PARTNERSHIP AND S CORPORATION DIFFERENCES

Fort Worth CPA 2015 Tax Institute

August 6, 2015

John R. Hunter, J.D., C.P.A.

THE BLUM FIRM, P.C.777 Main Street, Suite 700Fort Worth, Texas 76102Tel.: (817) 334-0066www.theblumfirm.com

Materials prepared by John Hunter and Emily Seawright.

Partnerships and S Corporations• Both flow through entities

• Generally, taxation of income, gain, deduction, and loss at shareholder and partner level.

• That is where most of the similarity ends.

• Many tax attorneys avoid S Corporations unless they are needed to accomplish a specific goal.

22

Partnerships and S Corporations• S Corporations are inflexible and restrictive.

• Placing assets in an S corporation is like placing them into a black hole because the distribution of assets is a taxable event.

• Conversely, partnerships are far more flexible and less restrictive.

• Knowing the differences between partnerships and S corporations helps determine which entity is most appropriate for the client.

3

Entity v. Aggregate ConceptsAggregate

(Partnerships)

• Partnership is treated more like an aggregation of individuals.

• Gain recognition on sale of assets is fragmented on asset by asset basis and passes through to owner.

• Owner taxed on entity’s income.

Entity(C Corporation)

• Entity is separate from owners.

• Gain recognition on sale of assets kept at entity level.

• Entity is taxed on entity’s income.

Hybrid: S Corporation 44

Examples of Differences Discussed

Partnerships• No ownership requirements.• Allocation of income, gain,

deductions, and loss flexible as long as maintain substantial economic effect.

• Generally, no gain or loss on distributions except to extent distributions of money exceeds basis.• There are exceptions under

sections 704, 707, 731, 737, 752).

S Corporations• Strict ownership requirements.• Allocation of income, gain,

deductions, loss, and distributions are ALWAYS pro rata.

• In-kind distributions ALWAYS treated as sale of asset by corporation at FMV as of date of distribution

• Gain ALWAYS recognized by shareholder on distribution if FMV exceeds basis.

55

Ownership RestrictionsPartnerships

• None.

S Corporations• Limited to 100 Shareholders,• Shareholders restricted to:

• Estates• Listed Organizations

• 401(a), 501(a), 501(c)(3)

• U.S. Individuals.• No partnerships, associations,

corporations, or Non-resident Aliens

• Specific Trusts• Grantor Trusts (2 years)• Testamentary Trusts (2 years)• Voting Trusts• Electing Small business Trusts• Qualified Subchapter S Trusts• Previous Grantor Trusts with

S Corporation Stock66

S Corporation Ownership• Grouping

• Family members counted as one shareholder.• Owner of disregarded entity, where owner is family member,

considered part of family grouping.

• Non-resident Alien• Filing joint tax return with U.S. resident or citizen prevents

termination of S election.

• Beware of Foreign Trusts• One non-resident fiduciary creates a foreign trust, which cannot be

an S corporation shareholder.

77

Election Requirements• Multi-member electing entities treated as partnerships for

tax purposes unless elect corporation tax treatment.• S Corporations

• Must meet the “Small Business Corporation” requirements.• Must make a §1362 election

• Made by S corporation with consent from shareholders.• The following are treated as shareholders of corporate stock held by

trust:• “Owner” of a Grantor Trust,• Within two (2) years of the date of death, the estate where no Testamentary

Trust has made an ESBT or QSST election,• Beneficial Owners of a Voting Trust,• Trust beneficiaries of a QSST,• Trustee of an ESBT.

• Separate election must be made for each corporation owned by QSST.88

Separately Stated Items of Income• Both Partners and Shareholders must separately state the

following items:• Income• Gain• Loss• Deductions• Credits• Charitable contributions• §179 expense deductions• §1231 gains or losses• Medical and dental expenses• Itemized deductions• Capital gains or losses• Foreign taxes paid

99

S Corporation Sometimes Pays Income Tax

• S corporation liable as an entity for taxes on the following:• Built-in gains (only if the entity operated as a C corporation prior to

making the S election);• Excess net passive income;• LIFO recapture.

1010

Cancellation of Indebtedness Income• Partnerships – Aggregate Concept

• Insolvency determined at the partner level.

• S Corporations – Entity Concept• Insolvency determined at the entity level.

11

Basis—S Corporations• Inside basis of assets.

