Partnership/S Corporation Basis and Distribution Issues (Psbd)

PARTNERSHIP/S CORPORATION BASIS AND DISTRIBUTION ISSUES (PSBD)

Edward K. Zollars, CPA (Arizona) [email protected] www.currentfederaltaxdevelopments.com www.currentfederaltaxdevelopments.com/idpsbd

• Draft Form 1120-S Instructions, 10/16/19 – New QBI flowchart (p. 39)

This Photo by Unknown Author is licensed under CC BY-SA

• Draft Form 1120-S Instructions, 10/16/19 – Detailed §199A instructions for K- 1 on page 38 – 3 new statements to be attached to K-1s

This Photo by Unknown Author is licensed under CC BY-SA

• Draft Schedule K-1, Form 1120S, 7/25/19 – Got rid of 5 codes for reporting §199A information – Now simply have code V, item 17 “other information” – Presumably will have to provide all

details required by regulations Photo by Ross Findon on Unsplash – Likely to see similar changes on other 2019 K-1s

• Draft Form 1065, 1120-S and K-1s, 9/26/19 – Tax basis capital only on K-1 – More §704(c) information on K-1 – At risk and passive activity disclosures – Separate out 2 types of guaranteed payments Photo by Ross Findon on Unsplash

• Instructions to Form 1065, 2/4/19, Notice 2019-20 – IRS wants information on partners with negative tax basis capital – Indicates likely future income that should be recognized – Required disclosure on Schedule K-1 in those cases – Given to March 15, 2020 Photo by Marvin Esteve on Unsplash

• Notice 2019-20, 3/7/19 – Tax basis capital disclosure if it is negative at beginning or end of the year – Partnerships protested that they wouldn’t be able to timely provide information – No penalty if omitted from 2018 K-1s – But have to provide information by March 15, 2020 Photo by Veri Ivanova on Unsplash

Photo by Christa Dodoo on Unsplash

• Clarification on line 28, column (e), of Schedule E (Form 1040), IRS Website, 2/6/19 – Basis schedules have been required when S corporation shows loss – Now have check box on Schedule E for that situation – IRS has also expanded list of situations where schedule must be included with the return Photo by Christa Dodoo on Unsplash

• §351 Nonrecognition Rules and When They Apply • Interests in Property – Services, Intangibles, Other Issues • Transferor Requirement • Control Test • Step Transaction Doctrine • Controlled Groups

• Definition of Stock • Boot and §351 • Transfers of Multiple Items of Property and Boot • Delayed Payments of Boot – Is it Boot or a Distribution?

• Transfer of stock in a controlled corporation – §304 issue • Installment obligations and §351 transactions • Receipt for services and §83(b) issues (and S complications) • No actual exchange is required

• General rule – liability not treated as boot • First exception – primary purpose is tax avoidance • Second exception – liabilities in excess of basis • Excluded liabilities • Allocation of gain

• Assumption defined for §351 • Contingent liabilities • Character of gain • Effect of Liabilities on Basis – considered boot when determining basis

• Basis of stock received: – Add: basis of property transferred – Less: boot received (including liabilities assumed) – Add: gain recognized

• Basis of assets received by the corporation: – Add: adjusted basis of property received in hands of transferor – Add: gain recognized by the transferor on the exchange

• Nonrecognition by corporation on issuance of own stock for property • Recapture rules • Incorporation of a partnership – including LLC previously taxed as a partnership making an S election

• Name & EIN of transferee corporation • Date of the transfer • Aggregate FMV and basis of the transferred assets • Date and control number of any PLR received

• Name and EIN/SSN of each significant transferor • Date(s) of the transfer(s) • Aggregate FMV and basis of transferred assets • Date and control number of any PLR received

• Number of shareholders • Eligible entity types as shareholders • Restrictions on foreign ownership • One class of stock • Ineligible corporations

