OVERVIEW OF SUB CHAPTER K

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OVERVIEW OF SUB CHAPTER K

• PATRICK HENNESSEE

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ENTITY CONCEPTVS.CONDUIT CONCEPT

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THE ENTITY CONCEPT

THE BUSINESS (PARTNERSHIP)
THE PARTNERS
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THE CONDUIT CONCEPT

THE PARTNERS
CREDITS
DEDUCTIONS
INCOME
THE BUSINESS (PARTNERSHIP)
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PART IDETERMINATION OF TAX LIABILITY

• 701 A partnership is not subject to income tax
  -- Persons carrying on business as
  partners are liable for the income tax.
• 702 Requires each partner to include his share
• of partnership income in his individual
  tax
• return and requires certain items to be
  stated
• separately so their tax status will be
• preserved. Character of items determined
  at partnership level.
• 703 Rules for computing partnership taxable
• income and provides for certain
  elections
• to be made by the partnership

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PART I (continued) DETERMINATION OF TAX LIABILITY
704 Sets out the rules for determining the
distributive shares of the partners.
Also, the rules regarding certain special
allocations of income and the rules for
family partnerships. 705 Rules for
determining a partners adjusted basis
for his partnership interest. ( also see
sec. 722 and 742) 706 Taxable year of the
partnership and partners.
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PART I (continued) DETERMINATION OF TAX LIABILITY
707 Governs transactions between partners
and partnerships. 708 Rules for which a
partnership is deemed to have
terminated. 709 Deals with amortization of
organization costs.
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PART II, SUBPART ACONTRIBUTIONS TO PARTNERSHIP

• 721 Generally, no gain or loss is recognized to
  the
• partnership or any of the partners on a
  contribution
• of property by a partner to a partnership.
• 722 The contributing partners basis for his
  interest in
• the partnership is his adjusted basis of
  the
• contributed property plus any money
  contributed.
• (outside basis)
• 723 The partnerships basis in the contributed
  property
• is the same basis it had in the hands of
  the
• contributing partner. (inside basis)
• 724 Unrealized receivables, inventory, and
  capital loss
• assets contributed to a partnership by a
  partner
• retain their character in the hands of the
  partnership.

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PART II, SUBPART BDISTRIBUTIONS BY A PARTNERSHIP

• 731 General rules governing the recognition of a
  
• gain or loss on partnership distributions.
• 732 Rules for determining the basis of
  distributed
• property in distributions.
• 733 The partners adjusted basis for his
• partnership interest is reduced by the
  money
• and the basis of property distributed to
  him
• (determined by Sec. 732) in a
  non-liquidating
• distribution. (outside basis)
• 734 Partnerships which have made an election
  under
• sec. 754 adjust the basis of the retained
  property
• after certain property distributions.

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PART II, SUBPART B (continued)DISTRIBUTIONS BY A
PARTNERSHIP
735 Gains realized by a distributee partner
on a disposition of unrealized
receivables distributed by the
partnership and any gain on the sale of
inventory within 5 years from its
distribution ordinary income. 736 Rules
governing liquidation payments to retiring
partners. 737 Partners recognition of
precontribution gains in certain
distributions to contributing partners.
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PART II, SUBPART CTRANSFERS OF INTERESTS IN A
PARTNERSHIP

• 741 Any gain or loss recognized on the sale or
  exchange of a
• partnership interest is a capital gain or
  loss - except for
• unrealized receivables and certain
  inventory items ( 751).
• 742 Transferee of partnership interests determine
  his basis
• for that interest under the general rules
  applicable to
• other property.
• 743 Generally, the basis of partnership property
  is not
• affected by death of a partners or the
  sale of a partner-
• ship interest by a partner, unless a sec.
  754 election is
• made. Then, the incoming partners basis
  in his/her
• underlying partnership property may be
  adjusted for the
• difference between the price paid by the
  transferee and
• the partnerships basis for that portion
  in the property.

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PART II, SUBPART DPROVISIONS COMMON TO OTHER
SUBPARTS

• 751 Contains the rules (and definition) regarding
  
• the treatment of unrealized receivables
  and
• inventory items upon a sale or exchange of
  
• part or all of a partnership interest.
• 752 Rules for the treatment of the assumption of
• liabilities in partnership transactions.
• 753 Income with respect of decedent rules for
• successor interest.

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PART II, SUBPART D (continued)PROVISIONS COMMON
TO OTHER SUBPARTS
754 Election to adjust basis in (1) assets
distributions and (2) partnership interest
transfers. 755 Rules for basis allocation when
there is a basis adjustment re an
election under sec. 754.
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PART IIIDEFINITIONS

• 761 Defines certain terms, specifically
• (1) Partnership
• (2) Partner
• (3) Partnership agreement
• (4) Liquidation of a partners interest
• (5) Distributions treated as exchanges.

