Business Entities Chapter 12 pp. 495 - 532 2015 National Income Tax Workbook™
Business Entities P. 495 1. Cancellation of Debt Income 2. Allocation of Partnership Liabilities. 3. Limited Liability Companies. 4. Series Limited Liability Companies. 5. Accidental Partnerships. 6. Compensation of Business Owners 7. Selection of Business Entity
Cancellation of Debt Income p. 496 § Debt reduction can be from: ▪ Gift ▪ Property sale with debt assumed ▪ Compensation ▪ Other deals § Otherwise the cancellation of debt results in taxable income unless an exception applies.
Cancellation of Debt Income p. 496 § Cancellation of debt results in taxable income unless one of these exceptions applies: ▪ Discharge due to bankruptcy. ▪ Insolvent debtor. ▪ Reduction of qualified farm debt. ▪ Election to exclude qualified real property business debt if debtor is not a C Corp. ▪ Qualified principal residence debt before 1 -1 -2014. (After 2014 if renewed by Congress. ) ▪ Reduction of purchase money debt held by seller. ▪ Limited reductions in student debt for work in designated occupations.
Bankruptcy & Insolvency p. 497 § Bankruptcy – ▪ The debt must be discharged by a court in a bankruptcy proceeding and the taxpayer must be a party to the proceeding. § Insolvency – ▪ When FMV of the debtor’s assets is less than the debtor’s debts. Comment: Taxable to the extent cancellation brings asset FMVs above debtor’s debt. ▪ The computation includes all assets including those exempt in a bankruptcy proceeding such as an individuals retirement accounts.
Qualified Farm Indebtedness p. 497 § 50% or more of debtor’s gross receipts in 3 taxable years preceding cancellation must be from an active farming trade or business. § Debt must have been incurred in the farming business. § Amount excludible must be reduced by: ▪ “Adjusted tax attributes” of the debtor (defined later) and the ▪ Adjusted basis of “qualified property”: Any property used in any trade or business. § Any excess is taxable.
Qualified Real Property Business Indebtedness p. 497 § This exception does not apply to C Corporations. § The debt must have been: ▪ Incurred or assumed in connection with real property used in an active trade or business and ▪ Must be secured by that real property. § Exclusion is only for debt incurred: ▪ After 12 -31 -1992 and ▪ To acquire, improve or rehabilitate real property used in the taxpayer’s trade or business.
Qualified Real Property Business Indebtedness p. 498 § This exclusion is limited to the lesser of: ▪ Excess of debt secured by the qualified real property over the property FMV OR ▪ Aggregate of the adjusted basis of the taxpayer’s depreciable real property.
Purchase Money Debt Reduction p. 498 § When seller of property agrees to reduce the purchase money debt there is no gross income to the debtor. ▪ Debtor must not be insolvent. ▪ Debt must not be part of a bankruptcy discharge. ▪ Debtor must reduce the basis in the property secured by the debt.
Attribution Reduction p. 498 § For exclusions due to bankruptcy & insolvency TP must reduce tax attributes in the following order: 1. NOL of the discharge year. 2. NOL carryover to that year. 3. General Business credit carryforward. 4. AMT credit for discharge year and carryforwards. 5. Capital loss in year of discharge. 6. Capital loss carryforwards to year of discharge. 7. Reduction of basis of all of taxpayer’s property. 8. Current passive activity losses & carryforwards. 9. Foreign tax credit carryover.
Effect of Entity Classification on Debt Discharge p. 498 - 499 § The entity you choose may impact the exclusion from cancellation of debt income. § LLCs that are “Disregarded Entities” including Grantor’s Trusts & some Subs of S Corps & REITS: ▪ The Disregarded Entity and the individual’s assets and liabilities are combined for the insolvency exclusion. ▪ The Disregarded Entity and the individual must both be a party to the bankruptcy for the bankruptcy exclusion.
Bankruptcy of SMLLC (Disregarded Entity) Ex. 12. 1 p. 499 § Deb owns all of DFT which is an LLC which did not elect to be a corp and so is a disregarded entity. § DT was in Bankruptcy and the Court discharged $100, 000 in debt. § If Deb was not a party to the bankruptcy proceeding the bankruptcy exclusion is not available to her. § However, check the court filings because Deb probably had to file for bankruptcy to have DT’s debts discharged.
Partnerships p. 499 § The entity you choose may impact the exclusion from cancellation of debt income. § The exclusion rules look to the partner(s) and not the partnership. § Discharge of partnership debt may be taxable to some partners and excludable for others. § Different partners may qualify for different exclusions.