• Shareholder contributes property in exchange for stock.• Basis is transferor’s basis, increased by the gain recognized to the

transferor on the transfer.

• Corporation receives property in reorganization.• Basis is transferor’s basis, increased by the gain recognized on the

transfer.

12

Basis—S Corporations

Initial Stock Basis (outside basis) is the basis of the property given in exchange for stock, increased by gain recognized on the transfer, and reduced by boot received.

13

Basis—S Corporations• Stock Basis – Annual Adjustments to Basis.

• Increased by:• Allocated income, including tax exempt income and• Depletion deductions in excess of basis.

• Decreased by:• Losses or deductions,• Distributions, and• Non-deductible expenses.

14

Basis—S Corporations• Debt Basis

• Increased by:• Bona fide loans to corporation and• Income allocated to extent of previously losses deducted in excess of

stock basis.

• Decreased by:• Pro rata losses in excess of stock basis

• Any income must first restore debt basis before increasing stock basis.

15

Basis—Partnerships• Inside Basis (partnership’s basis in partnership assets)

• Contributed Property• Basis of contributed property to transferor at time of contribution (not

increased by any gain recognized).

• Uncontributed Property• Basis determined by generally applicable basis rules.

16

Basis—Partnerships• Outside Basis (basis of partner’s interest in partnership)

• Money contributed to partnership, plus• Basis of any contributed property at time of contribution, plus • Gain recognized by partner on contribution, less • Boot received, less• Liabilities assumed by partnership, plus• Partner’s share of partnership liabilities.

17

Recognition of Gain—Contributions

Partnerships

• Generally, no gain or loss recognized at contribution.

• Exception for investment company.

S Corporations

• Contribution is a taxable event unless contributing shareholders own 80% of corporation after contribution.

• Exception for investment corporation.

18

Allocations

Partnerships• Income, gain, deductions, and

losses allocated in accordance with partnership agreement, as long as the allocations have substantial economic effect.

• If substantial economic effect is lacking, allocations must be made in accordance with the partner’s interest in the partnership, which is determined based on the facts and circumstances.

S Corporations• Income, gain, deductions, and

losses allocated pro rata.

• No concept of substantial economic effect.

19

Substantial Economic Effect—Partnership

• Income and loss allocated based on who bears the correlative economic benefits and burdens.

• Allocation must be consistent with economic arrangement of partnership.

20

Substantial Economic Effect—Partnership

• Allocation must meet the following requirements:• Capital account analysis:

• Partnership must maintain capital accounts by:• Allocating profits and losses to capital accounts and • Making distributions consistent with capital accounts.

• Economic effect must be substantial.

21

§704(c)—Allocation of Built-in Gain• Gains and losses from contributed property must be

allocated to take into account the built-in gain or loss as of the date of contribution.

• Prevents shifting of tax consequences on contributed property with built-in gain or loss.

• No corresponding provision for S Corporations.

22

§704(c)—Allocation of Built-in Gain• 3 methods to allocate depreciation:

• Traditional method,

• Traditional method with curative allocations, and

• Remedial method.

23

Allocation of Built-In Gain—S Corporation

• S corporation takes shareholder basis.• Corporation sells asset, built-in gain or loss allocated

across shareholders on pro rata basis.• Result is that a portion of built-in gain or loss is shifted to

other S corporation shareholders.• This shifting of gain or loss could be a planning point.

24

Crane Gain

Tom and Jerry were involved in a partnership that was in the business of developing real estate. Tom loaned money to the partnership, and Jerry contributed his skills and labor. Jerry guaranteed one-half of the debt and received basis for the liability. The partnership made distributions to Jerry throughout the five years in which Jerry was invested in the partnership. However, Jerry did not recognize any gain on the distributions because they did not exceed the amount of his allocated debt basis.

25

Crane Gain

Over the course of five years, Jerry’s wife, Sally purchased miniature donkeys (Sally’s passion) and built several thousand dollars’ worth of fences and barns to care for the donkeys. Similarly, Jerry took some of the money and spent it on his paramour. After five years and $4,000,000 of distributions to Jerry, the partnership sold the developed real estate for $8 million, all of which went to the partner to repay the loan. All the debt allocated to Jerry was eliminated when Tom was repaid.

26Colonel Travis

Crane Gain

Throughout the five years, Jerry and Sally paid no taxes on the $4,000,000 in distributions. Jerry and Sally were surprised when their CPA informed them that they owed $800,000 in capital gains taxes because Jerry’s debt relief was treated as a cash distribution to him. As would be expected, by this time, Jerry and Sally were divorced. Sally did not believe she owed her community property half ($400,000) in taxes because she was an innocent spouse and received no benefit.

