Module 23 Distributions From Flow- Through Entities

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Module 23Distributions From Flow- Through
Entities
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• 1. Distributions from flow-through entities
• 2. Tax treatment of distributions from a
  partnership
• 3. Distribution from an S corporation
• 4. Distributions from a partnership
• 5. Basis in distributed property
• 6. Taxable distributions
• 7. Tax effect of distributions on a partnership
• 8. Tax effect of distributions on an S
  corporation

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Distributions From Flow- Through Entities

• Key Learning Objectives
• Distributions from flow-through entities general
  rules
• Partnerships and S corporations contrasted
• When is gain recognized by an owner?

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Partnerships and S Corporations Contrasted

• Partnerships are pure flow-through entities
• The entity is never subject to tax
• Unless it is publicly traded
• Partnerships generally have larger basis for
  recognizing loses
• Due to treatment of liabilities

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Partnerships and S Corporations Contrasted

• S corporations that are former C corps may have
  complicated tax treatment of distributions to
  shareholder
• S corporation and its shareholders subject to all
  provisions of subchapter C
• Except to the extent provisions are inconsistent

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Gain Recognition By Owner

• S Corporation distributee recognizes gain only if
  the amount of the distribution exceeds the
  owner's basis
• A partner will always recognize gain if money is
  distributed in excess of basis
• Distributions of property are generally not
  taxable, even if the value of the property
  exceeds the partner's basis in her interest

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Tax Treatment of Distributions From a Partnership

• Key Learning Objectives (1)
• Overview of partnership distributions
• Reduction in liability share as a cash
  distribution
• Marketable securities as cash partnerships
• What amount of securities is treated as money?

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Overview of Partnership Distributions

• Gain is recognized when money is received
  in excess of the partner's basis in partnership
  interest.

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Overview of Partnership Distributions

• Loss is recognized when distribution
• Is in liquidation of the partner's interest
• Consists solely of money and certain
  ordinary-income assets AND
• Outside basis exceeds
• The amount of the money AND
• The partnership's basis in the ordinary-income
  property

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Reduction in Liabilitiesis a Cash Distribution

• A decrease in a partners share of partnership
  liabilities is treated as a cash distribution
• The partnership is deemed to have distributed
  money to the partner
• Who pays the creditor

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Reduction in Liabilities

• A reduction in a partner's share of liabilities
  may occur because the partnership has
• Made principal payments
• Refinanced the property
• Sold the property that secures a debt
• And repaid the debt
• Partner's share of the liability can be shifted
  to another partner--See Module 24

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Marketable Securities

• For distributions occurring after 12- 8-94
• FMV of marketable securities may be treated as
  money for purposes of determining
• Whether a partner must recognize gain from a
  distribution
• Marketable securities include a variety of traded
  financial instruments

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Tax Treatment of Distributions from a Partnership

• Key Learning Objectives (2)
• Character of gain when distributed property is
  sold
• Passive losses and gain from partnership
  distributions
• Partnership interests as marketable securities

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Character of Gain When Distributed Property is
Sold

• Basis of distributed property generally carries
  over to the distributee partner
• Any unrealized gain or loss will be recognized
  when the property is sold

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Character of Gain When Distributed Property is
Sold

• Any gain or loss attributable to
• Inventory
• Will be ordinary if the partner sells the
  property within five years of distribution
• Unrealized receivables
• Will be ordinary regardless of how long the
  partner holds the asset

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Distributions From an S Corporation

• Key Learning Objectives (1)
• S corporation distributions general rules
• Distributions without earnings and profits
• Effect of liabilities on an S distribution
• Basis of stock S distributions
• Basis of stock multiple blocks

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S Corporation Distributions

• Any distributions from earnings and profits are
  dividends to the shareholder
• Distributions that are not from earnings and
  profits are return of capital (ROC)
• Not taxable to the extent of the shareholder's
  basis in his stock

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Effect of Liabilities On Distribution