Partnership Debt Discharge Ex. 12. 2 pp. 499 - 500 § 3 Hopper family members each own 1/3 of the Hopalong, LLC, a farming PS in Rhode Island. § Claude is active manager of the PS business. § His sister Belle works elsewhere in N. Dakota. § Their sister Bunny works in Utah. § Claude arranged for a creditor to cancel $300, 000 of debt owed by the PS which rec’d a 1099 -C. § Each partner’s K-1 must show their share of the cancellation of debt from the PS. § How does each partner treat their share of the Cancellation of Debt Income?
Partnership Debt Discharge Ex. 12. 2 pp. 499 - 500 § Claude was solvent & was active in the PS ▪ He can exclude his share of the Cancellation of Debt Income under the Farming exclusion. § Belle is solvent and was not active in the farming operation. ▪ Her share of the cancellation of debt ($100, 000) is taxable income to her. § Bunny has college and other debts that exceed her assets before & after the cancellation of debt. ▪ Her share of the cancellation of debt is excludible under the Insolvency exclusion.
COD Income and Basis Reduction Ex. 12. 3 p. 500 § In prior example, each partner had $100, 000 in debt forgiven. § If any members basis in their PS interest is less than $100, 000 the excess of debt over basis is recognized gain. ▪ It does not appear this could happen. § Each member’s share of: ▪ Cancelled debt income increases basis ▪ But then basis is decreased by the cancellation of the debt if an exclusion applies.
S Corporation p. 500 § Again…. the entity you choose may impact the exclusion from cancellation of debt income. § The tests for exclusion are made at the corporate level when the entity is an S Corp. § It feels like the exclusions should work like they do for partnerships BUT that is not what Congress decided.
Changing Entity Status in Contemplation of Discharge of Debt p. 500 § Again…. the entity you choose may impact the exclusion from cancellation of debt income. § Thus, you may want to change the type of the entity in anticipation of a cancellation of debt. § If so, also consider what the other tax, local law consequences and impact will be.
Changing Nontax Status pp. 500 - 501 § Most State laws allow conversions between corps and LLC’s. § Fed Income Tax: ▪ Changing from unincorporated to incorporated entity – Typically no problem: § 351 permits tax free transfer of property for stock. ▪ Changing from incorporated to unincorporated entity – Typically can be a problem: § 336 and § 331 provide for potential gain or loss recognition on each asset distributed.
Changing Tax Status Without Changing Nontax Status p. 501 ▪ ▪ LLC with multiple owners is a PS. LLC with one owner is a Disregarded Entity. LLC can “check the box” to be a corporation. To be a C Corp a Form 8832 can be filed within 75 days after, or 12 months before, the intended effective date. ▪ To be an S Corp file a Form 2553 as of the first day it is seeking such classification. Form 8832 is not needed if Form 2553 is filed. ▪ Election generally cannot be changed for 60 -months. However, a new election can be changed within 60 months if 50% of ownership changes & majority of owners were previously not owners.
Separation from Owner for Bankruptcy Test Ex. 12. 4 p. 501 § Deb elected S Corp status for DT, LLC by filing form 2553 timely. § DT files for bankruptcy. § Treatment of DT’s cancellation of debt income is determined only by reference to DT’s as an entity since it is an S Corp. § The discharge in bankruptcy means that DT can exclude from income the cancelled debt. § Deb’s status is irrelevant. § Deb does not get a basis increase for the excluded income.
Qualifying Farm Indebtedness Test for S Corporation Ex. 12. 5 p. 502 § Hopalong PS elected to be an S Corp by filing Form 2553 timely. § Hopalong is in the farming business. § Hopalong can exclude cancellation of debt using the qualified farm indebtedness exclusion.
Pitfalls Connected with the Corporate Election p. 502 § Typically converting from unincorporated to a corporation is tax free (§ 351). § Exception: ▪ Excess of liabilities over basis of property contributed to the corporation is recognizable gain to the contributing shareholder. § Speaker’s Comment: Also, your client now needs to understand that the corporation is a separate entity…. . Good Luck.
Gain Realized on Deemed Contribution Ex. 12. 6 p. 502 § § § § Hopalong PS’s assets had an adjusted basis of $3, 000. Partners arranged to have $300, 000 of PS debt cancelled. Hopalong’s liabilities (before reduction) are $3, 900, 000. Hopalong PS converts to Hopalong Corp. so the partners (via the PS passthrough) can avoid $300, 000 in cancellation of debt income. The 3 partners become the 3 shareholders. The three partners transferred $3, 000 is assets and $3, 900, 000 in liabilities to the corp for stock. The three individuals each have to report their share of a $900, 000 gain. They would have been better off to stay as a PS which would have had $300, 000 in cancellation of debt income.
