bypass trust normally receive a step-up in basis upon the death of the first spouse. No step-up in basis would occur on the second spouse’s death. A strategy to obtain a stepped-up basis on assets held in the bypass trust on the second spouse’s death involves making QTIP and DSUE elections on a federal estate tax return for the first spouse to die. This strategy assumes the bypass trust is eligible for the QTIP election.45 Estate of Olsen v. Comm’r46 illustrates the perils of not properly administrating trusts. In the case, a married couple had revocable living trusts with identical terms that would be split on death into a marital trust and then two marital subtrusts. Mrs. Olsen’s trust contained assets valued at approximately $2.1 million at the time she died. At that time, the federal estate tax exemption was $600,000. The trust specified that the trust assets were to be divided into a pecuniary marital trust and a residuary credit shelter trust. Mr. Olsen, in his role as executor, did not transfer the assets as directed. In addition, the marital trust was to be divided into GSTT-exempt and non-exempt trusts. Mr. Olsen (the decedent in this case) had a limited power of appointment over principal from the credit shelter trust to appoint principal to his children, grandchildren, or charities. After his wife’s death, Mr. Olsen made over $1 million in withdrawals from the revocable living trust principal for charitable distributions and claimed charitable deductions on his personal return. He also withdrew other funds for distribution to his children and grandchildren.

41. Ltr. Rul. 9308002 (Nov. 16, 1992). 42. Ltr. Rul. 200101021 (Oct. 2, 2000). 43. See, e.g., Zaritsky, Running With the Bulls: Estate Planning Solutions to the “Problem” of Highly Appreciated Stock, 31-14 University of Miami Law Center on Estate Planning §1404; Williams, Stepped-Up Basis in Joint Revocable Trusts, Trusts & Estates (June 1994). 44. See, e.g., Keydel, Question and Answer Session II of the Twenty-Eighth Annual Institute on Estate Planning, 28-20, University of Miami Law Center on Estate Planning §2007. 45. Rev. Proc. 2016-49, 2016-42 IRB 462. 46. Estate of Olsen v. Comm’r, TC Memo 2014-58 (Apr. 2, 2014).

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After Mr. Olsen’s death in 2008 (when the exemption was $2 million), the revocable living trust contained over $1 million in assets. The estate took the position that all withdrawals had been from the marital trust (which were subject to an ascertainable standard) such that Mr. Olsen’s gross estate value was zero. The IRS claimed that withdrawn amounts were attributable to the credit shelter trust and included in Mr. Olsen’s gross estate or, in the alternative, were pro rata withdrawals. The IRS assessed an estate tax deficiency of $482,051. The Tax Court determined that the charitable gifts were from the credit shelter trust via Mr. Olsen’s limited power of appointment. It also determined that the other distributions were from the marital trust as discretionary distributions. The Tax Court rejected the estate’s argument that Treas. Reg. §20.2044-1(d)(3) applied. The court also determined that Mr. Olsen’s limited power of appointment to donate to charity from the credit shelter trust was exercisable during his life. The court noted that distributions from principal could only come from the marital trust. The value of Mr. Olsen’s gross estate was determined by subtracting all personal withdrawals from the value of remaining trust assets. The end result was an increase in tax liability of approximately $250,000. As mentioned earlier, there is uncertainty over the future of the federal estate tax and basis step-up. If the estate tax is repealed along with basis step-up (i.e, no estate tax and carryover basis), the planning process will require additional considerations such as the following. • Lifetime transfers of appreciated assets would not lose a basis adjustment at the transferor’s death. 6 • A carryover basis system could have a serious negative impact on taxpayers that have depreciated assets, refinanced their assets, or engaged in a tax-deferred exchange. If the assets were currently liquidated, the income tax liability could be large, and there would be no opportunity to escape that tax liability by achieving a basis step-up at death.

TRANSFEREE LIABILITY

Upon a decedent’s death, any liabilities for deficiencies on the decedent’s tax returns do not disappear. The decedent’s estate, in essence, is liable for the decedent’s tax deficiency at the time of death. Individuals receiving assets from a decedent take the assets subject to the claims of the decedent’s creditors — including the government. Asset transferees are liable for taxes due from the decedent to the extent of the assets that they receive. A trust can be liable as a transferee of a transfer under IRC §6901 to the extent provided in state law.47 The courts addressed transferee liability issues in several recent cases. •In U.S. v. Mangiardi,48 the court held that the IRS could collect estate tax more than 12 years after taxes were assessed. Mr. Mangiardi died in 2000. He owned a revocable trust worth approximately $4.58 million and an IRA worth $3.86 million. The estate tax was approximately $2.48 million. Four years of extensions were granted due to a market value decline of publicly traded securities. The estate paid estate taxes of $250,000, and the trust had insufficient assets to pay the balance. The IRS sought payment of tax from the transferee of an IRA under IRC §6324. The court held that the IRS was not bound by the 4-year assessment period of IRC §§6501 and 6901(c) and could proceed under IRC §6324 (10-year provision). The 10-year provision was extended by the 4-year extension period previously granted to the estate, and IRA transferee liability was derivative of the estate’s liability. The court held that it was immaterial that the transferee may not have known of the unpaid estate tax. The amounts withdrawn from the IRA to pay the estate tax liability were also subject to income tax in the transferee’s hands. The court also held that while an income tax deduction for estate taxes attributable to the IRA was available under IRC §6901(c), the deduction could be limited due to the failure to match the tax years of the deduction and the income.

47. See, e.g., Frank Sawyer Trust of May 1992 v. Comm’r, TC Memo 2014-59 (Apr. 3, 2014). 48. U.S. v. Mangiardi, 9:13-cv-80256 (S.D. Fla. Jul. 22, 2013).

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•In U.S. v. Tyler,49 a married couple owned real estate as tenants by the entirety (a special form of marital ownership recognized in some states). Mr. Tyler owed the IRS $436,849 in income taxes. He transferred his interest in the real estate to his wife for $1, and the IRS then placed a lien on the real estate. Mr. Tyler died with no distributable assets and no other assets with which to pay the tax lien. Mrs. Tyler died within a year of her husband’s death and the property passed to their son, the defendant in the case. Mr. Tyler was named as a co- executor of his mother’s estate. The IRS claimed that the tax lien applied to the real estate before legal title passed to Mrs. Tyler and that the executors had to satisfy the lien out of the assets of her estate. The executors conveyed the real estate to Mr. Tyler for $1 after receiving letters from the IRS asserting the lien. Mr. Tyler later sold the real estate and invested the proceeds in the stock market, subsequently losing his investment. The IRS brought a collection action for 50% of the sale proceeds from the executors. The trial court ruled for the IRS and the appellate court affirmed. Under the federal claims statute, the executor has personal liability for the debts and obligations of the decedent. The fiduciary who disposes of the assets of an estate before paying a governmental claim is liable to the extent of payments for unpaid governmental claims if the fiduciary distributes the estate assets, the distribution renders the estate insolvent, and the distribution takes place after the fiduciary had actual or constructive knowledge of the liability for unpaid taxes. • U.S. v. Whisenhunt50 is another case that points out that an executor has personal liability for unpaid federal estate tax when the estate assets are distributed before the estate tax is paid in full. IRC §7402 controlled, and the executor was personally liable for $526,507 in delinquent federal estate tax and penalties, which was the amount of the distribution at the time of the decedent’s death.

IRS GUIDANCE ON DISCHARGING ESTATE TAX LIENS In Treasury Memo SBSE-05-0417-0011, issued on April 5, 2017, the IRS provided interim guidance to its estate tax lien advisory group concerning applications or requests for discharge of the federal estate tax lien that are made after June 2016. Upon death, the assets in a decedent’s gross estate are subject to a federal estate tax lien under IRC §6324(a). The lien arises before any estate tax is assessed and is an unrecorded (“silent”) lien that exists for 10 years from the date of a decedent’s death. The lien is in addition to the regular federal estate tax lien of IRC §6321, which arises upon the assessment of tax. The lien can be discharged by making a request via Form 4422, Application for Certificate Discharging Property Subject to Estate Tax Lien. The lien is discharged if the IRS determines that it has been fully satisfied or provided for. Form 792, United States Certificate Discharging Property Subject to Estate Tax Lien, is used to discharge the lien from particular property under IRC §6325(c). The lien is typically “waived” in approximately 10 days. However, beginning in June 2016, all applications for discharge of liens are processed through Specialty Collection Offers, Liens and Advisory, in the estate tax lien group. When the IRS accepts a filed Form 4422, the entire net proceeds of estate asset sales are either to be deposited with the IRS or held in escrow by the estate’s legal counsel until the IRS issues a closing letter or determines that the federal estate tax return will not be audited. The amount deposited with the IRS or held in escrow is the full amount of net proceeds remaining after the amount necessary to pay tax on the proceeds of sale. The interim guidance to the Special Advisory Group explains how to handle lien discharge requests. Under applicable regulations, if the appropriate official determines that the tax liability for the estate has been fully satisfied or adequately provided for, a certificate that discharges the property from the lien may be issued. The interim guidance provides instructions on who within the IRS is consulted and will provide assistance in handling lien discharge requests. It also states which Code sections apply. The interim guidance also notes that Letter 1352, Request for Discharge of Estate Tax Lien, is issued when an estate does not have a filing requirement. Additionally, the interim guidance notes the procedures utilized to substantiate facts for nontaxable estates. The interim guidance also notes the circumstances when an escrow or payment will or will not be required.

49. U.S. v. Tyler, No. 12-2034, 2013 U.S. App. LEXIS 11722 (3rd Cir. Jun. 11, 2013). 50. U.S. v. Whisenhunt, No. 3:12-CV-0614-B (N.D. Tex. Mar. 25, 2014).

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BASIS OF ASSETS IN ESTATES

DATE OF DEATH VALUATION AND ALTERNATE VALUATION Under the general rule, the basis of an inherited asset from a decedent is the FMV of the asset on the decedent’s date of death. There are exceptions to this general rule, including income in respect of the decedent (IRD) and certain gifts of appreciated property acquired by the decedent by gift within one year of death.51

Note. For an extensive discussion regarding basis for inherited assets, see the 2013 University of Illinois Federal Tax Workbook, Volume B, Chapter 3: Advanced Individual Issues. The chapter includes sections on inherited assets, inheriting retirement assets, inheriting a partnership interest, and inheriting S corporation stock. This can be found at uofi.tax/arc [taxschool.illinois.edu/taxbookarchive].

The executor of an estate may choose to use the FMV on the date of death or on the alternate valuation date when filing Form 706.52 The alternate valuation date is six months after the date of death. The alternate valuation election may only be made if it lowers the overall value of the estate, lowers the estate tax, and is used for all assets in the estate. If the executor makes an alternate valuation date election, the beneficiary’s basis is equal to the FMV of the property as of the alternate 6 valuation date. Because the executor can make an alternate valuation election only if the value of the property in the gross estate and the federal estate tax liability are both reduced by making the election,53 the decedent’s gross estate must be a taxable estate. The purpose of alternate valuation is to reduce the federal estate tax burden if values decline in the 6-month period immediately following death. In that event, the estate can be valued up to six months after death.

Observation. If an estate is not subject to federal estate tax, an alternate valuation election could allow the estate’s heirs to obtain a higher income tax basis on property included in the gross estate if values increased after the decedent’s death. That is not permissible.