27

Crane Gain

Because Sally had clearly benefited from the distributions and had been relieved of the debt allocated to Jerry, Sally was liable for $400,000 of the tax bill. However, due to the complexity of partnership tax, Sally’s attorney did not understand that concept. Fortunately, the IRS innocent spouse expert also did not understand partnership taxation any better, and agreed that Sally was entitled to innocent spouse relief.

This proves that it is better

to be lucky than smart!

28

Distributions of Money

Partnerships and S Corporations that have

always been S Corporations

• Return of capital to the extent of outside basis.

• Capital gain to the extent that distribution exceeds basis.

S Corporations that were once C Corporations

• Distributions occur in the following order:• AAA Account,• Earnings and Profits (earned

as C corporation), and• Basis.• Distributions in excess of

basis are capital gain.

29

Basis Adjustment Upon Distribution—§734

Adjust basis under §734 when:

1. a) §754 election is in effect, or

b) There is a substantial basis reduction (over $250,000).

AND

2. a) There is a gain or loss recognized by a partner related to the distribution of money (§731), or

b) There is an in-kind distribution where the basis of the distributed property changes under §732.

30

Basis Adjustment Upon Distribution—§734

• How to adjust basis:• Increase by:

• Gain recognized by partner on distribution of money, plus• The amount by which the basis of the distributed property decreases

upon distribution.

• Decrease by:• Loss recognized by partner on distribution of money, plus• The amount by which the basis of the distributed property increases

upon distribution.

• Substantial Basis Reduction exists where the net basis decrease would exceed $250,000.

31

In-Kind Distributions of S Corporation Property

• Always treated as taxable sale of asset for FMV, followed by distribution of money equal to FMV.

32

$$$

In-Kind Distributions of S Corporation Property

Example: Tracing, Inc. is an S corporation with three equal shareholders: Abby, Bob, and Charlotte. Abby has a basis of $200 in the S corporation. The company buys an asset for $100 and later distributes it to Abby when the fair market value is $1000. The gain on the deemed “sale” is $900. The $900 gain is allocated to Abby, Bob, and Charlotte on a pro rata basis. Thus, Abby is allocated $300 of the gain, which increases her basis to $500 ($200 + $300). Next, Abby is deemed to receive $1000 in money since she received the asset from the corporation. This distribution results in an additional $500 capital gain to Abby ($1000 FMV- $500 basis).

33

Section 1374 BIG Tax• General Rule: If an S corporation sells an asset, gain or

loss flows through pro rata to the shareholders, and no tax is due at the corporate level.

• Section 1374 BIG Tax may arise when the corporation was a C corporation that made an S election.

34

Section 1374 BIG Tax• Upon the S election, all assets of the C corporation are

valued as of date of the S election (including good will).• The disposition of these assets generates a corporate

level gain or loss in addition to the gain or loss allocated to the shareholders.

• After ten (10) years, built-in-gain or loss is no longer recognized in regard to the corporate level tax.

35

B.I.G.

In-Kind Distributions of Partnership Property

• Generally, no gain or loss is recognized on a distribution.• The possibility for abuse of the system is great.• Congress imposed limitations to prevent abuses.

36

In-Kind Distributions of Partnership Property

• Exceptions to non-recognition rule:• §704(c), Allocation of Contributed Property• §707, Disguised sales• §731, Marketable Securities• §737, Precontribution gain• §752, Allocation of Liabilities

37

Contributed Property—§704(c)• Built-in gain is allocated to the book capital account of the

contributing partner upon contribution.• If contributed property is distributed within seven (7) years

of contribution, contributing partner recognizes gain on distribution.

• If contributed property is distributed beyond the seven (7) year period, contributing partner recognizes no gain on the distribution and the normal partnership rules apply.

3838

Contributed Property—§704(c)• If contributing partner sells all or a portion of his

partnership interest, the transferee partner receives all or the proportionate portion of the transferor partner’s built-in gain or loss.

3939

Contributed Property—§704(c)

Example: Sally owns real property worth $200 and has a basis of $40 in the property. Sally contributes the property to Salon, LP. Three years later, the property is worth $300, and the partnership makes a distribution of the property to Susie. According to the rules of 704(c), Sally recognizes a gain of $160. If, however, Sally transferred her partnership interest in year 2 to New Partner, Sam, and the partnership makes a distribution of the real property to Susie after 2 years of Sam joining the partnership (within the seven years of contribution), Sam would recognize gain on the contributed property.