Practitioner Note Shareholder Guarantee p. 502 § Transfer of liabilities to a corporation: ▪ Without a business purpose or for tax avoidance are treated as taxable boot. ▪ In excess of basis in transferred assets is treated as gain. § As long as the arrangement (including guarantees) anticipates the corporation paying the SH’s liabilities the arrangement is treated as the Corporation relieving the SH of the debt.
Allocation of Partnership Liabilities p. 503 § This section of the text discusses how debt is handled in computing basis in partnerships. § LLC’s treated as partnerships will be referred to as partnerships in this chapter. § LLC Members will be referred to as partners in this chapter where the LLC is treated as a partnership.
Effect of Partnership Liabilities on Basis p. 503 § When a person becomes a partner, or there is an increase in their interest in a PS, their basis is increased by the amount of debt for which they become liable. § A decrease in a partner’s share of debt decreases the partner’s basis but not below zero. § Record of debt allocation and basis need to be maintained.
Effect of Partnership Liabilities on Basis p. 503 § Each partner’s share of PS liabilities depends on: 1. Whether the liability is with recourse or nonrecourse. 2. What is each partner’s economic risk if the debt is with recourse. 3. What are the pre-contribution minimum gain, the minimum gain on chargeback and the partners share of PS profits if the debt is nonrecourse.
Effect of Partnership Liabilities on Basis p. 503 § Partnership Recourse Liability: ▪ When any partner, or person related to a partner, bears economic risk for payment. § Partnership Nonrecourse Liability: ▪ No Partner, or person related to a partner, has personal liability for a PS debt.
Partners’ Shares of Recourse Liabilities p. 504 A Partner’s share of liabilities for purposes of allocating outside basis among the partners is the partner’s share of the hypothetical loss that would be sustained if all of the partnership assets immediately became completely worthless.
Equal Allocations of Recourse Liabilities Ex. 12. 7 pp. 504 - 505 § Equal Partners Allen and Barbara each contributed $100 to AB Partnership. § AB borrowed, with recourse, $800. § AB bought a building for $1, 000. § AB PS agreement provides equal allocation of all items and provides a “deficit capital account restoration obligation” on liquidation. § Partner capital & basis accounts are:
Equal Allocations of Recourse Liabilities Ex. 12. 7, Fig. 12. 1 pp. 504 - 505 Capital Accounts Outside Basis Initial Contribution Loss on Constructive Liquidation Adj. Capital Account Share of PS Debt Outside Basis Allen $ 100 Barb Allen Barb $ 100 $100 ( 500) ($400) 400 $ 500
90/10 Allocation of Recourse Liabilities Ex. 12. 8 p. 505 § Allen and Barbara each contributed $100 to AB Partnership. § AB borrowed, with recourse, $800. § AB bought a building for $1, 000. § This time the AB PS agreement provides book and tax losses are divided: 90% to Allen and 10% to Barbara § Capital & basis accounts are:
90/10 Allocation of Recourse Liabilities Ex. 12. 8, Fig. 12. 2 p. 505 Capital Accounts Outside Basis Initial Contribution Loss on Constructive Liquidation Adj. Capital Account Share of PS Debt Outside Basis Allen $ 100 Barb Allen Barb $ 100 $100 ( 900) ( 100) ($800) ($ 0 ) 800 0 $ 900 $ 100 Only Allen has a negative capital account so is at risk for entire loss.
95/5 Allocation of Recourse Liabilities Ex. 12. 9 p. 506 § Allen and Barbara each contributed $100 to AB Partnership. § AB borrowed, with recourse, $800. § AB bought a building for $1, 000. § This time the AB PS agreement provides book and tax losses are divided: 95% to Allen and 5% to Barbara § Capital & basis accounts are:
95/5 Allocation of Recourse Liabilities Ex. 12. 9, Fig. 12. 3 p. 506 Capital Accounts Outside Basis Initial Contribution Loss on Constructive Liquidation Adj. Capital Account Share of PS Debt Outside Basis Allen $ 100 Barb Allen Barb $ 100 $100 ( 950) ($850) $ 50 800 0 $ 900 $ 100 Only Allen has a negative capital account so is at risk for entire loss.
Financial Condition Disregarded Ex. 12. 10 p. 506 § Financial condition of partners is disregarded in making allocations. § However, there could be side agreements that protect a partner from the economic impact of the entity’s debts. § We should ask about side agreements.