Alternate valuation is usually straightforward — there is one value as of the date of death and a different value six months after death.54 However, in some estates, events can occur during the 6-month period immediately following the decedent’s death that add complications to the valuation. This is a particular concern for an agricultural estate. For example, a decedent may have planted a crop shortly before death that was harvested and sold within six months after death. Or, perhaps the decedent had cows that were bred before the date of death, calved after death, and were sold after the 6-month period following death. Determining whether these types of property are subject to alternate valuation requires a determination of “included” and “excluded” property for purposes of the election. Included property is all property that is in existence at the decedent’s death. Under an alternate valuation election, included property is valued six months after death or as of the date of sale, whichever comes first. Thus, crops that are growing as of the date of death and are harvested and sold after death are valued as of the earlier of six months after death or the date of sale.

51. IRC §1014. 52. IRC §2032. 53. Treas. Reg. §§20.2032-1(a)(1) and (b)(1). 54. Treas. Reg. §20.2032-1(d).

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A unique situation exists for property that is included as of the date of death and is disposed of gradually during the 6- month period after death. For example, in the case of silage that is used as feed during the 6-month period following death, every day’s feeding event is a disposition. Thus, a calculation must be made not only as to the value, but as to how much was used. The same is true of shelled corn, hay, or similar items. The inventory must show the usage over that time period, and some value must be attached to it.55 Conversely, property that came into existence after the decedent’s death, but during the alternate valuation period, such as crops planted after death, are ignored for purposes of alternate valuation. This property is termed excluded property.56 56

BASIS CONSISTENCY RULES The Surface Transportation and Veterans Health Care Improvement Act of 2015 (Act) added IRC §6035 to the Code. IRC §6035 specifies that estates required to file a federal estate tax return (Form 706) after July 31, 2015,57 must provide basis information to the IRS and estate beneficiaries. The information must be provided by the earlier of 30 days after the due date of Form 706 (including extensions, if granted) or 30 days after the actual filing date of Form 706. This ensures that beneficiaries of estate assets use the same basis amounts when they subsequently sell the assets that were used in the decedent’s estate. The IRS moved the initial statutory filing deadline of August 31, 2015, forward to February 29, 2016,58 and then to March 31, 2016.59 However, the IRS failed to timely issue proposed regulations (and a temporary regulation). It waited until early March 2016 (in the middle of tax filing season) to do so, mere days before the filing deadline.60 As a result, practitioners had very little time to study the proposed regulations. Consequently, in late March, the IRS delayed the filing deadline to June 30, 2016.61 The new rules include the following. 1. Specify that the basis of property subject to the new rules cannot exceed the final value as determined for estate tax purposes in a decedent’s estate62 2. Impose a reporting requirement with regard to the value of property included in a decedent’s gross estate63

Filing Requirement IRC §6035(a)(1) requires an executor of an estate that is required to file a Form 706 (other than for the sole purpose of electing portability) to furnish a statement to the IRS and each person acquiring any interest in the estate property. The statement should provide the value of each interest in the inherited property as reported on Form 706, along with any other information that the IRS might require.64

55. Ibid. 56. Ibid. 57. IRS Notice 2015-57, 2015-36 IRB 294. 58. By statute, the filing deadline was August 31, 2015, for executors who either filed or should have filed Form 706 on August 1, 2015 (PL 114-41, §2004). However, there was no way to comply with the law without forms on which to report the required information, which had not been released. Thus, the IRS issued Notice 2015-57 stating that any reports due before February 29, 2016, should not be filed before that date. 59. IRS Notice 2016-19, 2016-09 IRB 362. 60. REG-127923-15, 2016-12 IRB 473 and Temp. Treas. Reg. §1.6035-2T were issued Mar. 4, 2016. Temp. Treas. Reg. §1.6035-2T merely specifies the due date of the relief that was provided in IRS Notice 2016-19, 2016-9 IRB 362. 61. IRS Notice 2016-27, 2016-15 IRB 567. 62. IRC §1014(f)(1). 63. IRC §6035(a). 64. IRC §6035(a)(2). Any statement filed under IRC §6035 is subject to the failure to file penalties contained in IRC §§6721 and 6722.

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An estate executor must:65 1. Furnish a statement (Form 8971, Information Regarding Beneficiaries Acquiring Property From a Decedent, and the accompanying Schedule A) to the IRS identifying the reported value of each asset that was included in the gross estate; and 2. Provide that information (Schedule A of Form 8971) to each person who acquired the interests and identify those individuals in the report to the IRS.

Form 8971 Information required to be furnished to the IRS and beneficiaries is reported on Form 8971. A filed Form 8971 should include a copy of each Schedule A. The beneficiaries must also receive Schedule A. Form 8971 and the attached Schedules A are not to be filed with Form 706. As mentioned earlier, Form 8971 is filed within the earlier of 30 days of the due date of the Form 706 or within 30 days of when Form 706 is actually filed.66 The Form 8971 instructions state that basis information statements are due within 30 days of the filing date if Form 706 is not filed in a timely manner. In addition, if an adjustment is made to Form 706, a supplemental basis information statement must be filed within 30 days of filing the adjusted Form 706. 6 Note. In many situations, estates (and trusts that are related to estates) have not proceeded through the administration process sufficiently within 30 days of filing the Form 706 to be able to determine the heirs that are to receive particular assets. Determining value is one task, but interpreting will and trust language to determine who gets each item of property is a completely different task.

The Form 8971 instructions direct an executor to report all of the potential assets that a beneficiary might inherit on Schedule A.67 In addition, after the executor knows the actual asset allocation to the beneficiaries, the executor files an updated Form 8971.68

Observation. For large estates, any beneficiary could receive a rather lengthy Schedule A and might assume that they are inheriting all the assets listed on the schedule. This assumption is corrected when they receive the updated Form 8971. It would make sense to statutorily change the due date of Form 8971 to either after the time when the actual assets to be distributed to a particular beneficiary are determined or after the distribution to a beneficiary is actually made.

The instructions for Form 8971 state that the form does not need be filed if the only reason for filing it is to elect the GSTT or make a GSTT allocation. However, the instructions are silent on portability. IRC §1014(f)(2) states that the new basis consistency rules only apply to property that increases the estate’s federal estate tax liability (reduced by any credits allowed against the tax). Property passing outright to a surviving spouse that qualifies for the marital deduction and property passing to a charity are not subject to the basis consistency rules because they do not trigger estate tax. Estates that file Form 706 for the sole purpose of electing portability of the unused estate tax exclusion at the death of the first spouse are not required to file Form 8971.

65. IRC §6035; see instructions for Form 8971 and Schedule A. 66. IRC §6035(a)(3)(A). 67. This is consistent with Prop. Treas. Reg. §1.6035-1(c)(3). This will result in duplicate reporting of assets on multiple Forms Schedule A. Also, assets do not have to be reported if they are not “property for which reporting is required.” 68. Instructions for Form 8971.

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Proposed Regulations69 As mentioned earlier, IRC §1014(f)(2) specifies that the application of the basis consistency rule is limited to property that would increase the liability for estate tax (reduced by allowable credits against the tax) if it were included in the decedent’s estate.70 This rule, however, applies only for purposes of the basis consistency rule; it does not apply to the information reporting requirements. Likewise, Prop. Treas. Reg. §1.1014-10(b)(2) states that property for which an appraisal is not required under Treas. Reg. §20.2031-6(b) is not subject to the basis consistency requirement.71 In addition, the basis consistency rule does not apply to a nontaxable estate even when Form 706 is required to be filed.72 Thus, if the estate owes no federal estate tax, the basis consistency rules do not apply to any of the estate assets. However, if the taxpayer is over the filing threshold, they must file Form 8971 and Schedule(s) A.73

Note. Example 1 in Prop. Treas. Reg. §1.6035-1(b)(2) indicates the appraisal exception applies to any individual asset that is valued at less than $3,000. However, Treas. Reg. §20.2031-6(b) applies if the total value of articles having marked artistic or intrinsic value exceeds $3,000. The instructions to Form 706 state that an appraisal is required for “works of art,” etc., if any item is valued at more than $3,000.

The proposed regulations allow for post-death changes in basis74 and also apply the basis consistency rules to property that was omitted from Form 706.75 If the omission is discovered and the omitted property is reported on a supplemental Form 706 before the period of limitation on assessment of tax expires, nothing changes. The normal rules on final value apply.76 If the omission is discovered after the statute of limitations expires for assessing estate tax, the beneficiary of the property receives a basis of zero.77 78

Note. There is no statutory authority in §1014(f) for the position taken in the proposed regulations of adjusting basis to zero for omitted assets discovered after the statute of limitations on assessment expires. Additionally, for assets discovered after Form 706 is filed but before the statute of limitations expires, practitioners may not find it worthwhile to file a supplemental Form 706 to avoid a zero basis. This is because no duty exists to report property discovered later with respect to an estate for which Form 706 was filed in good faith. This rule could put an estate executor in conflict. It is not advantageous for the estate to report the newly discovered asset, but the beneficiary will want the asset reported in order to obtain a date-of-death basis.78

69. Prop. Treas. Reg. §1.1014-10. 70. The corresponding regulation is Prop. Treas. Reg. §1.1014-10(b)(1). This means that the basis consistency rule applies to property that is included in a decedent’s estate under either IRC §2031 or IRC §2106 that triggers a federal estate tax that exceeds allowable credits (except for the credit for prepayment of estate tax). 71. Prop. Treas. Reg. §20.2031-6(b) requires an appraisal for “household and personal effects articles having marked artistic or intrinsic value of a total value in excess of $3,000.” Thus, the appraisal requirement generally applies to jewelry, furs, silverware, paintings, etchings, engravings, antiques, books, statuary vases, oriental rugs, and coin or stamp collections. 72. Prop. Treas. Reg. §1.1014-10(b)(3). 73. IRC §6034A(a). 74. Prop. Treas. Reg. §1.1014-10(a)(2). The estate tax value of the property sets the upper limit on the initial basis of the property after the decedent’s death. 75. Prop. Treas. Reg. §1.1014-10(c)(3). 76. Prop. Treas. Reg. §1.1014-10(c)(3)(i)(A). 77. Prop. Treas. Reg. §1.1014-10(c)(3)(i)(B). 78. Basis Consistency Temporary and Proposed Regulations. Akers, Steve. R. Mar. 8, 2016. Bessemer Trust. [www.bessemertrust.com/portal/ binary/com.epicentric.contentmanagement.servlet.ContentDeliveryServlet/Advisor/Presentation/Print%20PDFs/Basis%20 Consistency%20Proposed%20Regulations%20Summary%2004%2004%2016.pdf] Accessed on May 22, 2017.