One

H W

Joe

Son Daughter

Son Daughter Son Daughter

S D S D S D S D

S D S D S D One Shareholder

• Held by others • Joint tenancy (count each) • Widow/er and estate of deceased = 1 • Restricted bank director stock = 0

• Estate of Qualified Shareholder • Bankruptcy Estate • Life Estates if life tenant makes election (PLR 200404037)

• Grantor trusts (complete ownership) • Testamentary trusts for 2 years • Voting trusts • Qualified Subchapter S Trust (QSST) • Electing Small Business Trust (ESBT)

• Only one class issued • Voting rights are ignored • Must have same rights to distributions and liquidation proceeds

• If no §83(b) election made, ignore shareholder until restrictions lapse • If make §83(b) election, then count these shares • Deferred compensation plan

• Other agreements • Nonresident income taxes • ESOP Rules

• Death, disability, divorce or termination of employment agreements excluded • Other buy/sells – Not attempt to skirt 2nd class – Price near fair market value (GAAP exception)

• Prohibited features • Safe harbor rules

• Check the box allows to be treated as corporation • Tests interests under same dual tests

• Arrangement constitutes equity • Principal purpose to get around limitation on rights of stock • Straight debt rules

• §1361(c)(5) definition – Not contingent payments – No convertibility (direct or indirect) – Credit individual, estate, eligible trust, or commercial lender • Subordination is OK – but modifications are tested

• Corporation elects • Shareholders consent

Effective for Current Year First 2 1/2 Months or Following Year

Last 9 1/2 Months Effective for Following Year

• Begins on first day of corporation’s year • Can create short year with change in fiscal year

• First 2½ months of first taxable year • Note deemed incorporation if change LLC’s status to corporate with same 2½ month lookback

• First of the following: – First had shareholders, or – First had assets, or – Began doing business • Danger of electing too early

• Form 2553 • No extensions allowed for election

• Husband & wife if both have ownership interest (including community property) • Minors • Estates • Trusts

• IRS now has authority to waive effect • Requires user fee unless fall under automatic provisions of Revenue Procedures

• §721 recognition of gain or loss • Partners’ initial basis in interest – Add: cash contributed – Add: adjusted basis of property contributed – Add: gain recognized • Partnership gets carryover basis in property • Note contribution issue

Contribution of cash §752(a)

Distribution of cash §752(b)

• Generally, no recapture triggered on contribution • Must carry over all attributes to new partnership

• Beginning if contribute to partnership: – Add: money contributed – Add: adjusted basis of other property – Add: gain recognized under §721(b) • If acquired by purchase, gift, etc., will use standard basis rules

• Contributions of cash/property • Taxable income • Tax exempt income • Depletion deductions in excess of the basis of the properties subject to depletion

• First rule – never goes below zero • Distributions of cash or other property • Partnership losses • Nondeductible expenses • Depletion deductions to the extent of basis in the properties

New Client Rule Reg. §1.705-1(b) © Kaplan, Inc. 70 70 REG. §1.705-1(B)

(b) Alternative rule.

In certain cases, the adjusted basis of a partner's interest in a partnership may be determined by reference to the partner's share of the adjusted basis of partnership property which would be distributable upon termination of the partnership. The alternative rule may be used to determine the adjusted basis of a partner's interest where circumstances are such that the partner cannot practicably apply the general rule set forth in section 705(a) and paragraph (a) of this section, or where, from a consideration of all the facts, it is, in the opinion of the Commissioner, reasonable to conclude that the result produced will not vary substantially from the result obtainable under the general rule. Where the alternative rule is used, adjustments may be necessary in determining the adjusted basis of a partner's interest in a partnership. Adjustments would be required, for example, in order to reflect in a partner's share of the adjusted basis of partnership property any significant discrepancies arising as a result of contributed property, transfers of partnership interests, or distributions of property to the partners.

