S Corporation –Partnership Basis

Vicki H. Meyer CPA Thomas Howell Ferguson, PA [email protected] 850-668-8100 WHY

FIRM RISK MECHANICS

STRATEGIES What Basis Does …
Limits the amount of loss that can be deducted.
Determines gain or loss on disposal.
Determines the amount of tax-free distributions that can be received.
For a partnership, may determine allocation of income and deductions among the partners. Why all this headache?

Tax Savings

State Law

Liabilities Loss Limitations

Bucket O’ Loss BASIS A taxpayer can never deduct more than the amount that AT RISK flows through from the prior limit. PAL

Deduction Basis – At Risk – Passive Loss Rules ALL DIFFERENT
Different basis rules - IRC Sec. 704(d) and 1361.
Different at risk rules – IRC Sec. 465 Similar to basis, but disallows certain related party liabilities . Liabilities and related parties are defined differently, therefore different results.
Different passive loss rules – IRC Sec. 469 . Material participation. Defined differently depending on state law treatment of LPs and LLCs. Liabilities

S Corporations Partnerships
Not technically
General partners and considered basis but LLP holders get basis in a device that can recourse loans. offset losses.
Other partners can have basis with deficit.
Only direct loans, no restoration obligations guarantees. (DROs).
Special rules on open
Special rules for account debt. nonrecourse loans. Back to back loans

This approach is termed a back-to-back loan, which in the S corporation context has caused some tax uncertainty. In a back-to-back loan, a shareholder borrows the funds and then lends them to the S corporation. A number of courts have approved back-to-back loan arrangements where the loans are valid debt and the shareholder documents them appropriately and makes payments in a manner that is consistent with the loan documents. Therefore, if A had borrowed the funds from a bank, had documented the loan from the bank and the loan to B Inc. appropriately, and all payments were made in accordance with the loan documents (i.e., from B Inc. to A and from A to the bank), it is likely (although not certain) that under current case law A would have debt basis in her loan to the S corporation.
For example, in Raynor , the court allowed the shareholder basis for borrowed funds that the shareholder then lent to the S corporation. In Gilday ,30 the shareholder obtained basis when he exchanged his note for the S corporation’s note with the lender bank. Nevertheless, the IRS has successfully attacked back-to-back loans in certain circumstances. The courts have found that a shareholder cannot claim basis credit where there is no actual economic outlay. This is most frequently the case where there are related-party debt restructurings that the taxpayer intends to create basis and where the form of the transactions is not consistent with the substance the taxpayer claims. 31
Restructuring existing debt increases the risk that the shareholders’ new debt basis will not be respected under Sec. 1366(d). In Oren ,32 the court did not accept a circular flow of cash that the taxpayers intended to create basis because no one’s economic position was changed in the process. 33 In Kaplan ,34 the taxpayers accomplished the circular cash flow with a third-party bank, and the court disregarded the restructured loans. In Kerzner , however, the shareholder borrowed from a bank and contributed the proceeds to the S corporation, which then paid the proceeds to related entities, and the related entities lent the proceeds to the shareholder to repay the original bank loan.
Thus, the story of basis comes full circle. Properly structured, the cost basis in the land (partially funded by debt) can be reflected in A’s S corporation basis (also partially attributable to debt). However, as was previously noted, basis can be elusive and can disappear if not carefully watched. Open account loans
Can be netted if less than 25K
If net of advances and repayments, is more than $25,000 at the close of the S corporation's tax year, then beginning with the next tax year, the principal amount of the open account debt is no longer considered to be open account debt. Rather, it is treated as if it were indebtedness evidenced by a separate written instrument for purposes of the debt basis rules. Must be real stock or debt…
The shareholder must experience an actual economic outlay to acquire stock or debt basis . This means that, before basis can be increased, “there must have occurred some transaction which when fully consummated left the taxpayer poorer in a material sense” ( Rev. Rul. 81-187 ;
Giving only a note to the corporation or subscribing for more stock without making payment does not increase basis .( Silverstein ).
The partner's basis generally is increased only as the contribution obligation is fulfilled ( Rev. Rul. 80-235 and Oden ). Basis Calculation oprto Partnership
CorporationS Corporation S




S CorporationS CorporationS income itemsnot exceedto deduction Loss and Lessdistributions items Income gain and contributionsCapital BOY zero). EOY (cannot be below PartnershipPartnership







Partnership Capital contributions Capital BOY EOY items Loss and deduction DecreaseLiabilitiesin Less distributions Increaseliabilitiesin items Incomeand gain Initial Basis if Purchased:

S Corporation Partnership
Cost of the shares.
Carryover of selling partner's tax-basis capital account (inside basis) plus
FMV difference (outside basis). Contributions Partnership Basis Accounts

Inside Outside Economic Basis Basis Basis Inside and Outside S Corporations Partnership
Just one basis. (Even though debt can be used
Inside basis carries over to absorb losses after to new partner. stock basis is reduced to
Outside basis can be zero.) brought inside with Sec
Cannot amortize 754 and deducted. Large through current negative adjustments are deductions the increase required. attributable to FMV over basis to the corporation. Initial capitalization with property