Agreement Between the Parties Ex. 12. 11, Fig 12. 4 pp. 506 - 507 § Allen and Barbara each contributed $100 to AB Partnership. § AB borrowed, with recourse, $800. § AB bought a building for $1, 000. § This time the AB PS agreement provides book and tax losses are divided equally. § But, there is a side agreement that Barbara indemnifies Allen so that he will not be required to contribute any more than $650. § Capital & basis accounts are:
Agreement Between Partners Ex. 12. 11, Fig. 12. 4 pp. 506 - 507 Capital Accounts Outside Basis Initial Contribution Loss on Constructive Liquidation Allen $ 100 Barb Allen Barb $ 100 $100 ( 900) ( 100) Stop Loss Agreement __150 ( 150) Adj. Capital Account ($150 Share of PS Debt Outside Basis ($650) 650 __50 $ 750 $ 250
Overlapping Guarantees: Proposed Regulations p. 507 § Guarantees can exceed 100% of the debt. § In such cases each owner’s share is a percentage of the guarantees of all the owners. § See Example 12. 12…….
Overlapping Guarantees: Proposed Regulations Ex. 12 p. 507 § § § § Abigail & Meaghan are equal members in SIS, LLC. SIS is treated as a PS. SIS borrows $1, 000 from the bank. Abigail guaranteed $1, 000 & Meaghan guaranteed $500 of the PS bank loan. SIS’ $1, 000 increase in debt increases outside basis of partners as follows: Abigail = $1, 000 X (1, 000 / 1, 500) = $ 667 Meaghan = $1, 000 X ( 500 / 1, 500) = 333 Total increase in debt & outside basis $ 1, 000
Top Dollar & Bottom Dollar Guarantees: Proposed Regulations p. 507 § The proposed regulations ensure that economic risk exists before guarantees impact capital accounts and basis. § Facts and circumstances are used to determine each partner’s risk.
Related Person Guaranteeing Debt Ex. 12. 13 p. 507 § § Clyde owns 100% of Bubco, an S Corp. Bubco is a 1/3 owner in AMB, LLC is treated as a partnership. Bubco does not guarantee any of AMB’s debts. § Clyde does guarantee 1/3 of AMB’s debts. § Bubco has an economic risk of loss to the extent of Clyde’s guarantee.
Economic Risk p. 508 § To be treated as economic risk from a guarantee, indemnity or similar arrangement the guaranteeing partner must meet all 5 of the first criteria listed on page 508. § If the risk is from a guarantee arrangement it must also meet the 6 th item listed on page 508. § If the risk is from a indemnification, reimbursement or similar arrangement it must meet the 7 th item (but not the 6 th) listed on page 508.
Guarantee of First and Last Dollars Ex. 12. 14 pp. 508 - 509 § James, Evelyn & Josephine are equal members in LIT, LLC which is taxed as a partnership. § LIT borrowed $1, 000 from bank. § James guaranteed $300 and Evelyn guaranteed $200 but only if bank recovers less than $200. § James’ economic risk of loss is $300. § Evelyn’s guarantee has no economic risk since James’ guarantee ensures she will not have to pay § $300 of debt is allocated to James. § $700 of debt is without recourse & so allocated.
Indemnification of Guarantees Ex. 12. 15 Guarantee of Vertical Slice Ex. 12. 16 p. 509 These are additional examples of determining whethere is economic risk sufficient to provide basis in a partnership indemnification of a guarantee or a vertical slice. (Vertical slice – Guaranteeing a % of a loan. )
Nonrecourse Liabilities Defined p. 510 § Nonrecourse liability: ▪ When lender has no recourse against borrower except to take possession of property pledged as security for the debt. § Partnership nonrecourse debt: ▪ Lender makes a nonrecourse loan to a PS. § Partner nonrecourse debt: ▪ Lender makes a loan to PS and the PS guarantees the loan. ▪ No partner bears any economic risk.
Nonrecourse Liabilities Defined p. 510 § Generally, PS nonrecourse liabilities are allocated according to profit-sharing ratios. § Two categories of PS nonrecourse debt: ▪ Nonrecourse Liability Associated Directly with Pledged Property. ▪ Nonrecourse Liability NOT Associated Directly with Pledged Property.
Nonrecourse Liability Associated Directly with Pledged Property. pp. 510 - 511 § Nonrecourse debt falls into three categories & ordering is: 1. Minimum Gain Chargeback: ▪ Basis is less than the debt due to depreciation, etc. ▪ Debt allocated according to dep. deduction allocation. 2. Precontribution gain: ▪ Partner contributes property when basis is less than debt. ▪ Difference (gain) is allocated to contributing partner. 3. Excess Nonrecourse Liability: ▪ Any other nonrecourse debt. ▪ Allocated on profit or deduction allocation.
Nonrecourse Liability Secured by Contributed Property Ex. 12. 17 p. 511 § Alfie contributed property for 1/3 interest in ABC, PS. Property basis $400, 000 subject to $450, 000 nonrecourse debt. § Brenda & Clarence each contributed cash for 1/3 interest. § $60, 000 Deprec. deducted in 2 years of operation. § Deprec. was allocated equally to the 3 partners. § After two years Della admitted as ¼ owner partner. § Allocation of liability for inclusion in each partner’s basis is shown on Fig 12. 5, page 511.