4040

Disguised Sale—§707 • Partner contributes property and receives a distribution of

money or property in connection with contribution.• Two (2) rebuttable presumptions.

• If a distribution is made within two years of the contribution of property, the transaction is presumed to be a sale, and

• If a distribution is made outside of the two years of the date of contribution, then the distribution is presumed to not be a sale.

• A distribution that can be connected to the contribution will be considered a sale.• Use facts and circumstances to determine if a connection exists.

4141

Disguised Sale—§707 Ten (10) Factors for Facts and Circumstances

1. The certainty of the time and amount of transfer;

2. Whether the transferor has a legally enforceable right to the second transfer;

3. Whether the partner’s right to the distribution is secured;

4. Whether a third party is obligated to transfer money to the partnership in order for the partnership to make the distribution;

5. Whether a third party is obligated to loan money to the partnership for the distribution;

6. Whether the partnership is obligated to incur a debt from a third party in order to make the distribution;

7. Whether the partnership holds an unnecessarily large amount of funds in anticipation of the transfer;

8. Whether distributions are designed to effect an exchange of benefits and burdens of ownership of contributed property;

9. Whether the contributing partner’s distribution is disproportionately large in relation to his general and continuing interest;

10. Whether the partner has no obligation to return distributions to the partnership.4242

Disguised Sale Safe Harbor Rules• Guaranteed Payments for Capital and Reasonable

Preferred Returns.• Pro Rata Distributions.• Qualified Indebtedness.

4343

Qualified Indebtedness• Qualified Indebtedness.

• Recourse Liability,• Does NOT exceed FMV of encumbered contributed property, AND• Any of the following

• Liability incurred by partner more than two years prior to partner’s transfer of property to partnership, and encumbered property throughout entire period;

• Liability incurred in the ordinary course of a trade or business that was completely transferred to the partnership; or

• Liability incurred by the partner within two years prior to the transfer, but not incurred in anticipation of the property’s transfer to the partnership.

44

Qualified Indebtedness ExampleExample: George owns a business worth $20 million. He has a basis of $5 million in the business and good will worth $15 million. George would recognize a gain of $15 million upon the sale of his business and as a result, would pay a tax of $3 million (20% capital gain of $15 million). Instead, George borrows $15 million today and encumbers the entire company with the liability. Two years later, Peter approaches George with an offer to purchase his business for $20 million. Instead, George contributes his assets to a new partnership, which assumes the $15 million liability, and George receives a pro rata partnership interest based on a $5 million contribution.

George recognizes no gain.

  4545

Qualified Indebtedness ExampleIf the company pays only interest on the $15 million debt, and George continues to be personally liable on the debt, he never recognizes gain. If the new partnership pays off the debt, George would recognize a $10 million gain because the reduction in liability would reduce his basis from $5 million to ($10,000,000). After the $10 million gain, his basis would be $0.00. If George sold his partnership interest, his amount realized would be any cash he received, plus the $10 million debt no longer allocated to him. Even if he were to remain personally liable on the debt, he would have gain because the mere guarantee of a liability by a non-partner does not give him any basis. As long as George retains his partnership interest, and the debt is allocated to him, the $15 million gain is postponed. If he holds his interest until his death, George will receive a step-up in basis and he will never recognize gain. 4646

S Corporation – Qualified Indebtedness

If, instead, George contributed his business subject to the $15 million debt to an S corporation, he would have a $10 million gain upon contribution ($5 million basis, $15 boot).

4747

Precontribution Gain—§737• What if the contributing partner effectively swaps the

contributed property for other property in partnership?• To prevent this, IRC requires contributing partners to

recognize gain on contributed property upon the following:• Contributed property had built-in gain.• When contributing partner receives distribution of other property (other

than money) within seven (7) years of contributed property’s contribution.

• Property received has FMV greater than contributing partner’s outside basis.

• Gain is the lesser of:• FMV of distributed property that exceeds partner’s outside basis, OR• Precontribution gain.

• §737 does not apply to deemed distribution of interests in a new partnership caused by a technical termination. 4848

Net Precontribution Gain

• The total amount of built-in gain for property

contributed by the partner over the previous seven

(7) years, which is held by the partnership prior to the

distribution.