• The amount of a distribution is
• The amount of any money received plus
• The FMV of any property received
• The distribution is reduced by liability
• If property is distributed
• Subject to a liability OR
• If shareholder assumes liability as part of
  distribution

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Stock Basis and Distributions

• S corporation income is allocated on a per-share,
  per-day basis
• Adjustments to stock basis are also made on a
  per-share, per-day basis
• Basis is first increased for income
• Reduced for any distributions
• Then reduced for losses

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Distributions From an S Corporation

• Key Learning Objectives (2)
• Distributions with earnings and profits
• Distinguishing S and C distributions Accumulated
  Adjustments Account (AAA)
• Determination of AAA
• Distributions when AAA exists
• Election to distribute earnings and profits

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Distributions With EP

• Distributions must be divided between those
• From earnings and profits AND
• From S corporation earnings
• Distributions are first considered to come from S
  corporation earnings

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Accumulated Earnings AccountAAA

• AAA represents the earnings of the corporation
  after it became an S
• Distributions from AAA are taxed under the rules
  applicable to S corporations
• Distributions in excess of AAA are taxed under
  the C corporation rules
• To the extent the distributions come from
  earnings and profits.

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AAA Changes

• Increased by
• Items of income or gain
• Except tax-exempt income
• Decreased by
• Items of expense or loss
• Except tax-exempt related

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AAA Changes

• Can be negative if losses exceed income
• Cannot be made negative by cash or property
  distributions
• Distributions can reduce AAA to zero, but no lower

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Taxability of DistributionsNo E P

• Use 2-tier system
• Tax-free to extent of stock basis
• Excess taxable as capital gain

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Taxability of Cash Distributions With E P

• Use 5-Tier System
• Tier Taxability Stock Basis
• AAA Tax-free Decrease
• PTI Tax-free Decrease
• EP Taxable No Effect
• ROC Tax-free Decrease
• Excess Taxable No Effect

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Election to DistributeEarnings and Profits

• Must be consented to by all affected shareholders
• Includes any shareholder who has received a
  distribution during the year
• By making this election, a distribution will be
  treated as a dividend to the shareholders rather
  than a tax-free return of capital

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Why Election to DistributeEarnings and Profits

• To avoid the penalty tax on excess passive income
• Applies only if the S corporation has earnings
  and profits
• The election to distribute earnings and profits
  will allow the corporation to avoid this penalty
  tax and perhaps to save the S election

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Why Election to DistributeEarnings and Profits

• One or more shareholders may be in a relatively
  low tax year
• Prefer to receive a taxable distribution in the
  current year
• One or more shareholders may be subject to a
  limitation on the deductibility of investment
  interest
• Dividends are investment income

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Distributions from anS Corporation

• Key Learning Objectives (3)
• S corporation distributions of appreciated
  property
• When tax-exempt income can become taxable
• AAA and corporate restructurings
• Distributions from fiscal year S corporations
• Allocation of AAA among multiple distributions
• Post-termination transition period distributions

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S Corporation Property Distributions

• The amount of a distribution is
• The amount of any money received plus
• The FMV of any property received
• Reduced by liabilities assumed

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Taxability of Property Distributions

• Use C corporation rules
• Nonliquidating recognize gains, not losses
• Liquidating recognize gains and losses
• With some exceptions
• Gains and losses flow through to shareholders

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Distributions From a Partnership

• Key Learning Objectives
• Guaranteed payments
• Payments to retiring partners
• Payments for a retiring partner's share of
  goodwill
• Distributions involving 751 assets
• Definition of 751 assets

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Guaranteed Payments of Partners

• Compensation for
• Services performed OR
• Interest on invested capital
• Deductible to partnership
• Ordinary self-employment income to partner

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Cash Payments Due to Retirement or Death of a
Partner

• Payments for property
• Payments for hot assets generate ordinary income
• Other payments
• Either distributive shares or
• Guaranteed payments
• For service partnerships, other payments
  include payments for unrealized receivables
  and goodwill