Allocation of Nonrecourse Debt Secured by Property for Inclusion in Each Partner’s Basis Ex. 12. 17, Fig 12. 5 p. 511 Alfie Minimum Gain Chargeback *1 Brenda Clarence Della Total $20, 000 $0 $60, 000 Precontribution Gain *2 50, 000 0 50, 000 Excess Nonrecourse Liability *3 85, 000 340, 000 Total $155, 000 $105, 000 $85, 000 $450, 000 *1 Debt on property donated exceeds basis so debt allocated as depreciation deduction is allocated to partners. *2 Debt allocated to contributor as basis to extent of debt over basis. *3 Remaining debt allocated to basis based on profit & deduction allocation.
Nonrecourse Liability NOT Associated Directly with Pledged Property. pp. 511 - 512 § This debt should be allocated based on partner’s relative interest in partnership profits. § Proposed Regulations would allow partners to allocate debt based on the liquidation percentages. § See Example 12. 18.
Limited Liability Companies p. 513 § LLC Limited Liability Company. § One member – Treated as a Disregarded Entity & can choose to be a Corp. § Two member - Treated as a Partnership & can choose to be a Corp. § Election to be treated as a Corp done by checking the box on Form 8832. § Conversion to Corp can be simple but conversions can be involved.
Mandatory Change of Default Status p. 513 § LLC that goes from multiple members to one member that was not treated as a Corp must go through the same step as a terminated PS. § If new sole member was previously one of the multiple members the change is treated as if: ▪ PS made a distribution of assets to members. ▪ Continuing member acquired the assets deemed to have been distributed to selling members.
Buyout by Continuing Partner Ex 12. 19 p. 514 § Bob & Margaret have been equal owners of Walla. § Walla is an LLC which owns land & bldg. with Adj Basis of $400, 000 & bldg. depreciated using SL. § 4 -23 -15 Margaret bought Bob’s ½ interest $150, 000 § FMVs : Land = $100, 000 & bldg. = $200, 000 § Adj. Basis: Land = $ 80, 000 & bldg. = $320, 000 § Outside basis of each in the LLC is $200, 000. § Bob has recognizes a $50, 000 capital loss: § S/P $150, 000 – Outside Basis $200, 000 = ($50, 000) § What does Margaret do & what is her basis?
Buyout by Continuing Partner Ex 12. 19 p. 514 § Margaret treats deal as a liquidating distribution with each member getting their share of assets & then as if she bought Bob’s assets from him. § Each allocates their outside basis ($200, 000) to the assets distributed. § FMV of each asset / FMV of total assets X outside basis = allocation of outside basis to assets: § $ 40, 000 of outside basis is allocated to land. § $160, 000 of outside basis is allocated to bldg. § Margaret uses the allocated outside basis of each asset as her basis in each asset.
Buyout by Continuing Partner Ex 12. 19 p. 514 Margaret now owns the assets as a single member LLC which is treated as a Disregarded Entity & each assets basis is: Asset Land Building Total Purchase Basis $ 50, 000 Carryover Basis $ 40, 000 Total 100, 000 160, 000 260, 000 $150, 000 $200, 000 $350, 000 $ 90, 000
Buyout by Nonmember p. 514 § When all of the members sell their interest in an LLC the new owner is treated as having bought the assets from the entity. § The buyer’s: ▪ Basis in assets is the purchase price paid. ▪ Purchase price is then allocated to assets using the method prescribed by § 1060, IRC, when there is a sale of a business with goodwill and going concern values, etc.
Buyout by Nonmember Ex 12. 20 p. 514 § Bob & Margaret have been equal owners of Walla. § They both sell their interests to John for $150, 000. § Walla is an LLC which owns land & bldg. with Adj Basis of $400, 000 & bldg. depreciated using SL. § FMVs : Land = $100, 000 & bldg. = $200, 000 § Adj. Basis: Land = $ 80, 000 & bldg. = $320, 000 § Outside basis of each in the LLC is $200, 000. § Bob & Margaret recognize a $50, 000 capital loss: § S/P $150, 000 – Outside Basis $200, 000 = ($50, 000) § John allocates price paid to assets using § 1060.
Effect of Passive Activity Losses p. 515 § Losses suspended due to passive activity rules can be deducted when there is a disposal of the activity. § Recognized gain from disposal is passive income which can be used to off set passive losses. § Loss from disposal is deductible. § If gain is recognized in an installment sale the suspended losses are prorated and recognized as gain is reported annually.
