Module 24Flow-Through Entities:

Basis Issues

Menu

1. Computation of a partner’s basis in a partnership interest

2. Termination of a partnership interest

3. Computation of an S corporation shareholder’s basis in S corporation stock

4. Termination of an S corporation shareholder’s interest

Computation of a Partner’s Basis in a Partnership Interest

Key Learning ObjectivesKey Learning Objectives Acquisition of an interest in a partnershipAcquisition of an interest in a partnership Partnership liabilitiesPartnership liabilities Changes in a partnership interest as a result of Changes in a partnership interest as a result of

partnership operationspartnership operations Impact of nonliquidating distributions Impact of nonliquidating distributions

on a partnership intereston a partnership interest

Partner’s Partnership InterestOutside Basis

Intangible asset representing ownership Intangible asset representing ownership Similar to corporate stockSimilar to corporate stock

Partnership interest must have a non-Partnership interest must have a non-negative basisnegative basis

Partnership interest basis includes partner’s Partnership interest basis includes partner’s share of partnership liabilitiesshare of partnership liabilities

Generally considered a capital assetGenerally considered a capital asset

Partner’s Original Partnership Interest Basis

Cash contributedCash contributed Plus: Basis of non-cash assets contributedPlus: Basis of non-cash assets contributed Plus: Any service gain recognized Plus: Any service gain recognized

Note: NO adjustment for any liabilities > basis Note: NO adjustment for any liabilities > basis gain recognizedgain recognized

Plus: Other partner’s liabilities assumed by new Plus: Other partner’s liabilities assumed by new partnerpartner

Minus: New Partner’s liabilities assumed by other Minus: New Partner’s liabilities assumed by other partnerspartners

Post-Formation Adjustments to Partner’s Partnership Interest Basis Increases to basisIncreases to basis

Additional contributions by partnerAdditional contributions by partner

Partner’s share of any increase in Partner’s share of any increase in partnership liabilitiespartnership liabilities

Partner’s share ofPartner’s share ofpartnership partnership

income itemsincome items

Post-Formation Adjustments to Partner’s Partnership Interest Basis Decreases to basisDecreases to basis

Distributions to partnersDistributions to partners

Partner’s share of any Partner’s share of any decrease in partnershipdecrease in partnership

liabilitiesliabilities

Partnership’s Basis in Contributed Assets--Inside Basis Carryover basis for assets transferred inCarryover basis for assets transferred in

Depreciation recapture potential and holding Depreciation recapture potential and holding periods also carryover to partnershipperiods also carryover to partnership

Add any investment company gain Add any investment company gain recognized by partnerrecognized by partner

No adjustment for liabilities > basis gain No adjustment for liabilities > basis gain recognizedrecognized

Categories of Distributions

Nonliquidating (current)Nonliquidating (current) LiquidatingLiquidating

§751 “Hot Assets”

These assets produce ordinary incomeThese assets produce ordinary income They can affect both partnership distributions They can affect both partnership distributions

and sales of a partnership interestand sales of a partnership interest Two kinds:Two kinds:

(1) Unrealized receivables(1) Unrealized receivables

(2) Substantially appreciated inventory(2) Substantially appreciated inventory

Unrealized Receivables

Always hotAlways hot Includes:Includes:

Accounts receivable of cash method Accounts receivable of cash method partnershippartnership

Depreciation recapture itemsDepreciation recapture items

Substantially Appreciated Inventory

Hot only if aggregate FMV of inventory Hot only if aggregate FMV of inventory items exceeds 120% of their aggregate basisitems exceeds 120% of their aggregate basis

Broad definition:Broad definition: All assets other than cash, capital assets, and All assets other than cash, capital assets, and

§1231 assets§1231 assets

Current Distributions

Three tiers of property Three tiers of property Deemed distributed in this orderDeemed distributed in this order

CashCash

Unrealized receivables and inventoryUnrealized receivables and inventory

Other propertyOther property

Effect on Partner-- Current Distribution

No gain recognized unless cash distributed No gain recognized unless cash distributed exceeds partner’s predistribution partnership exceeds partner’s predistribution partnership interest basisinterest basis

Exception: disproportionate distribution of Exception: disproportionate distribution of hot assets (discussed later)hot assets (discussed later)

NOTE: reduction of a partner’s share of NOTE: reduction of a partner’s share of partnership liability = deemed cash distributionpartnership liability = deemed cash distribution