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751 Hot Assets

• These assets produce ordinary income
• They can affect both partnership distributions
  and sales of a partnership interest
• Two kinds
• (1) Unrealized receivables
• (2) Substantially appreciated inventory

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Unrealized Receivables

• Always hot
• Includes
• Accounts receivable of cash method
  partnership
• Depreciation recapture items

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Substantially Appreciated Inventory

• Hot only if aggregate FMV of inventory items
  exceeds 120 of their aggregate basis
• Broad definition
• All assets other than cash, capital assets, and
  1231 assets

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Basis in Distributed Property

• Key Learning Objectives (1)
• Partner's basis in distributed property
• Limitation on basis assigned to partnership
  distribution
• Basis assigned in liquidating distribution
• Basis of ordinary income assets

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Distributions

• Three tiers of property
• Deemed distributed in this order
• Cash
• Unrealized receivables and inventory
• Other property

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Effect on Partner Current Distribution

• Distributed tier two and tier three properties
  have a carryover basis to the partner
• However, basis carried over cannot exceed
  partners remaining partnership interest basis
• Allocation of bases is necessary if multiple
  assets are distributed within a tier
• Distributions reduce a partners partnership
  interest basis, but never below zero

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Effect on Partner-- Liquidating Distribution

• No gain recognized unless cash exceeds partners
  pre-distribution basis
• Exception disproportionate distributions of hot
  assets
• Partner may recognize a loss, if other property
  is not distributed
• If tier three property is distributed, any
  remaining basis is assigned to it
• Substituted rather than carry over basis

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Basis in Distributed Property

• Key Learning Objectives (2)
• What are ordinary income assets?
• Basis limitation may permit a loss
• Basis of distributed marketable securities
• Basis of property received S corporation
  distributions

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Taxable Distributions

• Key Learning Objectives
• Disguised sale provisions partnerships
• Protected distributions
• Illustrations of disguised sale
• Distributions that may trigger 704(C) gain
• Distributions to another partner
• Distributions to contributing partners
• Interaction of 704(C)(1)(b) and 737

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Tax Effects of Distributions on a Partnership

• Key Learning Objectives
• Effect of distributions on partnerships
• What is a 754 election?
• 734 adjustments
• Positive
• Negative

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Effect of Distributions on Partnership

• Will not generally recognize gain or loss when
  assets are distributed to a partner.
• May recognize gain or loss if the
  disproportionate distribution of 751 assets
• Treated as a deemed purchase-sale transaction
  rather than from the distribution itself
• May also adjust the basis of undistributed assets
  if 754 election is in effect

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If 754 Election is In Effect

• Whenever property is distributed
• To partner who recognizes either gain or loss
• Partnership adjusts inside basis of all assets
• Whenever interest in the partnership is
  transferred
• By sale or exchange or by death of a partner
• Only new partner adjusts the basis of assets
• So that outside basis inside basis

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Tax Effect of Distributions on an S Corporation

• Key Learning Objectives
• Effect of distributions on S corporation
• Distributions of appreciated property
• Avoid nonconforming distributions

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Effect of Distributions on S Corporation

• An S corporation is subject to all provisions of
  subchapter C except to the extent that subchapter
  S provides otherwise
• Both the AAA and earnings and profits are
  corporate-level accounts that must be adjusted
  for distributions to shareholders

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Distributions As Redemption of Stock

• The adjustment to AAA or EP depends on whether
  the redemption is classified as
• Distribution
• S earnings reduced first
• Exchange
• AAA and EP are reduced
• In proportion to number of shares redeemed in
  relation to the total outstanding shares

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Distributions of Appreciated Property

• If an S corporation distributes appreciated
  property, 311(b) will require the corporation to
  recognize gain
• If not in liquidation
• Gains are recognized as if the property were sold
  to the distributee at FMV
• Losses not recognized
• If liquidation, both gains/losses recognized