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The proposed regulations are the sole guidance on the basis consistency rules. As such, they must be relied upon for both the preparation of Form 8971 and the preparation of income tax returns of heirs receiving property subject to the basis consistency rules until final regulations are published. The proposed regulations on the reporting issue include the following provisions.79 • The values reported are the “final values” as reported on Form 706 (or as the IRS later determines or as agreed to or determined by a court). The final value establishes the initial basis with the normal post-death basis adjustments remaining available. If the basis is later determined to be less than the initial reported value, the recipient of the property so valued cannot rely on the value that was listed in the original statement and could have a deficiency and underpayment attributable to the difference.80 • For final values that later change, the estate must file a supplemental information return with the IRS and furnish a supplemental statement to the beneficiary. • Basis reporting for a nonresident, noncitizen decedent applies only to property in the estate that is subject to federal estate tax. • If property is subject to nonrecourse debt, the basis of the property is its gross value (rather than the net value that is reported on Form 706).81 6 • Only the decedent’s half of community property is subject to the basis consistency reporting requirement. However, both halves of the community property receive a basis adjustment in accordance with §1014(b)(6). • Generally, all property reported on Form 706 must be reported on Form 8971. However, there are exceptions for IRD property,82 cash (other than collectible coins and bills) or property for which an appraisal is not required (personal effects of the decedent, for example),83 or property that the estate disposed of that triggered recognition of a capital gain or loss. • If the executor has not identified the property that will be transferred to each beneficiary as of the reporting deadline, the executor must give the beneficiary a list of every asset the beneficiary might receive. After the bequest is funded, a supplemental Schedule A need not be filed with the IRS or the beneficiary.84 • The executor must include a statement concerning any beneficiaries that cannot be located and explain efforts undertaken to locate them. A supplemental filing is required if the property is ultimately distributed to someone else. A supplemental filing is also required to be filed within 30 days of locating the previously unascertained beneficiary.85 • A supplemental Form 8971 must be filed with the IRS and each beneficiary must receive a supplemental Schedule A if previously reported information turns out to be incorrect or incomplete, unless the erroneous information is merely an inconsequential error or omission. As stated in the Form 8971 instructions, an error on Form 8971 that relates to a taxpayer identification number, a beneficiary’s surname, or the value of the asset that a beneficiary is receiving is not inconsequential. Likewise, errors on Schedule A to Form 8971 that relate to the value of an asset that a beneficiary receives from an estate or relate to a “significant item in a beneficiary’s address” are not inconsequential. 86

79. Prop. Treas. Regs. §§1.6035-1 and 2. 80. Prop. Treas. Regs. §§1.6035-1(a)(1); 1.1014-10(c); and 1.1014-10(c)(2). 81. Prop. Treas. Regs. §§1.1014-10(a)(2) and 1.1014-10(e), Example 4. 82. It may not always be the case that IRA funds are not subject to the basis reporting rules. For example, an account could consist of nondeductible contributions and part of the amounts in the account may not be IRD. 83. However, works of art or an item or collection of items with an artistic or collectible value exceeding $3,000 as of the date of death must be reported. 84. Prop. Treas. Reg. §1.6035-1(c)(3). 85. Prop. Treas. Reg. §1.6035-1(c)(4).

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Note. Generally, a 30-day rule applies to supplemental returns. Such returns are due 30 days after the final value is determined, 30 days after the executor discovers incomplete or incorrect information, or 30 days after a supplemental Form 706 is filed.86

Contingent Beneficiaries For a contingent beneficiary, the executor’s reporting requirement is triggered when the contingent beneficiary actually receives the property from the estate.87 Thus, for a life tenant who is the beneficiary of a life estate, the executor must send Schedule A of Form 8971 to the life tenant and the remainder holders as the beneficiaries of the remainder interest. In addition, any change in a beneficiary due to a contingency must be reported. For example, if a remainder holder dies before a life tenant, the executor must file a supplemental report with the IRS and the new remainder holder.

Note. This rule appears to subject an estate executor to a continuing duty to provide supplemental reports into the future.

Entity Beneficiaries For beneficiaries that are entities, the executor files the basis information (Schedule A of Form 8971) with the appropriate entity representative of a trust or an estate (i.e., the trustee or executor) or directly with a business entity that is a beneficiary. Supplemental reporting could be triggered if the entity transfers the asset and the carryover basis rule applies.88

Transfers by Beneficiaries If a beneficiary receives property (that is subject to a basis reporting requirement) from an estate and then transfers the property to a related party89 and the transferee’s basis is determined at least partially by the transferor’s basis, the beneficiary that transfers the property must file a supplemental Schedule A with the IRS. Additionally, they must give the transferee a copy that reports the change in ownership and the final estate tax value of the property.90 The supplemental Form 8971 for such transfers is due within 30 days after the date of the transfer.91 Thus, when a beneficiary subsequently gifts the inherited property, for example, the basis reporting rule applies and Form 8971 must be filed within 30 days of the transfer. 92

Note. The position taken in the proposed regulations is contrary to §6035, which imposes the basis reporting requirement solely on the party responsible for filing Form 706.92

86. IRC §6035(a)(3). 87. Prop. Treas. Reg. §1.6035-1(c)(1). 88. Prop. Treas. Reg. §1.6035-1(c)(2). 89. A “related party” for this purpose is any member of the transferee’s family as defined in IRC §2704(c)(2), any controlled entity, and any trust of which the transferor is the deemed owner for income tax purposes. A grantor trust is considered a related party, but not a nongrantor trust. For grantor trusts, it appears that when the trust makes a distribution to a beneficiary, the trustee need not file a basis information statement with the IRS and beneficiary. Prop. Treas. Reg. §1.6035-1(f). 90. Prop. Treas. Reg. §1.6035-1(f). Thus, the rule would also apply in situations that involve, for example, a like-kind exchange of the property or an involuntary conversion of the property. 91. There is no specification in the proposed regulations that gifts covered by the present interest annual exclusion are excluded from the reporting requirement, and there is also no de minimis amount specified that would be exempt from the reporting requirement. 92. See IRC §6035(a)(1).

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Subsequent transfers can require further actions. • If the original recipient transfers the property before the estate is required to file a Form 8971, the original recipient still must file Form 8971 but only needs to report the change in ownership.93 • If the basis of the property changes after being distributed to the beneficiary, the transferor must report the original basis as received from the decedent’s estate and has the option of providing information on the change of the asset’s basis while in the transferor’s hands.94 • If a subsequent transfer occurs before a final value is determined, the transferor must provide the executor with a copy of the supplemental statement that is filed with the IRS. The executor must provide any required basis notification statement to the transferee.95 • If an individual beneficiary transfers the property to a grantor trust (a nontaxable event), the transferor must file a basis information statement with the IRS and the trustee of the trust (probably the transferor). A similar requirement does not apply if the transfer is made to a nongrantor trust.96

ACCURACY-RELATED PENALTY97 An accuracy-related penalty is imposed on taxpayers who report a basis higher than the amount that the estate reported on Form 8971. 6

Observation. The new basis information reporting rules are designed to address situations in which property is reported for federal estate tax purposes at one value (which establishes the basis of the assets included in the decedent’s estate) and then gain is reported for tax purposes based on an entirely different income tax basis. The solution as proposed in the regulations has shortcomings. Hopefully, final regulations will resolve the problems that the proposed regulations create. In any event, the administration of many decedents’ estates has become more complicated.

PRACTICAL ESTATE PLANNING

MODERATE-WEALTH TAXPAYERS For individuals with 2017 estates of less than $5.49 million98 ($10.98 million for married couples), the possibility of estate tax is largely nonexistent. Estate planning for these individuals should focus on basic matters such as income tax basis planning and plans to avoid common errors. In addition, divorce planning and protection may be necessary. A determination must be made as to whether asset control and creditor protection is necessary. Moreover, the income tax benefits of family entities to shift income (subject to family partnership rules of IRC §704(e)) and qualifying deductions to the entity may need to be considered. The entity may have been created for estate and gift tax discount purposes but now could provide income tax benefits. In any event, family entities, such as family limited partnerships (FLP) and limited liability companies (LLC) continue to be valuable estate planning tools for many moderate-wealth clients.

93. Prop. Treas. Reg. §1.6035-1(f). 94. REG-127923-15, 2016-12 IRB 473. 95. Prop. Treas. Reg. §1.6035-1(f). 96. Prop. Treas. Reg. §1.6035-1(f); IRC §2704(c); IRC §2701(b)(2)(A). 97. Prop. Treas. Reg. §1.6662-8. 98. Rev. Proc. 2016-55, 2016-45 IRB 707.

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Most of the moderate-wealth taxpayers will likely fare better by not making gifts and retaining the ability for the heirs to achieve a basis step-up at the taxpayer’s death. Additionally, consideration should be made as to whether insurance is still necessary to fund any potential estate tax liability. It also may be possible to recast insurance to fund state death taxes and serve investment and retirement needs, minimize current income taxes, etc. Other estate planning pointers for moderate-wealth taxpayers include the following. • Trust-owned life insurance — Clients should be cautioned to not cancel a policy before evaluating such factors as the amount of premiums that have been paid, what coverage would be lost if it were canceled, what was the original purpose of buying it, etc. • Pension-owned life insurance — If the taxpayer’s estate is safely below the $5.49 million exemption (in 2017), the adverse estate tax consequences may be avoided. • Irrevocable trusts — Such trusts should be evaluated to determine if they can be modified or terminated. • For durable powers of attorney, the limitation on gifted amounts (the annual exclusion is $14,000 for 2017)99 should be examined to make sure there is no inflation-adjusting reference to the annual exclusion. If there is an inflation-adjuster clause in a power of attorney, then it may end up authorizing a large amount of gifts that the principal never intended. • For qualified personal residence trusts (QPRT) that were created when the estate tax exemption was $2 million, the conventional advice was to deed the house from the QPRT to the children or a remainder trust (which might have been a grantor trust), with a written lease agreement in favor of the parent/donor who would continue to live in the house. Now, it may be desirable to have the home included in the estate for basis step-up purposes. • While FLPs and LLCs may have been created to deal with the IRC §2036 issue (a Code section that illustrates the government’s concern about lifetime transfers being used as a substitute for testamentary transfers), it may not be wise to simply dismantle them because a taxpayer is no longer liable for estate tax. A taxpayer may actually want to trigger the application of IRC §2036 and cause inclusion of the FLP interest in the parent’s estate. This can be accomplished by revising the partnership or operating agreement and having the parent document control over the FLP. Then, an IRC §754 election can be made, which can allow the heirs to get a basis step-up.

HIGH NET-WORTH TAXPAYERS Planning considerations for a high-net-worth individual include many factors such as if the taxpayer is middle-aged with a growing business or a widow(er) with an estate in excess of the $5.49 million (for 2017) exclusion and a portable exemption amount. The relatively higher income tax rates and fewer deductions (post-2012) on wealthier taxpayers could encourage such taxpayers to establish residency in a state with either no state income taxes or relatively low income taxes (as well as property taxes). For these taxpayers, creditor protection is often a major concern. If a small business is involved, business succession and retirement planning is important. Common bypass trust schemes may no longer address the complexity of the current transfer tax system, which includes the permanency of portability. Bypass trust schemes remain appropriate in a state (like Illinois) that has a significant estate tax with an exemption that is not portable.

Observation. Estate plans of high-net-worth individuals that rely simply on portability forfeit the GSTT exemption in the estate of the first spouse to die. Thus, if grandchildren are included in the estate plan and the assets exceed the applicable exclusion, sole reliance on portability is not optimal for estate and GSTT purposes.

99. Ibid.

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TAXABLE INCOME OF TRUSTS AND ESTATES

RETURN FILING AND SELECTING TAX YEAR Upon a taxpayer’s death, the decedent’s assets become property of the decedent’s estate, which is a separate entity from the decedent for income tax purposes. Any income those assets generate is also part of the estate and may trigger the requirement to file an estate income tax return. In general, an estate’s net income, less deductions for the value of property distributed from the estate to heirs, is taxed to the estate.

Observation. Examples of assets that generate income to the decedent’s estate include savings accounts, certificates of deposit, stocks, bonds, mutual funds, and rental property.

A Form 1041, U.S. Income Tax Return for Estates and Trusts, is required if the estate generates more than $600 in annual gross income.100 The decedent and the decedent’s estate are separate taxable entities. Before filing Form 1041, the executor must obtain an employer identification number (EIN) for the estate. The application is made using Form SS-4, Application for Employer Identification Number (EIN). The estate’s EIN is in the format 12-345678X. An application for the EIN can be 6 made online, or via fax or regular mail.101 Form SS-4 asks for the yearend of the trust or estate. An estate’s executor is not held to what is selected as the yearend on Form SS-4. Any yearend can be chosen that fits the estate’s needs.