• Unrestricted stock – general rule FMV of shares upon issuance, deduction to corporation • Restricted interests – §83(b) applies

• Must be a profits interest only • No income unless – Certain and predictable stream of income – Disposes within two years – Is a publicly-traded partnership • No deduction to partnership for FMV of interest

Contribution of cash §752(a)

Distribution of cash §752(b)

(a) Increase in partner's liabilities

Any increase in a partner's share of the liabilities of a partnership, or any increase in a partner's individual liabilities by reason of the assumption by such partner of partnership liabilities, shall be considered as a contribution of money by such partner to the partnership.

(b) Decrease in partner's liabilities

Any decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner's individual liabilities by reason of the assumption by the partnership of such individual liabilities, shall be considered as a distribution of money to the partner by the partnership.

• Recourse Liabilities • Nonrecourse Liabilities

(1) Recourse liability defined.

A partnership liability is a recourse liability to the extent that any partner or related person bears the economic risk of loss for that liability under section 1.752-2.

(2) Nonrecourse liability defined.

A partnership liability is a nonrecourse liability to the extent that no partner or related person bears the economic risk of loss for that liability under section 1.752-2.

• Only lender has risk of loss • Three tiered allocation – Minimum gain – §704(c) allocation – Proportionate share (reasonable basis)

Debt > Basis of Collateral

• Shareholder calculation • Not tied to AAA or retained earnings • Important for: – Gain or loss on disposition – Limits on deduction of losses – Tax-free distribution limits

• Purchase • Section 351 Transaction • Conversion to S status • Gifted • Inheritance

• Separately-stated items of income • Nonseparately stated income • Excess of deductions over basis for depletion • Recapture of general business credits • Only count if reported (§1367(b)(1))

• Distributions not includable in shareholder’s income • Separately stated items of deduction • Nonseparately computed loss • Expenses not deductible, not chargeable to capital • Shareholder’s deduction for oil & gas depletion

• Increased by items of income • Decreased by distributions • Decreased by items of loss • Basis can never go below zero

Property Cash FMV $75,000 $10,000 Basis $55,000

Stock Basis $65,000

• Buy shares for $35,000 • Six years pass – elect S • Initial basis $35,000

• Takes over donor’s basis generally • Gift tax paid, increases basis • If FMV < basis, have dual basis property • Passive losses added back to basis when stock gifted (does not release losses on donor’s return) (See Example 4)

• Installment sale – unrecognized gain of $800,000 at date of death • Basis = $1,000,000 fair market value less $800,000 IRD from unrecognized gain or $200,000

• Loss deductibility stops when basis hits zero • Balance carried forward

• Basis computed on share-by-share basis • §1377(a) requires use of per share, per day rule • Spillover rule allows use of loss if have basis in other shares

• Unique rules for S corporations • Malpractice traps galore

• Stock basis hits zero, debt basis is then reduced • Proportionate among multiple debts • Basis first restored to debt before adding to stock basis

• Debt to shareholder only (§1367(b)(2)(A)) • Guarantees don’t get basis • Co-maker doesn’t get basis

• Make payments, create basis (Rev Rul 71-288) • Can substitute debt (Rev Rul 75-144) • Must be true economic outlay (see Kaplan vs. Comm., TC Memo 2005-218 & Thomas v. Comm., TC Memo 2002-108)

• If have full basis in debt, no income • Otherwise prorated gain – Ordinary income if not evidenced by note – Capital gain if evidenced by note

• Brooks v. Commissioner, TC Memo 2005-204 – Repaid early in year – By end of year, loaned back enough to get net loan for year, so no gain triggered • IRS Reaction: Revised regulations to limit use of open account debt

• Same netting rule applies – but may cease to be open account debt • No longer open account debt if balance exceeds $25,000 at fiscal year end • Can only be repaid once converted, no advances allowed • Big danger if shareholder takes money immediately after year end

• Deals with difference in FMV and basis for contributed property • Required reasonable allocations to take into account such differences