4949

Precontribution Gain—§737

• Example:• Keepers, LP has three partners: Abe, Bob, and Cal.

• Abe contributes property to the LP. Abe has a basis in the property of

$50, and the property is worth $100. Thus, Abe has a net precontribution

gain of $50 ($100-$50).

• Bob and Cal each contribute $100 cash to the partnership.

• The partnership purchases land for $100. After 4 years, the land value

has appreciated to $900 and the partnership makes a pro rata distribution

of the land to the partners, each receiving an in-kind distribution of $300 in

land.

• Abe has an excess distribution of $250 ($300-50) and a net

precontribution gain of $50. Without §737, Abe would recognize no gain.

However, under §737, Abe’s net precontribution gain is triggered, and he

must pay tax on the $50 gain. 5050

Marketable Securities—§731 • FMV of distributed marketable securities treated as

distribution of money.• FMV of securities used to determine value at distribution.

• The partner’s taxable gain is generally:• The FMV of distributed securities, less the partner’s outside basis,• The taxable gain is reduced by the reduction in the partner’s net

gain caused by the distribution.

5151

Marketable Securities—§731 • Reduction in the net gain is equal to:

• The partner’s distributive share of net gain if all the partnership’s pre-distribution marketable securities were sold at FMV, over

• The partner’s distributive share of the net gain if all of the partnership’s post-distribution marketable securities were sold.

5252

Marketable Securities—§731 • Example: Partnership X owned marketable securities with

a FMV of $100 and a basis of $40, Partner A has a one third partnership interest and an outside basis in the partnership of $10. Net gain on the asset is $60, and the partner’s distributive share of net gain is $20. Under a pro rata distribution, the partner would receive $33.33 of the marketable securities. To determine the partner’s taxable net gain, the partner’s share of $33.33 is reduced by A’s $10 basis and then is further reduced by A’s net gain calculation is $20 and A’s post-distribution net gain is $0 pre-distribution. Thus, A has a total net gain of $3.33 on the distribution of the marketable securities.

5353

Marketable Securities—§731

A’s Money Received $33.33

A’s Outside Basis $10.00_______________

Gain before §731(c)(3)(B) $23.33

Net Gain Reduction ($20.00)_____________

A’s Recognized Gain $3.33

A’s Pre-Distribution Net Gain $20.00

A’s Post-Distribution Net Gain $0.00_____________

A’s Reduction in Net Gain $20.00

54

Liabilities—§752• A partner is treated as contributing money to the

partnership when his share of liabilities in the partnership increases. This increases the partner’s basis.

• If a partner’s share in the partnership liabilities decreases, the partner is treated as receiving a distribution of money, which decreases that partner’s basis.

• Any deemed distributions that occur once the partner’s basis reaches zero result in a taxable gain to the partner.

5555

Liabilities—§752• Recourse liability—at least one partner is personally liable

for the debt. • Liability is allocated to the partners based on the economic risk of

loss.

5656

Liabilities—§752• Nonrecourse liabilities—partners not personally liable for

debt; creditor assumes the economic risk of loss.• Allocated to each partner based on the partner’s share of

partnership profits. • Determined based on all facts and circumstances.• The partnership agreement may specify the partner’s share of

liabilities, as long as reasonably consistent with some other significant item of partnership income or gain.

5757

Liabilities—§752• The partnership’s assumption of a partner’s liability is

deemed to be a distribution of cash to the partner and reduces the partner’s basis in the partnership.

• The partner’s basis is then increased by the portion of the liabilities allocated to the partner.

5858

Liabilities—§752• Any liabilities associated with the contributed property that

are assumed by the partnership reduce the partner’s basis in the partnership by the amount of indebtedness that is allocated to the other partners in the partnership.

• The indebtedness allocated to the partners is treated as a cash contribution by the other partners in the partnership.

5959

Liabilities—§752

Example: John and Colleen each own a 50% interest in Caprock, LP. John’s basis is $100. John has a loan of $100 secured by an asset with a $200 basis. John contributes the encumbered asset to the partnership and the partnership assumes the liability. John’s basis is initially increased by $200 due to the contribution of the property.

6060

Liabilities—§752

However, John’s basis is decreased by $100 because the partnership agreed to pay the liability and the assumption is considered a cash distribution of $100. John is still personally liable on the note, however, so his basis is increased by $100, which increases his basis to $300.