S Corporations
Must have >80%
Do not have to keep ownership to be tax track of built in gain. free.
No disguised sale
Possible gain if rules. liabilities are in excess

Contributions of basis (IRC Sec. 357). Contributions - Initial capitalization with property

Partnerships
Can have any
Do have to keep track ownership and be tax of built in gain IRC free. 704(c).
Typically no gain if
Disguised sale rules if liabilities exceed distributed within 2

Contributions basis. yrs. Basis acquired by Gift

S Corporation Partnership
Donor's basis
The transferee
Plus Gift tax partner assumes the attributable transferor's tax-basis
Limited to FMV for capital account. Loss Purposes.
Section 754 basis

Contributions adjustments, mandatory for large built in losses. Basis acquired by Inheritance

S Corporation Partnership
FMV at date of death
The transferee partner assumes the transferor's tax-basis capital account.
Section 754 basis adjustments, Contributions mandatory for large built in losses . Basis acquired for services

S Corporation Partnership
Stock’s FMV rather
Liquidation value of than FMV of services the capital interest received.
Future profits in exchange for

Contributions contributing services is generally not a taxable event. Conversion from a C Corp

S Corporation Partnership
C corporation electing S
Considered a taxable status. Initial basis in S liquidation followed stock is the basis in C by a contribution of stock at the time of net assets to the conversion. Some partnership.

Contributions immediate tax (LIFO reserves) but typically built in gains can be deferre.) Income and Gain Items

S Corporation Partnership
Includes page 1 and
Same separately stated items on K-1
Tax Exempt Income- increase basis. Net income Net
Special depletion rules. Increases in Liabilities

S Corporation Partnership
Only increases in
Increases in liabilities direct loans, not as determined under entity loans. IRC Sec. 752, based on a zero value liquidation, who would perform on the debt. Distributions Partnerships S Corporations
Can be
Cannot be disproportionate. disproportionate
Reduce basis for a (second class of stock distribution made on rules). the date it is made
Taken into effect at
If nonliquidating, can the end of the year. be EOY to the extent
Should not be of the parnter's share “draws” but follow of income for the year corporate form, (advance or draw rule). Decreases in Liabilities

S Corporation Partnership
Can trigger income in
Decreases in in xcess of basis.. liabilities as determined under IRC Sec. 752.
Can trigger income if in excess basis. STOP HERE

S Corporations Partnerships
If after distributions
No gain on and decreases in distributions unless liabilities, the number distributions are in is negative, than cash or marketable income to securities. shareholder. Loss and Deduction Items

S Corporation Partnership

Includes page 1 and
Same separately stated items on K-1
Tax Exempt Income- increase basis. Net income Net Non Deductible Expenses

S Corporation Partnership
Decrease basis to
Same ensure that expenditures that, for income tax purposes, are neither deductible nor capitalizable, cannot be deducted when the interest is disposed. STOP HERE S Corporations Partnerships
If after negative items the
Same. number is negative, than losses carry forward to future years.
Loss is prorated over the
Same the character of income.
Special election for
Check rules. treatment of nondeductible items. Loss carryovers

S Corporations Partnerships
Lost if (1)the shareholder S
Sennett v . Commissioner 80 corporation election is A partner’s suspended terminated; (2) the deductions under IRC shareholder disposes of all of section 704(d) expire upon his or her stock to someone other than a spouse or former the sale of his partnership spouse incident to a divorce; interest. or (3) the shareholder dies.
Allocated to each share of stock. Allocations When a Interest Changes

S Corporations Partnerships
per-share, per-day basis
interim closing of the books allocated equally to each day method. of the tax year and then are
proration of annual income allocated equally among the shares of stock outstanding
any other reasonable on each day of the tax year. method.
special rules required when the S election terminates or an election to use specific accounting is made. Other S Corporation items
Gain on Sale of S Corporation Stock Does Not Increase Basis
If a shareholder with a suspended loss carryover sells his S corporation stock, he will have a gain reportable from the disposition. However, gain on the disposition of stock does not increase basis for purposes of using S corporation carryover losses. (See Key Issue 30D .) The adjusted basis of stock sold or otherwise disposed of during the year is determined immediately prior to the sale or disposition, as discussed in Key Issue 19D .Domestic Production Activities Deduction Does Not Affect Basis
Information necessary to calculate the Section 199 domestic production activities deduction is reported on each shareholder's Schedule K-1. The deduction is claimed by the shareholder and does not affect the shareholder's stock basis [ Reg. 1.199-9(c)(1)(i)]. The Section 199 deduction is covered in Key Issue 18A .Effect of Credits on Basis
The basis limitations do not apply to credits. For example, an S corporation shareholder with a zero stock basis who receives a $3,000 disabled access credit pass-through on Schedule K-1 can claim the credit even though his stock basis is zero. (See Key Issue 28D .) Responsibility

S Corporation Partnership
The shareholder's
The partners. As a (not the practical matter, corporation's) partnership return
AAA, PTI, and AE&P preparers have a maintained at the responsibility to make corporate level. it as easy as possible for partners to do so. Slow down…invest time upfront Firm Best Practices

S Corporations Partnerships
Copy of debt
Copy of partnership instruments. agreement.
Basis schedules.
Copy of debt instruments and underlying guarantees.
Basis schedules.