• Traditional Method • Traditional Method with Curative Allocations • Remedial Allocation Method

• Applies if: – Partner has unrecognized §704(c) gain – Receives distribution of property with FMV > basis • Triggers gain recognition immediately prior to distribution

• Gain recognized equal to lesser of: – Excess of FMV over partner’s basis, or – Net unrecognized pre-contribution gain of the partner • Basis of affected §704(c) assets increased on partnership books • Distribution subject to regular distribution rules from this point forward

An automatic extension of 12 months from the due date for making a regulatory election is granted to make elections described in paragraph (a)(2) of this section provided the taxpayer takes corrective action as defined in paragraph (c) of this section within that 12-month extension period. For purposes of this paragraph (a), the due date for making a regulatory election is the extended due date of the return if the due date of the election is the due date of the return or the due date of the return including extensions and the taxpayer has obtained an extension of time to file the return. This extension is available regardless of whether the taxpayer timely filed its return for the year the election should have been made.

(i) The election to use other than the required taxable year under section 444;(ii) The election to use the last-in, first-out (LIFO) inventory method under section 472; (iii) The 15-month rule for filing an exemption application for a section 501(c)(9), 501(c)(17), or 501(c)(20) organization under section 505; (iv) The 15-month rule for filing an exemption application for a section 501(c)(3) organization under section 508; (v) The election to be treated as a homeowners association under section 528; (vi) The election to adjust basis on partnership transfers and distributions under section 754; (vii) The estate tax election to specially value qualified real property (where the Internal Revenue Service (IRS) has not yet begun an examination of the filed return) under section 2032A(d)(1); (viii) The chapter 14 gift tax election to treat a qualified payment right as other than a qualified payment under section 2701(c)(3)(C)(i); and (ix) The chapter 14 gift tax election to treat any distribution right as a qualified payment under section 2701(c)(3)(C)(ii).

For purposes of this section, corrective action means taking the steps required to file the election in accordance with the statute or the regulation published in the Federal Register, or the revenue ruling, revenue procedure, notice, or announcement published in the Internal Revenue Bulletin (see section 601.601(d)(2) of this chapter). For those elections required to be filed with a return, corrective action includes filing an original or an amended return for the year the regulatory or statutory election should have been made and attaching the appropriate form or statement for making the election. Taxpayers who make an election under an automatic extension (and all taxpayers whose tax liability would be affected by the election) must file their return in a manner that is consistent with the election and comply with all other requirements for making the election for the year the election should have been made and for all affected years; otherwise, the IRS may invalidate the election.

Any return, statement of election, or other form of filing that must be made to obtain an automatic extension must provide the following statement at the top of the document: "FILED PURSUANT TO SECTION 301.9100-2". Any filing made to obtain an automatic extension must be sent to the same address that the filing to make the election would have been sent had the filing been timely made. No request for a letter ruling is required to obtain an automatic extension. Accordingly, user fees do not apply to taxpayers taking corrective action to obtain an automatic extension.

• Current vs. Liquidating • Proportionate vs. Disproportionate

• Cash distributions – if in excess of basis, gain • Receivables and inventory – if no other assets received can generate loss • Other assets

• Taxpayers may rely on them • Will go to a pair of deemed liquidations and see whose share of hot asset income/loss has changed • Would trigger recognition if share of income increased or loss decreased • If trigger §734(b) adjustment, recognize gain • Otherwise can elect to recognize gain in lieu of basis reduction

736(a)

• Distributions in excess of capital interest • Ordinary income to partner • Deductible to partnership

736(b)

• Liquidating distribution of capital account • Capital gain to partner (subject to hot asset rules) • Nondeductible to partnership (though may have some impact)

Section Partnership 704(c) Distribution Assets of Assets

Distribution within 7 years

• Short name – AAA • Undistributed taxable income earned in years after 1982 (replaced PTI) • Corporate level tax account