Tax Year Determination For calendar year estates and trusts, Form 1041 and Schedules K-1 (which report distributions to beneficiaries) must be filed on or before April 15 of the year immediately following the year of death. For fiscal year estates and trusts, Form 1041 must be filed by the 15th day of the fourth month following the close of the tax year.102 If more time is needed to file Form 1041, an automatic 5½-month extension of time to file can be obtained using Form 7004, Application for Automatic Extension of Time To File Certain Business Income Tax, Information, and Other Returns.103 A trust must generally adopt a calendar year. However, a qualified revocable trust can make an election in accordance with IRC §645, under which the trust is treated and taxed as if it were part of the estate. The election is made using Form 8855, Election to Treat a Qualified Revocable Trust as Part of an Estate. If the election is made, the estate (and, hence, the trust) can file using a fiscal year if the fiscal yearend is not later than the end of the month before the month of death.104 By filing a timely extension for the estate (or trust if no probate estate exists), the Form 8855 receives an extended due date, thereby also extending the trust.105 The fiscal yearend is established when the first Form 1041 is filed. The election period begins on the date of the decedent’s death and ends two years after the decedent’s death if Form 706 is not required. If Form 706 is required, the election period ends at the later of: • Two years after the date of the decedent’s death, or • Six months after the final determination of liability for estate tax.106

100. Instructions for Form 1041. 101. Deceased Taxpayers—Filing the Estate Income Tax Return, Form 1041. Feb. 7, 2017. IRS. [www.irs.gov/businesses/small-businesses-self- employed/deceased-taxpayers-filing-the-estate-income-tax-return-form-1041] Accessed on Jun. 12, 2017. 102. Instructions for Form 1041. 103. Instructions for Form 7004. 104. For example, if the date of the decedent’s death is May 5, the fiscal yearend must end by the following April 30. 105. Instructions for Form 8855. 106. IRC §645.

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If the decedent had multiple revocable trusts, they can be combined with the decedent’s estate and a consolidated estate income tax return is filed for the combined entities. In this instance, both the executor and the trustee must indicate that they have elected consolidated reporting.107

Note. For more information about the §645 election to treat a qualified revocable trust as part of an estate for income tax purposes, see the 2016 University of Illinois Federal Tax Workbook, Volume B, Chapter 3: Trust and Estate Taxation.

The executor or personal representative of an estate may elect any yearend provided it ends on the last day of the month and the initial year does not exceed 12 months in length. The election of a yearend is made by filing an initial Form 1041. Common considerations for determining an estate’s yearend include the following. • The ability to defer income to the next tax year is particularly important if the decedent’s estate holds an interest in a partnership or other pass-through entity. • Managing tax rates can be an issue if the tax rates were different the year after the decedent’s death. • It is important to consider the capacity to pay tax (particularly if the estate will be open or the trust will be administered over a longer period) and to minimize the number of returns that need to be filed. A fiscal year ending a couple of months after the decedent’s date of death is generally preferred if estate administration is anticipated to last longer than a year. This allows the $600 exemption to be claimed each year, for example. • A calendar yearend may work better for estates that consist primarily of investment accounts if the decedent died early in the year. This facilitates reconciliation of Forms 1099.

Calculating the Tax The taxable income of an estate or trust is computed the same way that it is for individuals, with certain modifications.108 For an individual, gross income is reduced by the cost of producing that income. The result is adjusted gross income (AGI). Taxable income is calculated by reducing AGI by certain other deductions. A tax table or rate schedule is then applied to taxable income, and the resulting tax is reduced by applicable credits. The same computational scheme is applied to estates and trusts. Gross income to an individual is also gross income to an estate or trust.109 Expenses that an individual can deduct are generally deductible by estates and trusts.110 AGI for a trust is only computed for limited purposes under IRC §67(e), but it is determined in the same manner as that prescribed for determining the AGI of individuals.

107. IRC §645(a); Treas. Reg. §1.645-1. An election to consolidate is irrevocable. IRC §645(c). 108. See, e.g., IRC §§67(e) and 641(b). 109. See, e.g., Treas. Reg. §1.641(a)-2. 110. IRC §641(b). For example, these expenses include court costs, attorney and fiduciary fees, taxes, etc. See Treas. Regs. §§1.212-1(i) and 1.641(b)-1; and IRC §164.

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Trust and estate taxable income is modified in several ways. • Trusts that are required to distribute all of their income currently are entitled to a $300 personal exemption deduction.111 For all other trusts, the personal exemption deduction is limited to $100. Estates are allowed a $600 exemption. • Estates and trusts are not entitled to the standard deduction.112 • In general, estates and trusts must deduct distributions to beneficiaries when determining taxable income but only to the extent of distributable net income (DNI).113 • A trust is not entitled to a charitable contribution deduction under IRC §170, but amounts that are paid via the terms of a trust or an estate for public charitable purposes are deductible by both estates and trusts. In addition, amounts that are permanently set aside for a charitable purpose are deductible by estates and certain trusts.114 • Estates and trusts can deduct miscellaneous itemized deductions to the extent that such deductions exceed 2% of the trust’s AGI.115 However, IRC §67(e) provides that an estate or trust, in arriving at AGI, is entitled to a deduction for 100% of the “costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate.” 6

Note. For a more thorough discussion about trust and estate taxation, see the 2016 University of Illinois Federal Tax Workbook, Volume B, Chapter 3: Trust and Estate Taxation. For more information about trusts, see the 2015 University of Illinois Federal Tax Workbook, Volume B, Chapter 3: Trust Accounting and Taxation. This can be found at uofi.tax/arc [taxschool.illinois.edu/taxbookarchive].

PASSIVE ACTIVITY LOSS LIMITATIONS IRC §469 generally limits deductions and credits derived from passive activities to the amount of income derived from all passive activities. This loss limitation rule applies to estates and trusts, and there are some unique applications of the rule to estates and trusts. An activity is generally deemed passive if it involves the conduct of any trade or business and the taxpayer does not materially participate in the activity.116 An estate or trust is treated as materially participating in an activity if an executor or fiduciary, in their capacity as such, is involved in operations of the activity on a regular, continuous, and substantial basis.117 For a grantor trust, material participation is determined at the grantor level.118 While the IRS’s position is that only the trustee of the trust can satisfy the material participation tests of IRC §469, this position was rejected by the one federal district court that ruled on the issue.119 In 2014, the U.S. Tax Court also rejected the IRS’s position.120 The Tax Court held that the conduct of the trustees acting in the capacity of trustees counts toward the material participation test as well as the conduct of the trustees as employees. The Tax Court also implied that the conduct of nontrustee employees would count toward the material participation test.

111. IRC §642(b). 112. IRC §63(c)(6)(D). 113. IRC §661. 114. IRC §642(c). 115. IRC §67(a) and (e). 116. IRC §469(c)(1). 117. Senate Report No. 99-313, 1986-3 CB 735. 118. See IRC §671. 119. Mattie Carter Trust v. U.S., 256 F.Supp.2d 536 (N.D. Tex. 2003). The IRS, while not appealing the court’s opinion, continued to assert its judicially rejected position. 120. Frank Aragona Trust v. Comm’r, 142 TC 165 (Mar. 27, 2014).

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Rental activities are considered passive, regardless of whether the taxpayer materially participates. However, for tax years of an estate that end less than two years after the date of the decedent’s death, up to $25,000 of the passive activity losses attributable to all rental real estate activities in which the decedent actively participated before death are allowed as deductions.121 Any unused losses and/or credits are deemed “suspended” passive activity losses for the year and are carried forward indefinitely until there is rental income (or other passive income) to deduct them against or the interest is entirely disposed of.122 123

Note. The $25,000 offset for rental real estate activities is reduced by the amount of the exemption “allowable to the surviving spouse of the decedent for the tax year ending with or within the taxable year of the estate.”123

Other issues concerning passive activity losses include the following. • Losses from passive activities are first subject to the “at-risk” rules of §465.124 Thus, if the losses are deductible under the at-risk rules, the passive activity limitations must be applied. • Passive losses only offset passive income. They cannot be offset against actively earned income. Thus, portfolio income of an estate or trust must be accounted for separately and may not be offset by losses from passive activities. Portfolio income generally includes interest, dividends, royalties not derived in the ordinary course of business, and income from annuities.125 • If a trust or estate distributes its entire interest in a passive activity to a beneficiary, the basis of the property is increased (no deduction is allowed) by the amount of any suspended losses generated by that passive activity. Gain or loss to the trust or estate and the basis of the property to the beneficiary is then determined under the rules set forth in IRC §643(e).126

TAX RATE SCHEDULE Estate and trust income that is not distributed to beneficiaries is subject to the following tax rates for 2017.127

128 If Taxable Income Is But Not Over Over The Tax Is Of the Amount Over $ 0 $2,550 15.0% $ 0 2,550 6,000 382.50 + 25.0% 2,550 6,000 9,150 1,245.00 + 28.0% 6,000 9,150 12,500 2,127.00 + 33.0% 9,150 12,500 a 3,232.50 + 39.6% 12,500

a For taxable income above $12,500, the additional 3.8% net investment income tax of IRC §1411 applies.

Note. Generally, net long-term capital gains are taxed at a maximum rate of 20%.128

121. IRC §469(i). 122. IRC §469(b). 123. IRC §469(i)(4)(B). 124. IRS Pub. 925, Passive Activity and At-Risk Rules. 125. IRC §469(e). 126. IRC §469(j)(12). 127. Rev. Proc. 2016-55, 2016-45 IRB 707. 128. IRC §1(h).

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ALTERNATIVE MINIMUM TAX The alternative minimum tax (AMT) applies to trusts and estates.129 The lowest applicable AMT rate is 26% and the maximum is 28%.130 Trusts and estates are entitled to a $22,500 exemption.131 The exemption is phased out if the trust or estate has alternative minimum taxable income (AMTI) that exceeds $75,000, with the phase-out rate set at 25% of AMTI exceeding $75,000.132 ESTIMATED INCOME TAX PAYMENTS Trusts and estates must make quarterly estimated income tax payments in the same manner as individuals except that estates and revocable trusts are exempt from making estimated payments during the first two tax years.133 For estates, estimated tax payments must be made on a quarterly basis for tax years that end two or more years after the date of the decedent’s death. The rule is the same for revocable trusts that receive the grantor’s residuary estate under a pour-over will or, if no will is admitted to probate, to a trust that is primarily responsible for paying the decedent’s debts, taxes, and administration expenses.134 However, an estate does not need to make estimated income tax payments for income earned before the decedent’s death when the payments are due after death.135 Example 4. George Knight died on December 15, 2016. His will stated “I give all of my property to the Trustee of the Knight Family Revocable Living Trust, which I created on August 5, 1989.” The trust reports its income on a calendar year basis, but the executor of George’s estate elected to report the estate’s income using a fiscal year ending November 30. 6 No estimated income tax payments are required for the estate for the fiscal years ending on November 30, 2017, and November 30, 2018. The trust is not required to make estimated income tax payments for the trust tax years ending December 31, 2016, and December 31, 2017. Estimated tax payments are required for the trust tax year ending December 31, 2018.136

Note. Penalties for underpayment of quarterly estimated income tax apply to fiduciaries as well as individuals.136

Under IRC §643(g)(1)(a), “the trustee may elect to treat any portion of a payment of estimated tax made by such trust for any taxable year of the trust as a payment made by a beneficiary of such trust.” The election must be made via Form 1041-T, Allocation of Estimated Tax Payments to Beneficiaries, on or before the 65th day after the close of the trust’s tax year.137 Estates may also make this election, but only in the “taxable year reasonably expected to be the last taxable year” of the estate.138 Thus, an estate may find itself in the position of claiming a refund of an overpayment of estimated taxes in a year other than its final year while the estate’s beneficiary will incur an underpayment penalty in the same year. The beneficiary’s underpayment penalty may result from an estate distribution during that year that is not taken into account for estimated income tax purposes. When a trust elects to attribute the estimated income tax payment to the trust beneficiary, the payment made by the trust is “treated as a payment of estimated tax made by such beneficiary on January 15 following the taxable year.”139 The amount of tax attributed to the beneficiary is treated as a distribution by the trust (and is deductible by the trust in computing its income tax liability) and as taxable income to the beneficiary.140

129. IRC §59(c). 130. IRC §55(b)(1)(A). 131. IRC §55(d)(1)(D). 132. IRC §55(d)(3)(C). 133. IRC §6654(l)(2). 134. Ibid. 135. Ltr. Rul. 9102010 (Oct. 10, 1990). 136. See Instructions for Form 2210 and IRC §6654(l). 137. IRC §643(g)(2). 138. IRC §643(g)(3). 139. IRC §643(g)(1)(C)(ii). 140. Instructions for Form 1041-T.