A loss is never recognizedA loss is never recognized

Effect on Partner-- Current Distribution

Distributed tier two and tier three properties Distributed tier two and tier three properties have a carryover basis to the partnerhave a carryover basis to the partner

However, basis carried over cannot exceed However, basis carried over cannot exceed partner’s remaining partnership interest basispartner’s remaining partnership interest basis Allocation of bases is necessary if multiple Allocation of bases is necessary if multiple

assets are distributed within a tierassets are distributed within a tier Distributions reduce a partner’s partnership Distributions reduce a partner’s partnership

interest basis, but never below zerointerest basis, but never below zero

Effect on Partnership-- Current Distribution

No gain or loss recognizedNo gain or loss recognized Exception: disproportionate distributions of Exception: disproportionate distributions of

hot assetshot assets Partnership may be entitled to a basis Partnership may be entitled to a basis

adjustment if: adjustment if:

Gain is recognized by the partnerGain is recognized by the partner

Basis “disappears”Basis “disappears”

Termination of a Partnership Interest

Key Learning Objectives Involuntary termination Voluntary termination

Sale or exchangeSale or exchange AbandonmentAbandonment Liquidation of a partnershipLiquidation of a partnership Liquidation of a partnership interestLiquidation of a partnership interest Merger/consolidationMerger/consolidation Conversion to limited liability companyConversion to limited liability company

Involuntary TerminationClose of Tax Year

Sale of Sale of >> 50% capital within 12 months 50% capital within 12 months Partnership ceases to do businessPartnership ceases to do business Causes loss of tax attributesCauses loss of tax attributes Deceased partnerDeceased partner

Successor in interest steps into deceased’s Successor in interest steps into deceased’s shoes, so no close of tax yearshoes, so no close of tax year

Successor’s partnership interest basis equals Successor’s partnership interest basis equals FMV of interest at date of deathFMV of interest at date of death

Voluntary TerminationClose of Tax Year

Partnership year closes with respect to Partnership year closes with respect to partner IFpartner IF

Liquidation or sale of entire interestLiquidation or sale of entire interest Gift of interestGift of interest

Sale of a Partnership Interest

Amount realizedAmount realized - partnership interest basis- partnership interest basis Gain or loss realizedGain or loss realized Amount realized includesAmount realized includes

CashCash

FMV of propertyFMV of property

Any partnership liabilities assumed by Any partnership liabilities assumed by the new partner the new partner

Sale of a Partnership Interest Gain or loss is generally capitalGain or loss is generally capital Exception: hot assets generate ordinary Exception: hot assets generate ordinary

incomeincome New partner may be entitled to a basis New partner may be entitled to a basis

adjustmentadjustment Adjustment is with respect Adjustment is with respect to to

new partner onlynew partner only

Liquidating Distributions

““Liquidation” refers to the termination of a Liquidation” refers to the termination of a partner’s interestpartner’s interest

Do not confuse this with the partnership Do not confuse this with the partnership liquidating, although it may beliquidating, although it may be

Liquidating Distributions

Three tiers of property Three tiers of property Deemed distributed in this orderDeemed distributed in this order

CashCash

Unrealized receivables and inventoryUnrealized receivables and inventory

Other propertyOther property

Effect on Partner-- Liquidating Distribution

No gain recognized unless cash exceeds partner’s No gain recognized unless cash exceeds partner’s predistribution basispredistribution basis Exception: disproportionate distributions of hot assetsException: disproportionate distributions of hot assets

Partner may recognize a loss, if other property is Partner may recognize a loss, if other property is not distributednot distributed

If tier three property is distributed, any remaining If tier three property is distributed, any remaining basis is assigned to itbasis is assigned to it

““Substituted” rather than carry over basisSubstituted” rather than carry over basis

Effect on Partnership--Liquidating Distribution

No gain or loss recognizedNo gain or loss recognized Exception: disproportionate distributions of Exception: disproportionate distributions of

“hot assets” (discussed later)“hot assets” (discussed later) Partnership may be entitled to a basis Partnership may be entitled to a basis

adjustment if:adjustment if:

Gain or loss is recognized by the Gain or loss is recognized by the partner, or partner, or

Basis “disappears” or is “created”Basis “disappears” or is “created”