• Retained earnings • Total shareholder basis • Of any real importance if there is no E&P or in the post-termination period • Used to trigger when E&P is deemed forced out

• Adjusted “similar” to stock basis [§1368(e)(1)(A)] • Differences – Not always adjusted for tax exempt income – May be reduced below zero – Not adjusted for shareholder transactions

• Separately stated items of income (other than tax exempt) • Nonseparately stated items of income • Excess non-oil & gas depletion

• Distributions • Separately stated losses (other than tax exempt income) • Nonseparately stated losses • Nondeductible expenses • Depletion deduction not in excess of basis

• No reduction for federal taxes attributable to C corporation years • Only adjusted for income as reported by shareholders • Pre-1997 – losses came before distributions

• Reduce AAA dollar for dollar unless: – A taxable dividend from earnings & profits – Redemption – PTI distribution (very unlikely now) • Noncash distributions reduce AAA based on fair market value of property distributed

• Redemptions not taxable as a dividend reduce AAA based on proportion of shares redeemed • Nature of property distributed does not affect

• Can exist • Distributions cannot create negative AAA account (Reg. §1.1368-2(a)(3)(ii)) • Must get back to positive to have tax free distributions if corporation has E&P

• Applied prorata to all distributions during year • Not an issue if no sale • Is an issue if a sale (and question of whether election to close the books has been made)

• Nondefinition at Reg. §1.312-6 • Need calculation of E&P when elect S status • New law technical change cleans up more pre-1982 S corporation E&P • E&P not allocated prorata--it is first/come first served basis

• To shareholder at FMV • Gain triggered at the corporate level • Very different from partnership treatment

• If no E&P, cannot make taxable dividend • No E&P – Distribution of AAA (non-taxable) up to shareholder basis – Return of capital – Gain from deemed sale or exchange of stock [§1368(b)]

• With E&P – Until AAA exhausted, same as if no E&P – After AAA exhausted, taxable dividend until E&P exhausted – Return to no E&P treatment list again

• As noted, triggers corporate gain • PLR 8908016 stated losses not allowed, but still reduce AAA • If FMV of cash & property exceeds AAA, allowed based on relative FMV

• Election to bypass AAA • Election to make deemed dividend • Election to bypass PTI (if any still exists)

• Statement attached to return • Signed by corporate officer and each shareholder

• Big reason – excess passive income tax and eventual loss of S status • May have tax planning issues

• 1 year after last day of S election or due date of final S return (if later) • 120 days after IRS audit changes S corporation year • 120 days after status determined by court decision or agreement with IRS

• Stuff that doesn’t go to AAA or E&P • Tax free income and related expenses

• Tax-exempt interest • Life insurance proceeds • Any other nontaxed sources

• Premiums paid on life insurance in excess of cash value • Expenses related to tax exempt interest • Similar expenses

• Nothing else effects OAA • Distributed only after AAA and E&P exhausted • Traps tax exempt income below E&P

• Pre-1983 undistributed passthrough income • Distributions tax free to extent of basis • Not affected by post-1982 passthrough items

• AAA • PTI • E&P • Reverts to standard distributions

• Stockholder owns his/her PTI • Loses ability to be distributed tax free when S election terminates • PTI distributions can only be cash (no property)

• Post S election E&P adjustments – Payment of income taxes – Refund of taxes from C year

• Calculation of Amount At Risk • Limitations Imposed on Passthrough Entity Interest Holders • Applicability of At-Risk Rules • Closely-Held Corporations

• Included §1245 Property • Exclusion for Real Property • Equipment Leasing in a Corporation • Exclusion for a Qualified Corporation • Separation of Activities

• Aggregating Activity Conditions • Special Categories

• Nonrecourse Financing • Exception for Qualified Nonrecourse Financing • Post August 3, 1998 Financing • Qualified Person • Protection Against Economic Loss • Guarantee of LLC Debt