61

Comparison of Liabilities Treatment

Partnership

Beginning Basis: $100

Asset Contribution: $200Partnership assumption

of liability: <$100>

John allocated $100: $100

______________________

John’s new basis: $300

S Corporation

Beginning Basis: $100

Asset Contribution: $200

Corporate assumption of liability: <$100>

No Allocation to John

______________________

John’s new basis: $200

62

In an S Corporation, however…..• Shareholders do not receive basis when the S corporation

incurs debt. • This rule applies even when the shareholder guarantees

the debt. • Therefore, an S Corporation shareholder in Jimmy’s

position would have recognized gain for the distribution of the loan proceeds.

6363

Liabilities—§752• Facts: Partnership property subject to a loan is sold to a

buyer that takes the property subject to the loan. • The relieved debt is considered part of the amount realized by the

partnership. This can result in Crane Gain.

6464

Liabilities—§752

Example: Now assume that in a new partnership, Capital Cows, LP, Jimmy is a 50% partner in the LP and has an outside basis of $200. The partnership’s only asset is a building and Jimmy’s portion of the building’s basis is $200. (Jimmy has the same inside basis and outside basis.)

6565

Liabilities—§752

The partnership borrows $1000 on a nonrecourse basis, and distributes it pro rata to Jimmy and Rhett, so Jimmy receives $500 of the loan proceeds. Jimmy’s outside basis is increased by $500 to $700 when the partnership borrows the funds.

Liabilities—§752

Capital Cows, LP then makes a distribution of $500 to Jimmy, which decreases Jimmy’s basis to $200. Jimmy then sells his partnership interest to Cliff for $100. Jimmy receives only $100 in cash. However, he is no longer allocated $500 of the debt. In calculating Jimmy’s total amount received, he received $100 of cash for his partnership interest and is determined to have a cash distribution of $500 for the debt hat is no longer allocated to him. Jimmy’s gain is equal to $600, less his $200 basis, resulting in a $400 gain.

6767

S Corporations• An S Corporation shareholder will be allocated debt basis,

only to the extent that he has personally loaned funds to the corporation.

• Shareholder may deduct corporate losses in excess of the shareholder’s stock basis only to the extent of the shareholder’s own loans to the corporation.

• As would be expected, the repayment of a reduced basis debt is taxable to the shareholder.

6868

S Corporations

Example: If Shareholder A contributes an asset with a $200 basis to an S corporation subject to $100 debt, the shareholder’s basis will be only $100 even if the shareholder remains personally liable on the note. Unlike in a partnership, the $100 debt is not allocated to any of the shareholders.

6969

Sale of Partnership Interest• A partnership interest is considered a capital asset.• A partner’s inside basis is transferred to a transferee

partner.• No inside basis adjustment for the partnership unless a

§754 election is in effect or unless there is $250,000 built-in loss.

• Adjust the basis of partnership assets to reflect built-in gains and losses.

7070

Section 754 Election• Section 754 Election

• Election made by Partnership.• Required basis adjustment in partnership property upon distribution

of partnership assets or sale of partnership interest.• Can result in the same partnership asset having a different inside

basis for different partners.• There is no S corporation equivalent to Section 754.

71

Basis Adjustment Upon Transfer ofPartnership Interest—§743 • Occurs when:

• 754 election is in effect, or• The Partnership has a substantial built in loss (over $250,000).

• Basis of Partnership Property is increased by• Basis of Transferee’s partnership interest less Transferee’s

proportionate share of partnership property’s adjusted basis.• A transferee's share of the adjusted basis to the partnership of

partnership property is • The sum of the transferee's interest as a partner in the partnership's

previously taxed capital, plus the transferee's share of partnership liabilities.

72

Basis Adjustment Upon Sale ofPartnership Interest—§743

• Generally, a transferee's interest as a partner in the partnership's previously taxed capital is equal to—• Cash the transferee would receive on hypothetical liquidation of the

partnership, increased by• Tax loss that would be allocated to the transferee from the

hypothetical transaction, and decreased by• The amount of tax gain that would be allocated to the transferee

from the hypothetical.

73

Basis Adjustment Upon Sale ofPartnership Interest—§743

• Basis of partnership property is decreased by• Transferee’s proportionate share of partnership property’s adjusted

basis less basis of Transferee’s partnership interest.

• Basis in partnership property is reallocated to property of a like character (capital gains v. ordinary income), then to property of the same class of assets as the reallocated basis.