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ELECTING OUT OF SUBCHAPTER K
Do you want to elect out?
Was the organization formed for 1. Investment
purposes, 2. Joint production or extraction,
or 3. Underwriting security issues?
yes

no
yes
Does the organization meet the requirements to
elect out? (Reg. sec. 1.761-2)
no
no
yes
no
File formal election out?
yes
no
Meet the requirements for a deemed election out?
yes
Organization will be taxed as a partnership
Organization is excluded from provisions of
Subchapter K
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Requirements for Election Out - Reg. 1.761-2
Participants must 1 Co-own the property 2
Reserve the rights separately to take in-kind or
dispose of their share of the product produced 3
Not jointly sell the product produced Each may
delegate authority to sell its share of the
production BUT NOT FOR A PERIOD OF TIME IN
EXCESS OF THE MINIMUM NEEDS OF THE INDUSTRY, AND
IN NO EVENT FOR MORE THAN ONE YEAR.
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Formal Election Out

• File Form 1065 - in first year it desires to
  elect out
• By due date (with extensions)
• With
• Name, address, etc.
• Statement it is an operating agreement - for the
  joint production, extraction.
• Statement that all members elect out, and
• Where a copy of the operating agreement is
  available

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Deemed Election Out

• ...if it can be shown from all the surrounding
  facts and circumstances that it was the intention
  of the participants to be excluded. 1.761-2
• May indicate intent by
• An Agreement
• Substantially all participants file return in a
  way that indicates an election out
• Only in the first year of the joint venture

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Partnership or ???(2 issues)
Simply Co-owners Employee/Employer Borrower/Lender
Seller/Buyer

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2
Two distinct entities
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Partnership vs. Co-owners

• Podel v. Commissioner (RE deal)
• Taxpayers argued for co-ownership
• Properties sold capital gain
• IRS argued for a Joint Venture
• Income ordinary course of business
• Courts Joint Venture
• A Contract showing intent - business venture
• An agreement for joint control proprietorship
• J. V. s. contribution of , property or services
• Joint sharing of profits

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Rev. Rul. 75-374

• Players
• X (life insurance company
• Y (REIT)
• Z (manager of apartment complex)
• Not enough joint business activity
• Z furnished more than customary services, but was
  not part of the deal
• No partnership - simply co-owners

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Allison V. Commissioner

• Taxpayer wanted a partnership
• Distribution of property tax free
• IRS wanted no partnership
• Distribution of Lots ordinary income for
  services rendered
• Upshot
• Not enough joint profit motive
• Lacking this aspect of the 4 criteria for a Joint
  Venture

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Wheeler v. Commissioner

• Tulsa Oklahoma
• Camelot Inn
• University Club Tower
• Mansion House
• Villa Roma
• Joint Venture between Perrault () and Wheeler
  (know-how) or employment contract?
• Long-term capital gain v. ordinary income

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A Partnershipor aCorporation
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Check the Box Regulations

• New Entity Classification Regulations
• Final as of - January 1, 1997
• Totally eliminate pages of existing text
• Limited Liability
• Free Transferability of Interest
• Centralized Management
• Continuity of Life
• Notice 97-1
• All prior rulings that used the old corporate
  classification rules are now obsolete

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The Process

• Is the organization an entity for federal tax
  purposes?
• Actively carry on a trade or business, financial
  operation or joint venture and divide the profits
• Mere passive co-ownership -- not an entity
• Exclude non business entities
• Government agencies, etc.
• Single owner entities that are not corporations
• Can choose entity recognition by using
  proprietorship rules

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The Process - continued

• 3 Is the entity a trust?
• (may be a trust or a business entity)
• not a trust if
• has associates
• business purpose
• 4 Is the entity classified as a corporation under
  state law?
• If so, it is taxed as a corporation

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The Process - continued
5 If the entity is not classified as a
corporation---- It is an eligible entity Can be
taxed either as a Corporation Partnership Sole
Proprietorship
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What does this mean?

• Much Greater Flexibility
• No election---Default classification
• Partnership or
• Sole Proprietorship
• Profound implications for LLCs
• States will rewrite statutes
• Eliminate requirements that LLC will dissolve
  either on withdrawal or death
• This will cause LLC to become the entity of
  choice for many (closely held) businesses.

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To be or not to beWhich Business Entity
General Partnership
Regular Corporation
Limited Partnership
S Corporation
Limited Liability Company
Publicly Traded Partnership
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Non-tax Factors

• Public Trading of ownership
• Access to Capital Markets
• Liability Considerations
• Size of Business
• Number of Owners
• Flexibility

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Tax Factors

• Tax Rates
• Double Taxation
• Distributions
• Contributions
• Flow Through of Income
• Flow Through of Losses

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Tax Rate ComparisonOrdinary Income (Married J)
(C Corp)
39.5
36
31
28
15
104K
283K
159K
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Corporate Strategies

• Earning Bailouts
• Sale of Stock LTCG
• No (Small) Distributions
• Hold Stock Until Death
• Problems
• Unreasonable compensation (Div.)
• Other disguised dividends
• Personal Holding Company Tax
• Accumulated Earnings Tax

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Pass Through Status

• Partnerships
• LLCs
• S Corporations

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Subchapter K vs. S Issues

• Shareholder Limits
• Flexibility of Allocations
• Basis for Loss Pass Through
• Distributions
• Self-employment Tax Issues
• State Tax Issues

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Changing Status

• C to P -- Liquidation Issues
• C to S -- BIG Tax
• S to C -- Minimum Issues
• P to C or S -- Sec. 351 and form issues