• Reductions of Amounts At Risk • Recapture Rule • Limited Losses

• Definition of a security for worthlessness • Bad debt deduction for debt not a security • §1244 stock issue

• Part sale/part gift • Sale price set at debt transferred • Gain only if debt exceeds basis • Potential assignment of income attack [Revenue Ruling 60-352]

• Part sale/part gift • Again debt assumed is the sales price • However basis is allocated rather than applied against sales price in full

• Partnership – Potentially passive activity – test at partner level – Trader issues – tested at the partnership level

• Look at the activity of the partner, not the partnership • Note distinction vs. §1402 self- employment tax

• If treated as limited partner, only 3 of 5 passive tests apply – 500 hours – 2 anti-abuse • Current regulation definition • Proposed “management” reg.

• Example: – If subject to SE tax, then only pay 2.9% – If not subject to SE tax, then pay 3.8% • Be careful about old “rules of thumb”

• Guaranteed payments – Received for services not part of NII – Received for use of capital is subject to NII • Section 736 payments – §736(a) payments are not treated as retirement funds – §736(b) payments treated under rules for sale of partnership interest

• “Holy Grail” of Medicare Tax income – Not §1411 investment income – Not subject to additional SE tax • Possible for partnership? – IRS Proposed Regulations (possible opening for significant participation activities) – Renkemeyer, Campbell & Weaver and the issue of capital

• Similar rules to partnerships – Trade or business issue – Passive activities (without LLC complication) • Material participation more complex

• Not a self-employment tax issue • Disguised salary matter • IRS court victories (and limits) • Sources of reasonable salary • CPA exposure

• Major changes in final regulations • Eliminated required entity level “deemed sale” calculation on each disposition • Now only deal with potential inside gain on “Section 1411 Property”

• Only have to do inside calculation if: – Engaged in at least one trade or business (or own interest in passthrough engaged in trade or business) and – Interest holder materially participates • If don’t meet both tests, disposition gain/loss goes into NII calculation

• §1411(c)(4) disposition (meets the 2 tests) • §1411 holding period – Year of disposition + 2 prior years or – Time disposing interest holder held interest if less • §1411 property – if sold would result in gain/loss included in calculation of NII

• Include in net NII gain loss lesser of: – Net gain on disposition of interest or – Share of net gain on deemed sale of §1411 property at entity level • Subject to optional reporting “election” (may have to elect, as we will see)

• Include in computation of net NII gain/loss lesser of: – Net loss on disposition of interest or – Share of net loss on deemed sale of §1411 property at entity level • Subject to optional reporting “election” (may have to elect, as we will see)

• Can use if meet one of two requirements and do not have disqualification • Requirements – 5% threshold for NII items (capped for gain/loss of no more than $5 million) – $250,000 gain/loss threshold

• Disqualifiers – Short-term owner – Transfers during §1411 holding period – Transfer of disproportionate interest – Knowledge of change in asset makeup – Prior C corporation

• Compute without regard to installment treatment initially • Will end up with % to use for installment payments that will represent NII gain

• Must report allocable Section 1411 property gain/loss if aware – Has a trade or business other than commodities and – Interest holder materially participates in one or more and – Seller not eligible to use simplified method • Otherwise no obligation to give seller information

• All information requested in forms plus – Name & TIN of passthrough entity – Gain/loss under regular income tax rules – Information provided by the passthrough entity and – If applicable, basis adjustments for CFCs and PFICs per proposed regulations • Additional information for installment sales

• Dispositions resulting in termination of S status (sell to disqualified shareholder) • Ignore tax that would have been paid on built-in gain • Treat QSST owner as holder of S corporation stock

• Liquidation following sale of assets – treat as single sale and don’t add to §1411 gain/loss based on these rules • Amounts not picked up under these rules is treated as an “excluded” gain/loss under regular §1411 gain/loss rules