Cash Payments Due to Retirement or Death of a Partner

Payments for propertyPayments for property Payments for hot assets generate ordinary Payments for hot assets generate ordinary

incomeincome ““Other” paymentsOther” payments

Either distributive shares orEither distributive shares or

Guaranteed paymentsGuaranteed payments

For service partnerships, “other” For service partnerships, “other” payments include payments forpayments include payments for unrealized receivables and goodwill unrealized receivables and goodwill

Disproportionate Distributions

Partner receives either too many or too few Partner receives either too many or too few hot assetshot assets

Rules apply to both liquidating and Rules apply to both liquidating and nonliquidating distributionsnonliquidating distributions

Gain or loss may be recognized by the Gain or loss may be recognized by the partner and/or the partnershippartner and/or the partnership

Disproportionate DistributionsTwo Step Analysis

To determine gain/loss recognizeTo determine gain/loss recognize When fictional steps 1 and 2 areWhen fictional steps 1 and 2 are

combined, results should reflect the actual combined, results should reflect the actual distributiondistribution

Disproportionate DistributionsStep 1

Pretend that the partner received a Pretend that the partner received a proportionate liquidating distributionproportionate liquidating distribution

This is a tax-free transactionThis is a tax-free transaction Partner has a carryover basis for Partner has a carryover basis for each each

assetasset

Disproportionate DistributionsStep 2

Pretend that the partner sells back to the Pretend that the partner sells back to the partnership some of the assets received in partnership some of the assets received in step 1 in exchange for other assetsstep 1 in exchange for other assets

This is a taxable transactionThis is a taxable transaction Use FMV for items received Use FMV for items received Use adjusted basis for items given upUse adjusted basis for items given up

In Class Exercise: Sale of a Partnership Interest

Basis FMV Basis FMV

Cash 18,000 18,000 Capital-X 16,000 25,000

Inventory 21,000 30,000 Capital-Y 16,000 25,000

Land 9,000 27,000 Capital-Z 16,000 25,000

48,000 75,000 48,000 75,000

Note: The Inventory is substantially appreciated: 30,000 > 21,000 x 120%

In Class Exercise:Sale of a Partnership Interest

Refer to the previous slideRefer to the previous slide If X sells her interest to W for $25,000 cashIf X sells her interest to W for $25,000 cash What are the tax consequencesWhat are the tax consequences

To partner XTo partner X To partner WTo partner W

Solution--In Class Exercise:Sale of a Partnership Interest

For XFor X Amount realizedAmount realized 25,00025,000 Basis:Basis: 16,00016,000 Gain:Gain: 9,000 9,000 3,000 of the gain is ordinary 3,000 of the gain is ordinary

X’s share of built-in gain for the inventoryX’s share of built-in gain for the inventory The remaining 6,000 of the gain is capitalThe remaining 6,000 of the gain is capital

Solution--In Class Exercise:Sale of a Partnership Interest

For WFor W W’s “outside” basis in his partnership W’s “outside” basis in his partnership

interest is $25,000interest is $25,000 Without special election by partnership, his Without special election by partnership, his

“inside” basis is $16,000“inside” basis is $16,000

In Class Exercise: Liquidation of Partnership Interest Using the facts of the last exerciseUsing the facts of the last exercise What are the tax consequences if the What are the tax consequences if the

partnership liquidates X’s interest for partnership liquidates X’s interest for $10,000 cash and $15,000 FMV inventory?$10,000 cash and $15,000 FMV inventory?

Note that this is a disproportionate Note that this is a disproportionate liquidation because X did not receive liquidation because X did not receive exactly her one-third share of the hot assetsexactly her one-third share of the hot assets

Solution--In Class Exercise: Liquidation of Partnership Interest

Step 1Step 1 Assume equal liquidating distribution Assume equal liquidating distribution

Pretend that X received one-third of each assetPretend that X received one-third of each asset See next slideSee next slide