74

Sale of Partnership Interest• Hot Assets in Sale of Partnership Interest.

• Money or property received for unrealized receivables and substantially appreciated inventory is considered ordinary income to the extent of the appreciation.

• Unrealized receivables encompass right to payment for:• Non-capital goods delivered or to be delivered,• Services rendered or to be rendered,• Recapture items, including depreciation recapture, §1245 property,

§1250 property and Intangible Drilling Cost recapture.

• Trap for the unwary: The installment sale of a partnership interest will not postpone gain to the extent of IDC recapture. 7575

Termination of Partnership• Actual termination.

• Occurs when only one partner remains in the partnership, and it ceases to be carried on by the partners.

• A technical termination.• Occurs when the sale or exchange of more than fifty percent (50%)

of the partnership interests occurs within twelve (12) months.

7676

Termination of Partnership• Under §708, a sale or exchange does not include the following:

• Disposition of interest by gift, bequest, or inheritance;• Liquidation of interest;• Acquisition of LLC interest by contribution of property.

• The sale of exchange of the interests can occur in one transaction or in a series of transactions over the course of the year.

• Technical termination is treated as a contribution of all partnership property to a new partnership followed by a distribution of the new partnership interests pro rata to the old partnership’s partners.

7777

Termination of S Corporation• A dissolving corporation must go through winding up to

terminate status as corporation. • To wind up, the corporation, or a trustee selected by the

corporation:• Distributes assets in kind to the shareholders, or • Liquidates the corporation’s assets and distributes the proceeds to its

shareholders, or• If the “corporation” is an electing entity that has previously made an

election (Form 8832), then the termination could be effected by making an election to become a partnership or disregarded entity.

• There is no concept of a technical termination of an S Corporation.

7878

Termination of S Corporation• Termination of S Election. A corporation will cease

operating as an S corporation and be treated as a C corporation if any of the following occur:• More than one-half of the shares consent to revocation of the S

election;• Corporation ceases to be a small business corporation;• More than 25% of the corporation’s income is passive investment

income.

7979

Termination of S Corporation• Terminations can be forgiven by the IRS where:

• IRS determines termination was inadvertent, • Disqualifying event is corrected within a reasonable period of time,

and • Shareholders agree to be treated as an S corporation during time

period in which the S election was terminated. • Requires a private letter ruling request.

• For non-inadvertent termination:• Corporation must wait five years before shareholders can make S

election again.

8080

Reorganization of Partnerships• Reorganize in two ways: Merger and Division• Mergers and divisions of partnerships are generally tax

free, unless the transaction results in gain under §704(c), §737, or §707.

8181

Reorganization of Partnerships• Two Types of mergers (divisions).

• Assets up merger (or division) or • Assets over merger (or division).

8282

Partnership Mergers and Divisions• Assets up merger (division).

• Terminating partnership distributes its assets to the partners in liquidation of the partner’s partnership interest.

• Partners then contribute the assets to the new partnership.

• Assets over merger (division).• Terminating partnership contributes all of its assets to the new

partnership in exchange for partnership interests in the new partnership.

• Terminating partnership then “distributes” partnership interests in the new partnership to its partners in a complete liquidation of the terminating partnership.

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Partnership Divisions• Resulting partnerships are either new partnerships or

partnerships that are a continuation of the original partnership.

• Continuation of original partnership • If members of resulting partnership owned more than a fifty percent

(50%) capital and profits interest in the originating partnership.

• New partnership• If the original partnership terminates or the members of the

resulting partnerships had a partnership interest in the original partnership of fifty percent (50%) or less.

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Partnership Divisions Continued• A merger (or division) is automatically treated as an

assets over merger (or division), unless the assets are actually transferred to the partners before being placed in the second partnership.

85

S Corporation Reorganization• Mergers and divisions of S corporations follow the same

rules as C corporations. • §355 Division Requirements

• Owners must have non-tax motives.• Corporate stock must be divided.• Both companies must be involved in a trade or business • Stock of controlling corporation acquired within five (5) years of

distribution by distributing corporation, treated as boot.

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S Corporation Reorganization• A corporate reorganization may occur in seven possible

forms: • Statutory mergers and consolidations, • Acquisitions by one corporation of the stock of another corporation, • Acquisitions by one corporation of the assets of another

corporation, • Transfers to controlled corporations, • Recapitalizations, • Changes in the form or place of organization, and • Insolvency reorganizations.