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BASIS CONSIDERATIONS FOR IN-KIND DISTRIBUTIONS

Under §643(e), the basis of property that is distributed in-kind by an estate or a trust is the “adjusted basis of such property in the hands of the estate or trust immediately before the distribution, adjusted for…any gain or loss recognized to the estate or trust on the distribution.” The estate or trust can make an election whether or not to recognize a gain or loss. Thus, an estate or trust has the option of treating an in-kind distribution as if it had been sold to the distributee at FMV. FMV is determined at the time of the distribution.141 The estate or trust recognizes a gain if the distributed property’s value has appreciated or a loss if the distributed property’s value has declined.142 If the election is made, it applies to all distributions made during the tax year. However, losses may not be deductible. IRC §267(a) denies loss recognition on the sale of property between certain related parties. A trust and its beneficiaries are related parties under IRC §267.143 Thus, if a property is distributed from a trust having an FMV less than its basis and the trust made the election under §643(e)(3), the trust cannot recognize the loss. However, an estate and its beneficiaries are not related taxpayers under IRC §267. 144

Note. An election under §643(e) is made on the estate or trust’s return for the tax year.144 The election does not apply if the trust or estate has no DNI or the cash distributed from the estate or trust absorbs the DNI. In either of those situations, the trust or estate has no distributions that may be treated as taxable to the beneficiaries.

SPECIFIC BEQUESTS IRC §643(e) has no application to property that is distributed in-kind to satisfy a specific bequest.145 Thus, the basis of such property to the beneficiary is the same as it was in the hands of the estate or trust.146 In essence, the transaction is treated as a sale or exchange.

Sale or Exchange Appreciated property that is distributed in-kind to satisfy a pecuniary bequest (the gift of a specific sum of money) is treated as a sale or exchange by the trust or estate.147 The transaction is treated as if the executor/trustee distributed cash and the beneficiary purchased the property with the cash. If there is a loss on the transaction, an estate can recognize the loss, but a trust cannot.148 149

Observation. If a decedent funded a revocable trust during their life and directed the trustee (under the terms of the trust) to distribute a pecuniary bequest to the surviving spouse and there is a loss on the transaction, the trust cannot claim the loss. However, the trustee could sell the loss property, realize the loss for income tax purposes, and satisfy the surviving spouse’s pecuniary bequest with cash.149

141. IRC §643(e)(3)(A)(ii). 142. The distribution of loss property carries out DNI only to the extent of the property’s FMV. In the case of an estate, the distributee assumes the basis of the property in the hands of the estate unless the estate elects to recognize the loss. 143. IRC §267(b)(6). 144. IRC §643(e)(3)(B). 145. IRC §643(e)(4). The requirements of IRC §663(a) must be satisfied. 146. IRC §643(e)(1). 147. Treas. Reg. §1.661(a)-2(f)(1). 148. IRC §§643(e) and 267. 149. Ibid.

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SALE OF A DECEDENT’S PERSONAL RESIDENCE

Upon death, an executor may face the need to dispose of a decedent’s personal residence. The basis of the residence must be determined under the IRS standard: FMV as of the date of the decedent’s death under the “willing buyer, willing seller” test. The FMV is determined based largely on sales of comparable properties and requires more than a simple market analysis by a real estate agent.150 If the decedent was the first spouse to die, the executor must determine how the residence was titled at death. For a residence held in joint tenancy or tenancy in common, only the value of the decedent’s share of the residence is included in the decedent’s estate. The decedent’s share receives a basis step-up to FMV under IRC §1014.151 For joint tenancies involving only spouses, the property is treated at the death of the first spouse as belonging 50% to each spouse for federal estate tax purposes.152 This is known as the “fractional share” rule.153 Thus, half of the value is taxed at the death of the first spouse and half receives a new income tax basis. The “consideration-furnished rule” is an important exception. In 1992, the Sixth Circuit Court of Appeals applied the “consideration-furnished rule” of IRC §2040(a) to a pre-1977 husband-wife joint tenancy who included the entire value of land in the estate of the first spouse to die.154 The consideration-furnished rule applied for joint tenancies created before 1977. Decedent’s estates valued joint tenancy 6 property by determining each spouse’s contribution of funds to acquire the jointly owned property. Thus, if one spouse had no income over a period of time prior to the acquisition of the property, the other spouse’s estate would include 100% of the value of the joint tenancy property in that spouse’s estate. The full value was subject to federal estate tax but was covered by the 100% federal estate tax marital deduction. The entire property received a new income tax basis, which was the objective of the surviving spouse. Other federal courts have reached the same conclusion.155 If the residence is community property, the decedent’s entire interest receives a basis step-up to FMV. If the residence is held in joint tenancy with rights of survivorship, the decedent’s interest is passed to the designated survivor.156

Observation. If a surviving spouse sells the marital home shortly after the first spouse’s death, the survivor often realizes a loss largely due to the expenses incurred from the sale. If the survivor realizes a gain, the survivor is eligible for the $250,000 gain exclusion under IRC §121. The exclusion is a maximum of $500,000 if the sale occurs within two years of the first spouse’s death.

150. Treas. Reg. §25.2512-1. 151. IRC §2040(b). 152. Ibid. 153. IRC §2040(a); and Treas. Reg. §20.2040-1(a)(1). 154. Gallenstein v. U.S., 975 F.2d 286 (6th Cir. 1992). 155. Anderson, et al. v. U.S., 96-2 USTC (D. Md. 1996); Wilburn v. U.S., 97-2 USTC (D. Md. 1997); Patten v. U.S., 116 F.3d 1029 (4th Cir. 1997); Baszto v. U.S., No. 95-1319-CIV-T-23B (D. M.D. Fl. 1997). 156. IRC §1014(b)(6).

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RESIDENCE HELD IN REVOCABLE TRUST157 A revocable trust is a common estate-planning tool. A decedent’s personal residence held in a revocable trust and passed to a surviving spouse upon the first spouse’s death continues to be held in a trust. The house receives a full step-up (or down) in basis to the current FMV at the death of the surviving spouse. If a house is distributed outright to a beneficiary and the beneficiary immediately sells the home, any loss is generally a nondeductible personal loss unless the home is first converted to a rental property before it is sold.

RESIDENCE SOLD BY ESTATE OR TRUST If the residence must be sold by the estate or trust to pay debts or to pay cash distributions to beneficiaries, any loss on the sale might be deductible. That loss could potentially offset other income of the trust or estate, or it could flow through to the beneficiaries. However, the IRS’s position is that an estate or a trust cannot claim such a loss unless the residence is a rental property or is converted to a rental property before it is sold.158 This position has not been widely supported by the courts, which have determined that a trust or estate can claim such a loss if no beneficiaries use the home as a residence after the decedent’s death and before it is sold.159

TERMINATION OF ESTATES AND TRUSTS

Once the administration of an estate is finished or a trust is deemed to be terminated for federal income tax purposes, the income of the estate or trust is taxable to the beneficiaries even if it has not been distributed to those beneficiaries.160 The determination of whether a trust is terminated depends on whether the trust property has, in fact, been distributed to the trust beneficiaries.161 The period of administration of an estate is the “period actually required…to perform the ordinary duties of administration, such as the collection of assets and the payment of debts, taxes, legacies, and bequests...”162

EXCESS DEDUCTIONS If an estate or a trust, in its last tax year, incurs tax-deductible expenses that exceed the income of the estate or the trust, excess deductions result.163 The personal exemption and any charitable deductions are not counted in calculating the excess deductions.164 Any excess deductions flow through to the beneficiaries of the estate or trust.165 The beneficiary can claim these excess deductions as itemized deductions on the beneficiary’s income tax return for the tax year in which the estate or trust tax year ended.166 167

Note. Estate administration expenses are deductible in computing the federal estate tax or the estate’s income tax. However, such expenses are not deductible for both purposes.167

157. IRS Pub. 559, Survivors, Executors, and Administrators. 158. SCA 198-012 (Apr. 7, 1998). 159. See e.g. Campbell v. Comm’r, 5 TC 272 (Jun. 18, 1945); Carnrick v. Comm’r, 9 TC 756 (Oct. 23, 1947); Crawford v. Comm’r, 16 TC 678 (Mar. 30, 1951). 160. Treas. Reg. §1.641(b)-3(d). 161. Treas. Reg. §1.641(b)-3(b). 162. Treas. Reg. §1.641(b)-3(a). 163. IRC §642(h)(2). 164. Treas. Reg. §1.642(h)-2(a). 165. IRC §642(h)(2). 166. Instructions for Form 1041. 167. IRC §642(g).

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The 2% Rule In general, “excess deductions” in the final year of an estate or trust are miscellaneous itemized deductions (as defined in IRC §67(b)) in the hands of a beneficiary. It is possible that excess deductions that are allocated to a beneficiary would be allowed only to the extent that the aggregate of the deductions exceeds 2% of AGI.168 IRC §67(e), however, provides that the 2% rule is not applicable to “deductions for costs which are paid or incurred in connection with the administration of an estate or trust and which would not have been incurred if the property were not held in such trust or estate.” In 2008, the U.S. Supreme Court in Knight v. Comm’r,169 provided a broad test for the exception to the 2% floor for trusts and estates. The Court’s test is whether the expense at issue is commonly or customarily incurred outside of a trust or an estate. If so, then the 2% floor applies and the exception does not. In Knight, the Court reasoned that because investment advisory fees are commonly incurred by individuals (not only trusts and estates), they do not qualify for the exception to the 2% rule (i.e., the 2% floor applies). However, the Court noted that it is possible that some types of advisory fees may exclusively relate to trusts and estates, in which case the 2% floor would not apply. Incurring advisory fees simply to comply with fiduciary “prudent investor” rules (i.e., the fiduciary obligation of investment advisors) is not sufficient to qualify for an exception to the 2% rule. Shortly after the Supreme Court issued its opinion in Knight, the Treasury issued proposed regulations that became final regulations applicable to tax years beginning on or after January 1, 2015.170 Under the general rule,171 a cost incurred to defend a claim against a trust or an estate is commonly and customarily incurred by an individual but not if 6 the claim challenges the trust’s validity, administration, or existence. The final regulations describe the applicability of the 2% floor to five specific types of costs. 1. Ownership costs that a trust or an estate incurs because of its ownership of property are deemed to be expenses that an individual owner would incur.172 Therefore, such costs are subject to the 2% floor. 2. Certain tax preparation fees are not subject to the 2% floor. Those fees include preparation fees for estate tax returns, GSTT returns, fiduciary income tax returns, and a decedent’s final individual income tax return. However, the cost of preparing all other types of returns is subject to the 2% floor.173 3. Investment advisory fees are generally subject to the 2% floor. However, in certain situations, the excess portion of the fee is not subject to the 2% floor. Those situations include incremental costs of investment advice that go beyond what a normal investor would be charged. This is advice rendered to an estate or a trust caused by an unusual investment objective or a need for balancing the interests of the parties that makes a reasonable comparison with individual investors improper. The excess portion of the fee (i.e., the amount that normally would not be charged) is not subject to the 2% floor.174 4. Certain types of appraisal fees are not subject to the 2% floor. These include FMV appraisals at date of death or at the alternate valuation date (six months after death); appraisals to ascertain a value when making trust distributions; and appraisals required for return preparation (estate, trust, or GSTT). All other appraisal fees are deemed those that an individual would incur (including insurance-based appraisals) and are therefore subject to the 2% floor.175 5. Certain fiduciary expenses are specifically listed as not subject to the 2% limitation. These include probate court fees and costs, fiduciary bond premiums, costs of providing notice to creditors and/or heirs, costs of providing certified copies of the decedent’s death certificate, and costs of maintaining fiduciary accounts.176

168. Treas. Reg. §1.642(h)-2(a). 169. Knight v. Comm’r, 552 U.S. 181 (2008). 170. TD 9664, 2014-32 IRB 254. 171. Treas. Reg. §1.67-4(b)(1). 172. Treas. Reg. §1.67-4(b)(2). 173. Treas. Reg. §1.67-4(b)(3). 174. Treas. Reg. §1.67-4(b)(4). 175. Treas. Reg. §1.67-4(b)(5). 176. Treas. Reg. §1.67-4(b)(6).