Related Party Issues p. 515 § Losses suspended due to passive activity rules can be deducted when there is a disposal of the activity. § If the loss is from sale to a related party the seller cannot deduct the loss. § The loss can be claimed by the related purchaser when sells to an unrelated party. § Suspended losses not deductible until sale to unrelated party.
Disposition of Interest in LLC to Related Party Ex. 12. 21 p. 515 § § § Bob & Margaret have been equal owners of Walla. They both sell their interests to John for $150, 000. This time Margaret & John are brother & sister. Bob is not related to either John or Margaret. Bob claims his $50, 000 loss & can claim any suspended losses since he has disposed of the activity. § Margaret cannot claim her $50, 000 capital loss or any of her suspended losses (unless she has other passive income). § Margaret can get the suspended losses & the capital loss to offset any gain from a subsequent sale to an unrelated party.
No Automatic Change of Elected Status p. 516 § Once an LLC has elected to be treated as a Corporation it retains that status until properly revoked. § General Rule: ▪ Corp cannot elect to be a non-corp within 60 months of election to be a corp. § Exception: ▪ 60 month restriction to change does not apply if election to be a corp was made of date formation as a legal entity. ▪ IRS can grant change if 50% ownership changes
Initial Election vs. Change of Status Ex. 12. 22 p. 516 § MJ and EL are both single member LLC. § MJ chartered on 2 -17 -2011 & made corp election on 4 -1 -2012. ▪ MJ cannot change back before 4 -1 -2017 unless it gets IRS approval. § EL chartered on 4 -1 -2012 & made corp election on that same day 4 -1 -2012. ▪ EL can change back at anytime it wants.
S Corporation or C Corporation p. 516 § Once an LLC elects to be treated as a corporation: ▪ The corp is a separate entity. ▪ The member(s) become shareholders. ▪ Employment tax rules apply.
Filing Form 2553 to Elect S Corporation Status pp. 517 - 518 § Form 2553 if filed to become an S Corp. § Form 2553 is due by the 15 th day of the 3 rd month of the year for which it is take effect. § If the business is a C corp and wants to become an S corp it can file a Form 2553. § If the business elects to be a C corp and an S Corp at the same time it need only file a 2553…. . No Form 8832 is not necessary.
Disqualification from S Corporation Status Ex. 12. 23 p. 518 This example relates how & the impact of form changes: § Jack contributes assets to Jacklaw, LLC. § Jacklaw is a Disregarded Entity. § Admission of new foreign attorneys will convert Jacklaw into a PS. § Jacklaw can still become a C Corp. § Jack would like to make Jacklaw an S corp. to limit his FICA costs. § Admission of new foreign attorneys means that Jacklaw cannot be an S Corp. § Once a C Corp conversion back to a PS requires a corporate liquidation that has tax implications.
LLC Filing Form W-9 p. 518 § Paying funds means the payer may need and request a W -9 to have the Payee’s SSN or TIN so a Form 1099 can be issued. § Failure to issue a Form 1099 could cost the payer backup withholding which is 28% of the amount payed. § If an LLC is a: § Disregarded Entity – W-9 should include the individual owner’s name and that of the LLC entity and either the entity’s TIN or the owner’s SSN. § Partnership, C Corp or S Corp – Check “LLC” and enter the appropriate classification and information.
Issuing Form 1099 to an LLC pp. 518 - 519 § Form 1099 is required for certain trade or business payments to entities other than corporations and to certain types of corporations. § Partnerships and individuals are not exempt. § When payments are made to an LLC information needs to be gather to know whether a W-9 needs to be secured to issue a Form 1099.
LLC Member and Self-Employment Tax p. 519 § SE Income includes income from a trade or business excluding: 1. Rents – Unless substantial services are rendered…Bobo, 70 TC 706. 2. Dividends and interest. 3. Capital gains and losses except from sales in the ordinary course of business. 4. Several other items under § 1402, IRC.
Self-Employment Income of a Partner p. 519 § General Partner’s SE Income includes: ▪ Partner’s share of trade or business income & ▪ Guaranteed payment for services or capital. § Limited Partner’s SE Income: ▪ Includes guaranteed payments for services performed for the partnership. ▪ Generally does not include limited partner’s share of PS income.
Uncertainty for Members of LLCs pp. 519 - 520 § LLC status provides certain limited liability to members. So, the issue is whether they are general partners or limited partners for SE taxes. § IRS position is that a member having management rights is subject to SE tax…. . and……
Uncertainty for Members of LLCs pp. 519 - 520 § Under 1997 Proposed Regs an LLC member is a limited partner unless meets one of three conditions: 1. Member has unlimited liability for company debts. 2. Member can contract on behalf of company. 3. Member participates in trade or business activity more than 500 more a year. § In addition, any member who provides services as the predominant part of the trade or business is subject to SE taxes. ▪ This is intended to cover attorneys working in a law firm, accountants working in an accounting firm, doctors working in a medical firm, etc.
