Module 22 Operations of Flow- Through Entities

1. Module 22Operations of Flow- Through Entities

2. Menu (1) 1. Definition of a flow-through entity 2. Reporting the operations of a flow-through entity 3. Accounting periods and methods 4. S corporation qualifications

3. Menu (2) 5. Allocations of partnership income and deductions 6. Compensation of employee-owners 7. Limitations on flow-through losses 8. Special taxes imposed on S corporations 9. Terminating the S election

4. Definition of a Flow-Through Entity Key Learning Objectives • What is a flow-through entity? • The association issue • Relief from the association issue • The association issue and LLC statutes

5. The Flow-Through Entity • An organization separate from the owners • Not generally subject to tax • Entity functions as a reporting mechanism for the owners • All income or loss is reported by the owners on their own tax returns • The entity serves as a tax conduit

6. Flow-Through Entities • There are four general categories of entities classified as flow-through entities: S corporations Partnerships Limited liability companies Limited liability partnerships

7. The Association Issue • An association is an unincorporated entity with more corporate characteristics than non-corporate characteristics • Four characteristics distinguish associations from other entities • To avoid association status, noncorporate entities can have no more than two of these characteristics

8. Corporate Characteristics For Association • Limited liability • Centralized management • Continuity of life • Free transferability of interests

9. Reporting the Operations of a Flow-Through Entity Key Learning Objectives • Reporting operations • Entity tax reporting by flow-through entities • Ordinary and separately stated items • How a flow-through entity reports to the owners • Example of reporting by a flow-through entity • Entity level audit procedures

10. Partnership Reporting of Income • Ordinary operating income • Separately stated items • See Form 1065 and Schedule K

11. Partner Reporting of Income • Distributive share of income, deduction, or credit • Based on partnership agreement • Year partner reports income • Rules for contributed property with built-in gain or loss • Special allocations allowed if they have substantial economic effect

12. Entity Level Audit Procedures • An audit change to the entity's income will affect all owners • The IRS will conduct audit proceedings at the entity level • An adjustment to the entity's income will affect all owners.

13. Accounting Periods and Methods Key Learning Objectives • Choice of tax year • Required year: partnerships • Required year: S corporations • Business purpose year • §444 year • Available accounting methods • Restrictions on use of cash method by partnership

14. Partnership Required Tax Year • Majority partners • Principal partners • Least aggregate deferral • Exceptions: Natural business year §444 election

15. Choice of Taxable YearS Corporation • Calendar year • Business purpose year • 25%, 2-month, 3-year Test • §444 election

16. §444 Election • No more than 3 months deferral • Must make noninterest-bearing deposit • As if paid tax on deferral

17. S Corporation Qualifications Key Learning Objectives • S corporation qualification • S corporations: maximum shareholder limit • Permitted shareholders of an S corporation • Single class of stock requirement • Affiliated group membership restriction • S election requirement • S election: who must consent

18. Only Eligible Corporations May Elect S Status • Domestic corporations • No financial institutions or insurance companies • Only one class of stock • No more than 75 shareholders Only individuals, estates, and certain trusts Not partnership, nonresident aliens

19. S Election Requirement • All shareholders must consent • Made by March 15 • Effective January 1 • Made after March 15 • Effective following year

20. Allocation of Partnership Income and Deductions Key Learning Objectives (1) • General allocation rules • Required partnership allocations • §704(C) allocations: the traditional method • §704(C) allocations: ceiling rule limitation • §704(C) allocations: curative allocations • §704(C) allocations: remedial allocations

21. Allocation of Partnership Income and Deductions Key Learning Objectives (2) • Optional special allocations • Partnership special allocations: economic effect • Partnership special allocations: substantiality • Partnership special allocations: nonrecourse • Changes in partnership ownership • Changes in S corporation ownership

22. Substantial Economic Effect • Special allocations must be charged to partners' capital accounts • Liquidating distributions must be in accordance with capital account balances • Partners must have an obligation to restore negative capital accounts upon liquidation

23. Compensation of Employee-Owners Key Learning Objectives • Who may be an employee? • Compensating partners for services • Compensating S corporation shareholder-employees for services • Reasonable compensation in S corporations

24. Guaranteed Payments of Partners • Compensation for Services performed OR Interest on invested capital • Deductible to partnership • Ordinary self-employment income to partner

25. Limitations on Flow-Through Losses Key Learning Objectives • Limitations on utilization of flow-through losses • Basis limitations • At-risk basis limitations • Passive loss limitations

26. Loss limitations of Partnerships • Overall loss limit • At-risk loss limit • Passive activity loss limit

27. Partner's Share of LiabilitiesGeneral Partners • Recourse vs. nonrecourse • Use profit sharing % • For nonrecourse loans • Use loss sharing % • For recourse loans

28. Partner's Share of LiabilitiesLimited Partners • Recourse vs. nonrecourse • Use profit sharing % for nonrecourse loans • Generally no basis adjustment for recourse loans unless partner has pledged additional contributions

29. S CorporationOverall Loss Limit • Cannot deduct losses in excess of • Stock basis PLUS • Basis of loans from shareholder to corporation • Unused losses can be carried forward indefinitely until bases restored • At-risk and passive loss limitations also apply

30. Special Taxes Imposed onS Corporations Key Learning Objectives • Taxes imposed on flow-through entities • LIFO recapture tax • Tax on excess passive income • Built-in gains tax • Computation of built-in gains tax • How to avoid the built-in gains tax • Reporting the built-in gains tax

31. Special S Corporation Taxes • LIFO recapture tax • Actually a C corporation tax, but triggered by an S election • Excess net passive income tax • C corporation E&P must be present • >25% gross receipts test

32. Special S Corporation TaxesBuilt-In Gains Tax (BIG) • Applies only to C corporations that elected to become S corporations after 1986 • Tax is in effect for first 10 years after becoming an S • Tax rate is highest corporate rate • Currently 35%

33. Special S Corporation Taxes Built-In Gains Tax (BIG) • Big tax is applied against the net recognized built-in gain for the year • Or taxable income, if lower • "Net" means recognized built-in gains minus recognized built-in losses

34. Built-In Gains Tax (BIG) • NOLs and capital losses carried over from C years offset net recognized gain • Net unrealized built-in gain at time of conversion to S serves as the 10-year cumulative limit • Tax is paid by the S corporation • Gain that flows through to shareholders is net of any tax paid

35. Terminating the S Election Key Learning Objectives • Termination of S election • Effective date of S termination • Re-election of S status • Partnership terminations

36. Termination of S Status • Revocation • Requires majority vote • Filed by March 15— • Effective January 1 or prospective date • Filed after March 15 • Effective next year or prospective date

37. Termination of S Status • Inadvertent termination • Violate any S condition • Flunk 3-year passive income test • >25% Gross receipts test and • Have C corporation E&P • Possible IRS relief

38. Re-Election of S Status • 5-year rule precludes reecection for five years

39. Involuntary TerminationClose of PartnershipTax Year • Sale of > 50% capital within 12 months • Partership ceases to do business • Loss of tax attributes