Module 22 Operations of Flow- Through Entities

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Module 22Operations of Flow- Through Entities
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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

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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

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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

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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

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Flow-Through Entities

• There are four general categories of entities
  classified as flow-through entities
• S corporations
• Partnerships
• Limited liability companies
• Limited liability partnerships

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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

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Corporate Characteristics For Association

• Limited liability
• Centralized management
• Continuity of life
• Free transferability of interests

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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

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Partnership Reporting of Income

• Ordinary operating income
• Separately stated items
• See Form 1065 and Schedule K

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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

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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.

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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

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Partnership Required Tax Year

• Majority partners
• Principal partners
• Least aggregate deferral
• Exceptions
• Natural business year
• 444 election

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Choice of Taxable YearS Corporation

• Calendar year
• Business purpose year
• 25, 2-month, 3-year Test
• 444 election

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444 Election

• No more than 3 months deferral
• Must make noninterest-bearing deposit
• As if paid tax on deferral

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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

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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

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S Election Requirement

• All shareholders must consent
• Made by March 15
• Effective January 1
• Made after March 15
• Effective following year

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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

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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

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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

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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

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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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Limitations on Flow-Through Losses

• Key Learning Objectives
• Limitations on utilization of flow-through losses
  
• Basis limitations
• At-risk basis limitations
• Passive loss limitations

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Loss limitations of Partnerships

• Overall loss limit
• At-risk loss limit
• Passive activity loss limit

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Partner's Share of LiabilitiesGeneral Partners

• Recourse vs. nonrecourse
• Use profit sharing
• For nonrecourse loans
• Use loss sharing
• For recourse loans

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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

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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

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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

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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 EP must be present
• gt25 gross receipts test

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Special S Corporation Taxes Built-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

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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

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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

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Terminating the S Election

• Key Learning Objectives
• Termination of S election
• Effective date of S termination
• Re-election of S status
• Partnership terminations

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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

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Termination of S Status

• Inadvertent termination
• Violate any S condition
• Flunk 3-year passive income test
• gt25 Gross receipts test and
• Have C corporation EP
• Possible IRS relief

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Re-Election of S Status

• 5-year rule precludes reecection for five years

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Involuntary TerminationClose of PartnershipTax
Year

• Sale of gt 50 capital within 12 months
• Partership ceases to do business
• Loss of tax attributes