Partners in Limited Liability Partnerships pp. 520 - 521 § Renkemeyer, 136 TC 137 (2011): ▪ Partners were not limited partners because they had managerial powers. ▪ Income was subject to SE tax. § Riether, 919 F. Supp 2 d 1140 (D. N. M. 2012): ▪ Husband wife owned and operated an LLC. ▪ Had LLC issue W-2 forms for avoid SE tax. ▪ Income was subject to SE tax. § C. C. A. 2014 -36 -049 (2014) ▪ “Limited partners” of an investment management firm were not limited partners based on work performed.
LLCs and IRC § 179 & Limits p. 521 § 179, IRC 2013 2014 2015 Unless Extended by Congress Maximum Deduction $500, 000 $25, 000 Phaseout Begins $2, 000, 000 $200, 000 LLC Partnership the limitations apply at Partnership & Partner level. Problem – Where a partner is in several PSs and the PS § 179 deductions allocated exceed partner’s limitation……
Limits of IRC § 179 Ex. 12. 24 p. 521 § 2014 § 179 deduction limitation was $500, 000. § Caroline owns 40% in 3 partnerships. § Each PS elected to deduct $500, 000 under § 179. § Each allocated $200, 000 of § 179 deduction to Caroline. § Caroline received $600, 000 in § 179 deduction from PSs. § But, she can deduct $500, 000 under § 179. § And, she must reduce her basis in each PS by $200, 000. § She has permanently lost $100, 000 in § 179 deductions.
Electing Out of Partnership Status pp. 521 - 522 § To avoid loss of 179 deduction a client might be able to elect out of partnership status if: § Property must be used solely for benefits of members and § Entity must not deal with outsiders. § The entity must be either: 1. For investment purposes only. 2. For joint production, extraction or use of property 3. For underwriting, selling or distributing a particular issue of securities.
Electing Out of Partnership Status Ex. 12. 25 p. 521 § Greg, Guido and Claire own adjacent farms. § They form GGC, LLC to hold title to farm equipment they will share for harvesting crops. § Ownership of assets is equal and bills will be paid based upon each’s hourly use of equipment. § In 2014 GGC bought $1, 200, 000 in equipment. § If GGC is a PS it can only claim a $500, 000 § 179 deduction to be shared by the 3 owners. § BUT: § If they elect out and are not a PS each 1/3 owner can claim a $400, 000 § 179 deduction.
§ 179 Noncorporate Lessor p. 522 § Property held for rent does not qualify for § 179 unless: ▪ Lessor is a C Corporation or ▪ Owner / Lessor has manufactured or produced the property or ▪ Lease is short and owner / lessor incurs substantial expenses with respect to the property. • Short lease – Lease is less than 50% of class life. • Substantial expenses – At least 15% of income produced during 1 st 12 -months after lessee takes possession.
Series Limited Liability Companies p. 522 § “Series Limited Liability Companies” allow an LLC to form subunits. § The LLC is like a Parent owning the subunits which are like separate businesses within the LLC. § Each subunit is termed a “series”. § Each “series” is protected from claims against other “series” in the parent LLC.
Series Limited Liability Companies p. 522 § States that allow Series Limited Liability Companies are: Delaware Oklahoma Illinois Tennessee Iowa Texas Nevada Utah
Series Limited Liability Companies Speaker’s Comment No Page § Virginia Maryland, North Carolina and DC do not recognize Series Limited Liability Companies so we won’t spend time on them but the text does if you want to know more. § I will say the purpose is to: ▪ Reduce costs since you only need to form and charter one LLC. ▪ Provide added liability protection. ▪ Allow an LLC to have different types of operations and assets in the different series.
Accidental Partnerships p. 524 § The Code defines a partnership as a: Syndicate, group, pool, joint venture or other unincorporated business through which any business, financial operation or venture is carried on. § The broad definition of PS can result in people being in a partnership who do business together even though no partnership agreement exists.
Accidental Partnerships p. 524 One result of failure to recognize you are in a PS: § The Penalty for Failure to File PS Return: $ 195 per month X the # of K-1 s = Penalty § Maximum for any one PS return is 12 months or $2, 340. 00 per partner (K-1). § After 2014 the $195 is indexed for inflation.