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Bundled fees could end up with mixed treatment. If a single fee is paid that covers costs that are not subject to the 2% floor and others that are, the fee must be allocated between the two types of costs. Fiduciary fees, attorney fees, and accountant fees may be subject to mixed treatment.177 For fees that are not charged on an hourly basis, only the portion of the expense that relates to investment advice is subject to the 2% limitation.178 This exception allows professional fiduciaries who calculate their fees as a percentage of the assets that they manage from being required to separate their fee into the categories of the various types of services that they provide. Thus, a fee schedule can be established for “investment management” (subject to the 2% limitation) and “other fiduciary services” (not subject to the 2% limitation).179 Any payments made to third parties out of a bundled fee that would have been subject to the 2% limitation if paid directly by an estate or trust are not required to be allocated. Similarly, no allocation is necessary for expenses assessed by a payee of the bundled fee for services that are commonly or customarily incurred by an individual.180 Any reasonable method can be used to allocate fees between those subject to the 2% floor and those that are not. Treas. Reg. §1.67-4(c)(4) lists certain factors that can aid in making the allocation.

NET OPERATING LOSSES181 The final tax year of the decedent closes at the date of death. A net operating loss (NOL) in the final short year can be carried back to offset income from earlier years. However, carrying an NOL forward presents a problem. An NOL carryforward does not transfer to a decedent’s estate.182 The NOL deduction available to estates and trusts is computed in a manner similar to NOLs for individuals. However, because an NOL computation is a measurement of economic business loss, NOLs tend to be fairly uncommon for estates and trusts. This is because NOLs can only result when business activities are conducted within the entity. Estates are more likely to incur NOLs than trusts because estates more frequently must deal with the closing of a business entity on behalf of a decedent.

NOL Computation Certain expenses deducted on a fiduciary income tax return may be allocable partially to business income and partially to nonbusiness income. Examples include real estate taxes, interest expense, legal fees, and court costs. Only the portion of these expenses allocable to business income can generate an NOL. Legal fees paid during the course of probate administration often generate a fiduciary NOL. In calculating a fiduciary NOL, the assets of the estate must be examined to determine which portion of these fees relates to business income and which portion relates to nonbusiness income.

Note. An NOL cannot be generated by fiduciary fees because a fiduciary’s administrative responsibilities to the estate or trust do not constitute an active trade or business for purposes of IRC §172.

177. Treas. Reg. §1.67-4(c)(1). 178. Treas. Reg. §1.67-4(c)(2). 179. Treas. Reg. §1.67-4(c). 180. Treas. Reg. §1.67-4(c)(3). 181. This section is adapted from the 2016 Iowa Bar Association Tax Manual by A. David Bibler, et al., and is used with permission. 182. Rev. Rul. 74-175, 1974-1 CB 52.

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Example 5. John Stevens, a retired farmer, died on October 5, 2015. At the time of his death, his estate was composed of several tracts of farm real estate (operated on a crop-share basis), several life insurance policies upon which John retained ownership, and an investment portfolio that included stock, mutual funds, certificates of deposit, and annuities. The first fiduciary income tax return filed for John’s estate covered the period from October 5, 2015, through September 30, 2016. It reflected taxable income of $18,500, upon which the estate paid federal and state income taxes. The second fiduciary income tax return covered the year ended September 30, 2017. The estate return reflects the following income and expense information.

Interest income $ 1,196 Capital gain (Schedule D) sale of farm equipment 752 Net farm income (Form 4835/Schedule E) 1,636 Form 4797 (§1245 recapture) 1,021 Total income $ 4,605 $ 4,605 Real estate taxes (farm) $ 140 Legal fees (probate administration) 12,236 Court costs (administration) 1,735 Total expenses ($14,111) (14,111) 6 Adjusted total income (loss) ($ 9,506) Less: exemption (600) Taxable income (loss) ($10,106)

Because the estate reports a net loss for the year ended September 30, 2017, an NOL computation should be prepared to determine if an NOL exists that could be carried back to the first fiduciary return filed for the estate to obtain a refund.

Claim for Refund If an estate or trust elects to carry back an NOL, it can file a claim for refund by using either Form 1045, Application for Tentative Refund, or an amended Form 1041 under rules similar to those for individual taxpayers. Generally, an NOL can be carried back two years and forward 20 years. The estate or trust may also elect to forgo the carryback of the NOL.183

Note. The special carryback periods for certain types of losses also apply to activities of estates and trusts (e.g., three years for casualty and theft losses and five years for farm losses).

Effect on Beneficiaries NOL carrybacks may have the effect of reducing DNI previously reported by income beneficiaries. Thus, when an NOL is carried back, income beneficiaries may be entitled to a refund on their individual return because the amount previously included in their gross income from the carryback year is limited to the estates’ or trusts’ DNI after application of the NOL carryback.184 The correction in DNI applicable to the beneficiary is reflected on an amended Schedule K-1 when the estate/ trust prepares its Form 1045 or amended Form 1041, U.S. Income Tax Return for Estates and Trusts, to carry back its NOL. Income beneficiaries must file an amended return within three years of the due date of the return (including extensions) of the tax year of the NOL (i.e., a 2013 refund claim resulting from a 2014 calendar year estate/trust NOL carryback generally must be filed by April 15, 2018, if the 2014 estate/trust return was not extended).

183. IRC §172 (b)(3). 184. Rev. Rul. 61-20, 1961-1 CB 248.

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Example 6. In 2014, the Sam White Trust had DNI of $35,000, which it distributed to Sam’s wife, Mildred, the trust’s sole beneficiary. In 2016, the trust sustained a $20,000 NOL that it carried back to 2015. The carryback results in the reduction of the trust’s DNI for 2015 to $15,000 ($35,000 – $20,000). In 2017, Mildred files Form 1040X to claim a refund based on the reduction in taxable DNI reported on the trust’s fiduciary income tax return after the NOL carryback. Mildred attaches her amended Schedule K-1 to Form 1040X to substantiate her claim.

Unused NOLs Upon Termination of an Estate or Trust Any unused NOL carryovers existing upon termination of an estate or trust pass through to the beneficiaries of the estate or trust upon termination.185 The unused NOL carryovers retain their character as NOLs on the beneficiaries’ individual returns and can offset a beneficiaries’ income over any remaining carryover life. If the final tax year of the estate or trust is the last tax year to which an NOL can be carried over (i.e., the 20th year under current carryover rules), any remaining NOL constitutes an excess deduction on termination.186

EXECUTOR/ADMINISTRATOR FEES RECEIVED187 An executor (or trust administrator) must include fees paid to them from an estate or trust in their gross income. If the executor is not in the trade or business of being an executor (determined under the regular, continuous, and substantial standard of IRC §469(h)), the fees are reported on the executor’s Form 1040, line 21 (other income). If the executor is in the trade or business of being an executor, the fees received from the estate are reported as self-employment (SE) income on the executor’s Schedule C, Profit or Loss From Business, or Schedule C-EZ, Net Profit From Business. If the trust or estate operates a trade or business and the executor (or trustee) materially participates in the trade or business in their fiduciary capacity, any fees received that relate to the operation of the trade or business are reported as SE income on Schedule C (or Schedule C-EZ) of the executor/administrator’s Form 1040.

VALUATION DISCOUNTING VIA FAMILY LIMITED PARTNERSHIPS

Note. In August 2016, the IRS issued proposed regulations under IRC §2704 that could have seriously impaired the ability to generate valuation discounts for the transfer of family-owned entities. On April 21, 2017, President Trump issued Executive Order 13789, a directive to the Treasury Secretary to reduce regulatory tax burdens by identifying regulations that either imposed an undue tax burden on taxpayers, added undue tax complexity to the Code, or exceeded the statutory authority of the IRS. The IRS identified the IRC §2704 proposed regulations for either simplification or repeal.

Valuation discounts are important succession planning tools. Discounting is a well-recognized concept by the Tax Court and other federal courts and is commonplace in the context of closely held businesses regarding lifetime transfers of interests in the business or transfers at death. Discounts from FMV in the range of 30–45% are common for minority interests and lack of marketability in closely held entities.188

185. IRC §642(h). 186. Treas. Reg. §1.642(h)-2(b). 187. IRS Pub. 559, Survivors, Executors, and Administrators. 188. See Estate of Watts v. Comm’r, TC Memo 1985-595 (Dec. 9, 1985) (35% discount of partnership interest for nonmarketability for federal estate tax purposes); Peracchio v. Comm’r, TC Memo 2003-280 (Sep. 25, 2003) (gifts of FLP interests discounted 6% for minority interest and 25% for lack of marketability).

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While discounting can apply to interests in corporations, one of the most common vehicles for discounting is the FLP. The principal objective of an FLP is to carry on a closely held business in which management and control are important. In addition to nontax advantages, FLPs have the significant tax advantage of transferring present value as well as future appreciation with reduced transfer tax.189 In many family businesses, the parents contribute most of the partnership assets in exchange for general and limited partnership interests. Discounts from the underlying partnership value can result from the nature of the partnership interest itself in terms of whether the transfer creates an assignee interest (an interest giving the holder the right to income from the interest, but not ownership of the interest) with the assignee becoming a partner only upon the consent of the other partners. A discount can also be a function of state law and provisions in the partnership agreement that restrict liquidation and transfer of the partnership interest.190

Observation. As use of FLPs has expanded, so has the focus of the IRS on methods to avoid or reduce the discounts. In general, FLPs have withstood IRS attacks and produce significant transfer tax savings. However, there are numerous traps for the unwary.