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Example of Functional Entity Differences

Client comes to you owning a business entity that has a business and related real estate. He tells you he would like to transfer the real estate to trusts for his children.

Example of Functional Entity Differences

If the entity is a partnership you tell him that, that can probably happen.

Example of Functional Entity Differences

If it is an S Corporation, you have to tell him that in-kind distributions are always taxable events. Also, he cannot create a second class of stock to represent the real estate.

Mr. ObediahEntity Structure

OBEDIAH

S COPORATION

10,000 acres Ezra Shale

EZRA ENERGY, LP

EZRA ENERGY GP, LLC

STEP 1 Bank loan of $5 million dollars

STEP 5 $3 million dollars of capital

gain to Obediah!BAD!

STEP 3 New partners

contribute $5 million dollars

STEP 4 $3 million dollars

distributed to Obediah through the S Corporation

STEP 2 Ezra leases 10,000

mineral acres

J

Limited Partnership

AssetsLiability—Foreign

Currency

§988 Gain Transaction

NewLimited

Partnership

U.S. Charity

NewLimited

Partnership

Foreign Charity

§355

§1361

92

Similarities• Both are flow through entities.

• Taxed at owner level.

• In-kind contributions generally tax free, unless investment company rule applies.

• Both generally avoid double taxation.• Distributions of money are not taxable to extent of basis

(except for C corporation earnings and profits).• S corporations and limited partnerships are favored

methods of reducing NII where the taxpayer has trade or business income.

9393

Important DifferencesPartnerships

• Flexible ownership requirements.

• Allocation of income, gain, deductions, and loss is flexible as long as maintain substantial economic effect.

• No gain or loss on in-kind contributions.

S Corporations

• Strict ownership requirements.

• Allocation of income, gain, deductions, and loss is pro rata.

• Initial contributions are a taxable event unless 80% of the shares are owned by the contributing shareholder.

9494

Important Differences

Partnerships

• Generally, no gain or loss on in-kind distributions.• Exceptions apply where

disguised sale or crane gain occurs (§704, §707, §731, §737, §752).

• Distributions flexible.

• Divisions usually tax free.

S Corporations

• In-kind distributions treated as sale of capital assets.

• Distributions always pro rata.

• Divisions taxable unless comply with Section 355.

95

Important Differences

Partnerships• Sale of Partnership interest

can cause ordinary income when there are hot assets.

• Partner’s outside basis increases by debt allocable to partner.

• 704(c) prevents shifting of built-in gain or loss of contributed property to other partners

S Corporations

• Sale of corporate stock always generates capital gain.

• Shareholder’s outside basis not increased by corporate debt unless shareholder is lender.

• Built-in gain or loss on corporate property may be shifted to other shareholders; because all gains and losses must be allocated pro rata. 96

Important Differences

Partnerships

• Can give compensatory profits interest to partners that will lead to equity without generating a taxable event.

S Corporations

• Compensatory equity is not possible without a taxable event occurring.

97

Planning Points• Limited partner must work at least 500 hours to avoid the

passive loss rules.

• If a person wants to contribute appreciated property to a partnership, consider a long-term installment sale instead. An installment sale avoids complex allocation rules under §704(c), especially where the asset is depreciable.

• If choosing the S Corporation, opt to be an LLC that elects to become an S corporation so that creditors are limited by a charging order and are prohibited from seizing entity interests.

98

When to choose an S corporation?• To shift income and losses and avoid 704(c) allocations.• As an entity for professional services, where the

corporation will never own appreciated assets.• As a general partner for a limited partnership.• To avoid self-employment income and NII where a limited

partnership is not preferable.• To avoid the issue of hot assets.• If taxpayer will have losses in early years, works less than

500 hours in the activity, and the income is passive, the losses may be used to offset active income.

• Currently a C corporation.• If client wants to establish a bank (State law rules).

9999

Bottom Line• S corporations may be more simplistic in tax calculations,

but do not offer much flexibility in ownership or in the allocation and distribution of income, gain, deductions, and losses.

• Although complex, partnerships are powerful tools that can provide clients with the flexibility required to achieve business and estate planning goals, most of which are not obvious when the entity is first created.

100100

JOHN R. HUNTER, J.D., C.P.A.THE BLUM FIRM, P.C.

777 MAIN STREET, SUITE 700FORT WORTH, TEXAS 76102

TEL.: (817) 334-0066WWW.THEBLUMFIRM.COM