Accidental Partnerships Ex. 12. 29 p. 524 § Les sells cars and EZ repairs cars. § In addition to their separate businesses Les buys cars in need of repair, EZ repairs them and Les sells them. § They buy, repair & sell about 1 car month. § No written agreement, no charter, no books and records. § IRS examines 2 years, holds there is a PS and asserts failure to file penalty of: $9, 360. 00 = $2, 340. 00 X 2
Compensation of Business Owners pp. 524 - 525 § In some cases IRS argues compensation is excessive: ▪ C Corp is trying to hide dividends. ▪ There is an attempt to shift income to family members. § In other cases IRS argues compensation is insufficient: ▪ PS or S Corp is being used to shift income to low bracket individuals (often children). ▪ S Corp is trying to avoid FICA taxes.
Compensation of Partners & LLC Members p. 525 § Compensation issues arise in PSs as well as in C and S Corporations. § City Ranches #4 JV, TC Memo 1999 -209: ▪ Guaranteed payments held not deductible since PS could not substantiate services provided.
Excessive Compensation of C Corporation Shareholders p. 525 § Excessive compensation of C Corporation is usually treated as a dividend. § Since dividends are taxed at capital gains rates this might not be bad even though the C Corp losses the deduction. § However, the IRS could: ▪ Disallow the C Corp deduction and ▪ Not adjust the individual return.
Amount of Reasonable Compensation pp. 525 - 526 § Determination is by facts and circumstances including: 1. Employee’s qualifications. 2. Nature, extent and scope of the job. 3. Size of the business. 4. Complexity of the business. 5. Comparing salary to gross receipts & net income. 6. General conditions of the economy. 7. Comparing salaries to dividends paid. 8. Salaries paid to similar position in similar businesses. 9. Salary policy of business. 10. Prior years compensation. 11. Approval of a Board of Directors.
Amount of Reasonable Compensation pp. 525 - 526 § Courts have considered: ▪ What an independent investor would pay in salary. ▪ What an independent investor would want back as a return on investment. § As well as: ▪ A consistent salary policy and dividend policy. ▪ Compensation tied to business performance such as sales. ▪ Difference in ratio of compensation and stock ownership. ▪ Special training or experience. ▪ Similar pay to non-stockholders.
Amount of Reasonable Compensation p. 527 Court Cases have dealt with: § Catch-up Payments: ▪ Proof of underpayment in some years supports higher payments in other years. ▪ Repayment Agreements: § Thought to be a good idea but may not be: ▪ In one such case the Tax allowed a deduction for repayment (Oswald, 49 TC 645 (1968)). ▪ But often used as proof that salary was excessive. ▪ Repayment may not be deductible (Pahl, 67 TC 286 (1967)). ▪ Repayment might be subject to 2% of AGI limitation.
Excessive Compensation Nonowners p. 527 § Deduction for excessive compensation to family members not allowed. ▪ Westbrook, TC Memo 1993 -634 ▪ Carlins, TC Memo 1988 -79 § Be especially careful when payments are to children.
Insufficient Compensation of Business Owners pp. 527 - 528 § IRS often attacks insufficient compensation. § Issues are where: ▪ Taxpayer is trying to assign earned income to someone else. ▪ Taxpayer is trying to avoid FICA taxes. § The person who earns the income must report it. Lucas, Sup Ct. 281 US 111 (1930.
Family Partnership and S Corporations p. 528 § § 1366(e) and § 704(e) give IRS power to reallocate income to who earned it or provided the services or capital to generate it. ▪ IRS won Fundenburger, TC Memo 1980 -113. ▪ See Ex. 12. 30, Page 528. ▪ IRS lost Davis, 64 TC 1034 (1975) where a family member performed minimal services.
Attempts to Disguise Compensation to S Corporation Shareholder p. 529 § Attempts to treat S Corporation net income as profits with no salary to those running the business to avoid payroll taxes have consistently been lost by taxpayers in court: ▪ Radtke, 895 F. 2 d 1196 (7 th CA, 1990) ▪ Spicer Accounting, Inc. , 918 F. 2 d 90 (9 th CA, 1991) ▪ Esser, 750 F. Supp 421 (D. Arizona, 1990). § IRS has never lost a case on this issue.
Attempts to Disguise Compensation to S Corporation Shareholder p. 529 § § § Barron, TC Summary (2001 -10) CPA practiced via S Corp. Rec’d $2, 000 in salary one year. Rec’d no salary in other years. Distributions in no salary year were $50, 000. IRS & Court treated most of distributions as salary subject to FICA.
Selection of Business pp. 529 - 532 § Pages 529 – 532 give tables showing how various rules apply to different types of businesses such as: ▪ Maximum # of owners. ▪ Allocation of income and losses. ▪ Loss limitations. ▪ Application of employment and SE taxes. ▪ Etc.
That’s All for NOLs
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