Example 7. Tom and Mary own a family business. They establish an FLP with the general partner owning 10% of the company’s value and the limited partner interest owning 90%. Every year, Tom and Mary give each of their children limited partnership shares with a market value that does not exceed the gift tax annual 6 exclusion amount. Mary and Tom progressively transfer business ownership to their children consistent with the present interest annual exclusion for gift tax purposes and significantly lessen or eliminate estate taxes at death. Even if the limited partners (children) together own 99% of the company, the general partner (parents) retain all control, and the general partner interest is the only partnership interest with unlimited liability. The IRS has successfully limited or eliminated valuation discounts upon a finding of certain factors, such as formation shortly before death when the sole purpose for formation was to avoid estate tax or depress asset values with nothing of substance changed as a result of the formation.191 However, while an FLP formed without a business purpose may be ignored for income tax purposes, lack of business purpose should not prevent an FLP from being given effect for transfer tax purposes. Valuation discounts are thus produced if the FLP is formed in accordance with state law and the entity structure is respected. 192

Note. The legislative history of Chapter 14 (IRC §§2701–2704) indicates that Congress intended ordinary minority and marketability valuation discounts to be respected, even in a family context.192

189. See, e.g., Estate of Kelley v. Comm’r, TC Memo 2005-235 (Oct. 11, 2005) (FLP interest valued under net asset value method with 35% discount). 190. See, e.g., Kerr v. Comm’r, 113 TC No. 450 (Dec. 23, 1999). 191. See, e.g., Estate of Beyer v. Comm’r, TC Memo 2016-183 (Sep. 29, 2016); Estate of Powell v. Comm’r, 148 TC No. 18 (May 18, 2017). 192. See Omnibus Budget Reconciliation Act of 1990, PL 101-580, §11602(a); H.R. Conf. Rept. No. 101-964. However, see Estate of Bongard v. Comm’r, 124 TC 95 (Mar. 15, 2005).

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IRC §2703 is of particular concern regarding the valuation issue. Under §2703(a), the value of property for transfer tax purposes is determined without regard to any restrictions on the right to use property. However, it exempts a restriction that is a bona fide business arrangement, is not a device to transfer property to family members for less than full consideration, and has terms comparable to those in an arm’s-length transaction.193 Much of the litigation in this area has involved FLPs and various restrictive agreements, but taxpayers have been successful in situations in which a legitimate business purpose can be established and personal assets are kept out of the entity.194 195 196

Note. Discounts based on restrictive agreements were allowed prior to enactment of the “freeze” rules that went into effect on October 8, 1990.195 It is now much harder to achieve discounts via a restrictive agreement such as a buy-sell agreement. Currently, to depress the value of transferred interests, a buy-sell agreement must constitute a bona fide business arrangement, not be a device to transfer property to family members for less than full and adequate consideration, and have arm’s-lengths terms.196

In addition, no valuation discount is allowed when an interest in a corporation or partnership is transferred to a family member and the transferor and family members hold, immediately before the transfer, control of the entity. In such instances, any applicable restrictions (such as a restriction on liquidating the entity that the transferor and family members can collectively remove) are disregarded in valuing the transferred interest.197 The term “applicable restriction” does not include any restriction imposed by federal or state law.198

Observation. It is important to form the entity in a jurisdiction in which state law reinforces liquidation and dissolution provisions of the partnership agreement for §2704(b) purposes.

While the technical aspects of §§2703 and 2704 are important and must be satisfied, the more basic planning aspects that establish the tax benefits of an FLP must not be overlooked. These include the following. • The parties must follow all requirements set forth in state law and the partnership agreement in all actions taken with respect to the partnership. • The general partner must retain only those rights and powers normally associated with a general partnership interest under state law (no extraordinary powers). • The partnership must hold only business or investment assets and not assets for the personal use of the general partner. • The general partner must report all partnership actions to the limited partners. • The limited partners must act to ensure that the general partners do not exercise broader authorities over partnership affairs than those granted under state law and the partnership agreement.

193. IRC §2703(b). 194. See, e.g., Church v. U.S., No. 00-50386 (5th Cir. 2001). 195. See Estate of Novak v. U.S., No. CV-84-0-511 (D. Neb. 1987). The “freeze” rules were enacted pursuant to PL 101-508, §§11601, 11602 (1990). The legislation added IRC §2701 et seq. 196. See IRC §§2701–2704. 197. The regulations provide that an applicable restriction is a limitation on the ability to liquidate the entity that is more restrictive than the restriction that would apply under state law in the absence of the restriction. Treas. Reg. §25.2704-1(a). 198. IRC §2704(b)(3).

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FAMILY LIMITED PARTNERSHIPS AND IRC §2036 Under IRC §2036(a), a gross estate includes the value of all property that a decedent previously transferred for which the decedent retained for life: • The possession or enjoyment of, or the right to the income from, the property; or • The right to designate the persons who will possess or enjoy the property or its income. Thus, the IRS may claim that because a general partner (or majority shareholder) controls partnership distributions, a partnership interest transferred by that partner should be taxed in that partner’s estate. In the typical FLP scenario, parents establish an FLP, then gift the limited partnership interests to their children and the parents (or parent) are the general partners (GP). In this situation, if the GPs have the discretionary right to determine the amount and timing of the distributions of cash or other assets (rather than the distributions being mandatory under the terms of the partnership agreement), the IRS could argue that the GPs have retained the right to designate the persons who will enjoy the income from the property transferred to their children. However, transfers made pursuant to a bona fide sale for an adequate and full consideration in money or money’s worth are not included in the gross estate.199

Observation. The “purpose clause” in a partnership agreement is critical. The clause can either be drafted as 6 a 1-sentence general statement or it may take up an entire page. The length is not important. The actual reasons for creating the partnership are more important than what the agreement says. If the reasons for creating the partnership are explained in great detail, the stated reasons should be consistent with the actual purposes and not simply be a list of possible partnership purposes.

From a succession-planning perspective, it may be best for one parent to be the transferor of the limited partnership interests and the other to be the GP. For example, both parents could make contributions to the partnership in the necessary amounts so that one parent receives a 1% general partnership interest and the other parent receives the 99% limited partnership interest. The parent holding the limited partnership interest then makes gifts of the limited partnership interests to the children (or their trusts). The other parent retains control of the family assets. Unlike IRC §672(e), which treats the grantor as holding the powers of the grantor’s spouse, IRC §2036 does not have a similar provision. Thus, if one spouse retains control of the partnership and the other spouse is the transferor of the limited partnership interests, then §2036 should not be applicable.

USE OF FORMULA CLAUSES FOR GIFTING/TRANSFERRING ASSETS Formula clauses come in two general types: a definition clause and a savings clause. A definition clause defines a transfer by reference to the value of a possibly larger, identified property interest. A savings clause retroactively adjusts the value of a transfer due to a subsequent valuation determination.200 Taxpayers use formula clauses to avoid unintended gift, estate, and GSTT consequences when transferring property. The estate tax version utilizes the clause in a will or trust and involves the decedent leaving a set dollar amount of the estate to the decedent’s children (or specific beneficiaries) with the residuary estate passing to a charitable organization. An alternative technique is for the estate to leave everything to a specific beneficiary, with that beneficiary having the power to disclaim whatever property the beneficiary desires to disclaim, and the disclaimed property is then passed to charity. The portion passing to the charity qualifies for the estate tax charitable deduction and, thus, puts a “lid” on the amount of estate tax owed. The technique can be very beneficial in minimizing tax on the transfer of assets from one generation to the next when family business assets that are difficult to value are involved.201

199. IRC §2036(a). 200. Formula Clauses: Adjusting Property Transfers to Eliminate Tax. Skarbnik, John H. and West, Ron. Jan. 31, 2013. The Tax Advisor. [www.thetaxadviser.com/issues/2013/feb/skarbnik-feb2013.html] Accessed on Jul. 25, 2017. 201. Ibid.

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The gift tax version works in a similar way by specifying via formula an amount of gifted property to be transferred to family members (or specified nonfamily beneficiaries), with the balance passing to charity.202 A benefit of using a formula clause is that it can prevent the IRS from increasing estate or gift tax by denying or diminishing valuation discounts. If the IRS succeeds in reducing a claimed valuation discount, the enhanced value either passes to a charity (estate tax formula clause) or is transferred to a charity (gift tax formula clause). The result is an enhanced charitable deduction on either Form 706 or Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, with no resulting increase in tax. The following cases illustrate this point. • McCord v. Comm’r203 involved a husband and wife that each held 41.17% of an FLP. They entered into an assignment agreement involving their children, GSTT trusts for the children, and two charities. Under the agreement, the McCords assigned all of their FLP rights to the assignees. A formula clause in the agreement specified that the children and GSTT trusts were to receive portions of the gifted interest having an aggregate FMV of over $6.9 million. If the FMV of the gifted interest exceeded $6.9 million, then a charity was to receive a portion of the gifted interest having an FMV equal to the excess, up to $134,000. If any amount of the gifted interest remained after the allocation to the children, the trust and the two charities received that portion, which was to be allocated by the assignees. The FMV of the assignee interest was determined to be $89,505. The agreement essentially changed the dollar value of what each donee received (based on an appraisal of the FLP interests at the date of the gifts) into percentages of FLP interests. Ultimately, the McCords were entitled to a charitable deduction of $324,345. The amount was calculated by subtracting the $6.9 million given to the children and a small amount given to another donee from the FMV of the property, which was approximately $7.37 million. The court upheld the defined value gift clause (e.g., “charitable lid”), stating that the gifts were complete as of the date of the assignment. •In Estate of Christiansen v. Comm’r,204 the U.S. Court of Appeals for the Eighth Circuit affirmed the Tax Court in rejecting the IRS’s position of refusing to recognize “defined value” types of formula clauses. In the case, a sole beneficiary of a South Dakota family ranching operation disclaimed all of the estate (under a fractional formula) in excess of $6.35 million. The disclaimed assets passed 75% to a charitable lead annuity trust (CLAT) and 25% to a foundation. The IRS and the estate agreed to increase the value of the gross estate by virtue of a reduction in the claimed valuation discount in the deceased mother’s estate.205 For the 25% passing to the charity, the IRS argued that a charitable deduction should not be permitted for the increased value because any increased amount passing to the charity was contingent on future events — the IRS’s final determination of the value of the transfer.206 In addition, the IRS claimed that the transfer violated public policy because it diminished the IRS’s incentive to audit estate tax returns. The Tax Court and the Eighth Circuit rejected both arguments.

202. Ibid. 203. McCord v. Comm’r, 461 F.3d 614 (Sep. 15, 2006), rev’g 120 TC 358 (2003). 204. Estate of Christiansen v. Comm’r, 586 F.3d 1061 (8th Cir. 2009). 205. The Tax Court held that the disclaimer as to the 75% that passed to the CLAT did not satisfy all the technical disclaimer requirements so the estate owed estate tax on that portion of the increased value of the estate. The estate did not appeal that aspect of the case. 206. The IRS position was based on Rev. Rul. 86-41, 1986-1 CB 300.

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Observation. The case is a significant taxpayer win validating the use of defined value transfers when the transfer is made and allocated between a taxable and nontaxable portion based on gift or estate tax values or based on agreement. The case is also important for transfers whereby the amount transferred is defined by a formula that refers to gift or estate tax values. A value “enhancement” by the IRS (typically by denying or reducing a claimed valuation discount) works the same way that a standard marital deduction formula clause works in a will or trust. Under such a clause, an increased value allocates a larger value to the surviving spouse but does not generate additional estate tax. Until the Christiansen decision, it was not certain whether courts would uphold inter vivos defined-value transfers against a challenge on the grounds of public policy (even though standard marital deduction formula clauses in wills have operated in that same manner for decades).