Solution--In Class Exercise: Liquidation of Partnership Interest

Basis FMV ChangePartnershipinterest 16,000 25,000 9,000

Cash 6,000 6,000 -0-Inventory 7,000 10,000 3,000Land 3,000 9,000 6,000

16,000 25,000 9,000

Solution--In Class Exercise: Liquidation of Partnership Interest

Step 2 Step 2 Assume a sale between X and partnershipAssume a sale between X and partnership Pretend that X gave back the land (9,000) Pretend that X gave back the land (9,000)

received in Step 1 received in Step 1 In exchange for more cash ($4,000) and more In exchange for more cash ($4,000) and more

inventory ($5,000)inventory ($5,000) Treat Step 2 as a taxable transactionTreat Step 2 as a taxable transaction Use FMV for items received and basis for Use FMV for items received and basis for

items given upitems given up

Solution--In Class Exercise: Liquidation of Partnership Interest Amount realized Amount realized 9,000 9,000

4,000 cash + 5,000 inventory4,000 cash + 5,000 inventory Basis Basis 3,000 3,000

Basis of land given upBasis of land given up Gain realizedGain realized 6,0006,000

Solution--In Class Exercise: Liquidation of Partnership Interest The entire gain is a §1231 gain from the The entire gain is a §1231 gain from the

“sale” of land“sale” of land X holds $15,000 FMV of inventory X holds $15,000 FMV of inventory Basis of $12,000 Basis of $12,000

$7,000 from step 1$7,000 from step 1 $5,000 from step 2$5,000 from step 2

She will realize $3,000 of ordinary income She will realize $3,000 of ordinary income when she sells the inventorywhen she sells the inventory

Computation of an S Corporation Shareholder’s Tax Basis

Key Learning ObjectivesKey Learning Objectives Acquisition of S corporation stockAcquisition of S corporation stock Shareholder loans to an S corporationShareholder loans to an S corporation Changes to basis as a result of operationsChanges to basis as a result of operations Changes to basis as a result of distributionsChanges to basis as a result of distributions SummarySummary

Acquisition of Acquisition of S Corporation StockS Corporation Stock

The tax consequences of the incorporation of an S corporation follows the regular C corporation rules and were covered in Module 6

Purchase of stock of existing S corporation No immediate tax consequencesNo immediate tax consequences Cost becomes shareholder’s basisCost becomes shareholder’s basis

Shareholder Loans toShareholder Loans to S Corporation S Corporation

Third party lender No change in the equity interest No change in the equity interest

Shareholder creditor The indebtedness will create basis for the The indebtedness will create basis for the

purpose of deducting losses from the S purpose of deducting losses from the S corporationcorporation

Shareholder Loans toShareholder Loans to S Corporation S Corporation

Loan must be: Made directly from shareholder to Made directly from shareholder to

corporationcorporation A bona fide indebtedness A bona fide indebtedness Written note specifying a: Written note specifying a:

Principal sum to be repaidPrincipal sum to be repaid A rate of interestA rate of interest A term loan or a demand loanA term loan or a demand loan

Changes to Basis Changes to Basis as a Result of Operationsas a Result of Operations

Each shareholder's distributive share of S corporation income is reported on his or her tax return according to the percentage of stock owned

The adjustment to the basis in the stock is Made on the last day of the S corporation's

taxable year

Changes to Basis Changes to Basis As a Result of DistributionsAs a Result of Distributions

Cash reduces basis S corp uses the corporate rules when

making property distributions to its shareholders

The distribution of appreciated property to an S shareholder is deemed a sale by the corporation Gain is reported by shareholdersGain is reported by shareholders

Termination of an S Corporation Shareholder’s Interest Key Learning Objectives

Termination of S corporation election Termination of shareholder’s ownership

interest Termination of an S corporation

Voluntary Termination of S Corporation Election

Filing a written statement indicating the Filing a written statement indicating the corporation's desire to revoke its election. corporation's desire to revoke its election.

If made on or before the 15th day of the If made on or before the 15th day of the third month of the taxable year,third month of the taxable year,

It is generally effective as of the first day of It is generally effective as of the first day of such taxable yearsuch taxable year

Involuntary Termination of S Corporation Election

Election may be revoked because of a disqualifying event

The corporation ceases to be a small business corporation OR

The corporation has accumulated earnings and profits AND

Passive investment income > 25% of gross receipts for three consecutive tax years

Termination of Shareholder’s Interest

By sale, abandonment, or redemption An unused S corporation loss carryover

disappears

Termination of S Corporation

By selling off its assets and distributing the By selling off its assets and distributing the proceeds to its shareholdersproceeds to its shareholders A liquidationA liquidation

By being absorbed by another corporation By being absorbed by another corporation A merger or consolidationA merger or consolidation