•In Petter v. Comm’r,207 Ms. Petter inherited several million dollars of UPS stock when UPS was a closely held company. The stock doubled in value at the time it became publicly traded. Utilizing a part-gift, part-sale transaction, Ms. Petter transferred her interests in an LLC to intentionally defective trusts. Pursuant to an agreement, a block of units in the LLC was first allocated to grantor trusts consistent with the gift tax exclusion and the balance was allocated to charities. The LLC interests were allocated based on value as determined by an appraiser, but the IRS claimed that the discount should be less and did not respect the 6 formula allocation provisions for gift tax purposes. The court held that the formula allocation provision did not violate public policy. As a result, the gift tax charitable deduction was allowed for the full value passing to charity based on the value as finally determined by the IRS. •In Hendrix v. Comm’r,208 the Hendrixes made a small gift to a charitable donee. The gift was a fixed dollar amount of stock that was transferred to family trusts, with the excess passing to the charity. The transfers to trust were structured as part gift/part sale transactions. Only the amount that the aggregate amount of the defined transfers to the trusts exceeded the consideration that the trusts paid was treated as a gift. The IRS objected on the basis that the defined value formula clause was not bona fide because it was not arm’s length. The Tax Court, however, disagreed. The court noted that the transfers to the trusts caused the trusts to incur economic and business risk because, if the value of the stock as initially computed was undervalued, more shares would shift from the trusts to the charity. •In Wandry v. Comm’r,209 the taxpayer prevailed in the utilization of a defined value clause that was used to determine the FMV of gifts for gift tax purposes. The formula referenced a fixed dollar amount rather than a transfer of a fixed quantity of property. The Wandrys, a married couple, transferred interests in their family LLC valued at $261,000 to each of their four children. Interests valued at $11,000 were transferred to each of their five grandchildren. No residual beneficiary was specified if the IRS issued a redetermination of value. However, the transfer document specified that if a subsequent IRS valuation determination (or a court decision) changed the value of the gifted membership units, the number of the gifted LLC units would be adjusted such that the same value as initially specified would be transferred to each child and grandchild. The IRS challenged the use of the defined value clause to transfer fixed dollar amounts of LLC interests to the transferees. However, the Tax Court ruled that there is no public policy against formula clauses that simply define the rights transferred without undoing prior transfers (as opposed to a “savings clause”).

207. Petter v. Comm’r, TC Memo 2009-280 (Dec. 7, 2009). 208. Hendrix v. Comm’r, TC Memo 2011-133 (Jun. 15, 2011). 209. Wandry v. Comm’r, TC Memo 2012-88 (Mar. 26, 2011).

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Advising Clients Based on the preceding cases, advice to clients can include the following points. 1. Formula clauses can be used to restrict the value of nonmarketable or difficult to value gifted property or bequests to establish specified amounts. 2. The formula clause utilized in Wandry is relatively easy to implement, but the IRS still views formula clauses as improper and will likely challenge them when it can. This is particularly true when a charitable donee is not involved. 3. If the client is inclined to benefit a charity, the type of formula clause used in Petter may be desirable. 4. When drafting formula clauses, it is critical to ensure that the gift is complete when the transfer occurs. Attorneys must make sure that the gift is deemed complete at the time of the transfer. 5. The transfer should always be reported on Form 706 or Form 709 (whichever is applicable). An accompanying statement may be required explaining that it may be necessary to adjust the amount of property being transferred due to judicial (or IRS) redetermination of value. 6. The capital accounts of partnerships and LLCs should match the transfer. 7. To avoid a Procter-like challenge,210 transfer documents must not use any language that could be construed as a savings clause that takes property back. There should always be an unambiguous intent to transfer a set value of property rather than a percentage interest or number of membership units.

THE LIFE ESTATE/REMAINDER TRANSFER STRATEGY

The life estate and remainder transfer is a common estate- and succession-planning strategy. This strategy is often integrated as a component of a succession plan, but it is typically not the primary focus of a succession plan. It is also a simple way to own property and move it from one generation to the next. This technique is often employed in relatively smaller-sized estates, sometimes on an informal basis. Thus, an understanding of the basics of life estate/ remainder arrangements is critical. The life estate/remainder arrangement is a form of co-ownership that gives both the life tenant and the person or persons holding the remainder interest certain rights to the property. The life tenant has a current right to possession and the holder of the remainder interest has a right of possession upon the life tenant’s death.

CREATION OF AND PROPERTY SUBJECT TO A LIFE ESTATE A life estate can be created by gift or sale (by virtue of a deed), at death under the terms of a will or trust, by state law, or by a settlement agreement in divorce proceedings (or via court order). Most often, life estates are created with respect to real property, but they can also be utilized with personal property and even intangible personal property. The life tenant has possession of the property subject to the life estate and is entitled to all of the income generated by the property. Accordingly, the life tenant is subject to the normal tax consequences associated with property ownership. For example, the life tenant is taxed on all of the income received from the property and can deduct items attributable to the property, such as real estate taxes, mortgage interest, depreciation (if the property is depreciable), and depletion (if the life estate is acquired by purchase). If life estate property is sold, its income tax basis must be apportioned between the life estate interest and the remainder interest in proportion to the respective present values of the interests as determined by the IRS valuation tables. The IRC §7520 rate in effect at the time of valuation is used for this purpose.

210. Comm’r v. Procter, 142 F.2d 824 (4th Cir. 1944), cert. den. sub. hom., 323 U.S. 756 (1944).

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The share of uniform basis allocable to each interest is adjusted over time. This occurs in the following ways. • If the property is not sold during the life tenancy, the holder of the remainder interest receives the entire income tax basis in the property. • If the life estate interest is sold, the life tenant’s portion of uniform basis is disregarded for purposes of determining gain or loss.211 This means that the gain on sale is equal to the amount realized on sale (i.e., the sale proceeds). The gain would most likely be capital in nature.

Note. If the life estate property is a personal residence, both the holder of the life estate interest and the remainder interest are potentially eligible for the IRC §121 gain exclusion. However, they would have to satisfy the §121(a) requirement to own and use the residence for two years during the 5-year period ending on the date of sale.

• If both the life estate interest and the remainder interest are sold during the life tenancy, the uniform basis of the property and the sale proceeds must be allocated between the life estate interest and remainder interest. This allocation is based on their respective values at the time of sale and determines gain or loss on the sale attributable to each respective interest.212 Any gain is likely capital gain. 6 • If the holder of the remainder interest sells the property after the life estate terminates, gain or loss on the sale is determined by subtracting the uniform basis in the property from the amount realized on the sale.

Income Tax Basis It is important to understand the basis rules associated with life estate/remainder arrangements. Basis depends on how the life estate was created and acquired. •For a granted life estate/remainder arrangement, those created by will or trust on the grantor’s death, the property receives a basis in the hands of the recipient of the life estate equal to the FMV at the time of the grantor’s death. •For a reserved life estate, those created by deed when the grantor retains the life estate, the full value of the property is included in the grantor’s gross estate at death. The holder of the remainder interest receives a basis equal to FMV at the time of death. • A carryover basis applies to a life estate/remainder interest that is created by a gift. • For purchased interests, the basis is the purchase price.

Note. If the life tenant takes depreciation during the life tenancy, the uniform basis in the property is reduced accordingly.

211. IRC §1001(e). 212. See Rev. Rul. 72-243, 1972-1 CB 233.

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Estate and Gift Tax A transfer of a life estate during life by deed qualifies as a present interest gift (and qualifies for the marital deduction if transferred to the transferor’s spouse). However, gifts of successive life estate or remainder interests are future interests that do not qualify for the gift tax present interest annual exclusion. The amount of the gift equals the present value of the interest in the property transferred as determined using the IRS valuation tables. The §7520 rate in effect at the date of the gift applies.

Note. If a grantor retains certain interests in the property and gifts the other interests in the property to members of the grantor’s family, the special valuation rules of IRC §2702 apply. This discussion is beyond the scope of this material.

For interests created by will or trust, the entire FMV of the property is included in the decedent’s taxable estate for federal estate tax purposes. For granted interests when the grantor retains the life estate, the full value of the property is included in the grantor’s taxable estate at death. A life estate to a spouse at death does not qualify for the marital deduction unless it is in the form of a QTIP.

Planning Issues The life estate/remainder arrangement is a very simple technique that involves minimal cost. It avoids probate because the property passes automatically to the remainder-interest holder. The strategy protects the property from the creditors of the remainder-interest holders during the term of the life estate. However, creditors of remainder holders can reach “vested” remainder interests.213 This can indirectly cause problems for a life tenant who wants to sell or mortgage the property. Additionally, in some states, the life estate/remainder arrangement can provide a benefit in the event of the need for long-term care when a Medicaid benefit application is filed. For purposes of calculating benefit eligibility, only the value of a retained life estate is considered in determining eligibility and is subject to Medicaid recovery provisions at the recipient’s death. Alternatively, the life estate/remainder strategy can spur conflicts between the life tenant and the holders of the remainder interest. Neither the life tenant nor the remainder holders can independently sell or mortgage the property without the consent of the other party.

Summary Table The table on the following page addresses a granted life estate/remainder arrangement but does not address retained life estates.

213. A “vested” remainder is one that is certain to become possessory in the future.

B320 2017 Volume B — Chapter 6: Beneficiary and Estate Issues Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook c Remainderman Allocated (Treas. Reg. §1.1014-5) No adjustment to uniformheir’s basis, basis but determined byto adding or subtracting fromuniform adjusted basis assigned tointerest remainder the difference between DoD value of remainderbasis interest of and remainder interestremainderman’s before death. Basis FMV 100% ownership (IRC §1014) No depreciation while life tenant living Allocate: sale price, basis (Determined Treas. Reg. §1.1014-5) Allocated (Treas. Reg.rules) §1.1014-5 100% remaining basis (after depreciation taken while lifealive). tenant No step-up basis. Uniform basis rules using(Treas. FMV DoD Reg. §1.1014-4) b a Testamentary Transfer (Basis FMV DoD of Grantor) 6 Life Tenant Entitled to depreciation (Treas. Reg. §1.1014-4(b)) Allocate: sale price, basis (Determined Treas. Reg. §1.1014-5) Allocated (Treas. Reg. §1.1014-5 rules) Not subject to estateLife tax. estate terminates.step-up No basis. Uniform basis rules using FMV DoD (Treas. Reg. §1.1014-4) (Treas. Reg. §1.1014-5) N/A N/A c gift tax rules (Treas. Reg. Uniform basis rules usingbasis carryover No depreciation while lifeliving tenant Allocate: sale price, basis (Determined Treas. Reg. §1.1014-5) Allocated (Treas. Reg.rules) §1.1014-5 100% remaining basis (after depreciation taken while lifealive). tenant No step-up basis. heir’s basis determined byto adding or subtracting fromuniform adjusted basis assigned tointerest remainder the difference between DoD value of remainderbasis interest of and remainder interestremainderman’s before death. §1.1015-1(b)) Allocated (Treas. Reg. §1.1014-5) Allocated but disregarded Basis FMV 100% ownership (IRC §1014) Remainderman b gift (Carryover Basis Gift Tax Rules) Uniform Basis Rules for ‘‘Granted’’ Life Estate and Remainder Transfer (Grant) Made during Life tax rules (Treas. Reg. §1.1015-1(b)) Uniform basis rules using carryover basis (Treas. Reg. §1.1014-4(b)) Allocate: sale price, basis (Determined Treas. Reg. §1.1014-5) Allocated but disregarded Allocated (Treas. Reg. §1.1014-5 rules) Not subject to estateLife tax. estate terminates.step-up No basis. N/AN/A No adjustment to uniform basis, but Life Tenant (Treas. Reg. §1.1014-5) 1.1014-8(a)(1). ï 1001(e). ï This table does not apply to lifetimeIRC transfers with retained life estates. ItTreas. does Reg. apply, however, to split interests whether created by deed, trusts , or wills. Original basis at time of transfer During life tenant’s life Entitled to depreciation Complete sale by life tenant and remainderman during life tenant’s life Sale by life tenant during life tenant’s life Sale by remainderman during life tenant’s life Death of life tenant before remainderman Death of remainderman before life tenant Death of remainderman after life tenant dies a b c

2017 Volume B — Chapter 6: Beneficiary and Estate Issues B321 Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed. 2017 Workbook

B322 2017 Volume B — Chapter 6: Beneficiary and Estate Issues Copyrighted by the Board of Trustees of the University of Illinois. This information may not be redistributed.