Module 22Operations of Flow- Through Entities

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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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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

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

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

Flow-Through Entities

There are four general categories of entities classified as flow-through entities:

S corporations

Partnerships

Limited liability companies

Limited liability partnerships

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

Corporate Characteristics For Association

Limited liability Centralized management Continuity of life Free transferability of interests

Reporting the Operations of a Flow-Through EntityKey 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

Partnership Reporting of Income

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

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

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.

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

APRIL15

Partnership Required Tax Year

Majority partners Principal partners Least aggregate deferral Exceptions:

Natural business year

§444 election

Choice of Taxable YearS Corporation

Calendar year Business purpose year

25%, 2-month, 3-year Test25%, 2-month, 3-year Test §444 election§444 election

§444 Election

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

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

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

S Election Requirement

All shareholders must consent Made by March 15

Effective January 1Effective January 1 Made after March 15

Effective following yearEffective following year

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

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

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

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

Guaranteed Payments of Partners

Compensation for

Services performed OR

Interest on invested capital Deductible to partnership Ordinary self-employment income to

partner

Limitations on Flow-Through Losses

Key Learning Objectives Limitations on utilization of flow-through

losses Basis limitations At-risk basis limitations Passive loss limitations

Loss limitations of Partnerships

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

Partner's Share of LiabilitiesGeneral Partners

Recourse vs. nonrecourse Use profit sharing %

For nonrecourse loansFor nonrecourse loans Use loss sharing %

For recourse loansFor recourse loans

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

S CorporationOverall Loss Limit

Cannot deduct losses in excess of Stock basis PLUSStock basis PLUS Basis of loans from shareholder to corporationBasis of loans from shareholder to corporation

Unused losses can be carried forward indefinitely until bases restored

At-risk and passive loss limitations also apply

Special Taxes Imposed onS Corporations

Key Learning Objectives Taxes imposed on flow-through entitiesTaxes imposed on flow-through entities LIFO recapture tax LIFO recapture tax Tax on excess passive income Tax on excess passive income Built-in gains tax Built-in gains tax Computation of built-in gains tax Computation of built-in gains tax How to avoid the built-in gains tax How to avoid the built-in gains tax Reporting the built-in gains taxReporting the built-in gains tax

Special S Corporation Taxes

LIFO recapture tax Actually a C corporation tax, but triggered by Actually a C corporation tax, but triggered by

an S electionan S election Excess net passive income tax

C corporation E&P must be presentC corporation E&P must be present >25% gross receipts test>25% gross receipts test

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%Currently 35%

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 lowerOr taxable income, if lower

"Net" means recognized built-in gains minus recognized built-in losses

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

Terminating the S Election

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

Termination of S Status

Revocation Requires majority vote Filed by March 15—

Effective January 1 or prospective dateEffective January 1 or prospective date Filed after March 15

Effective next year or prospective dateEffective next year or prospective date

Termination of S Status

Inadvertent termination Violate any S conditionViolate any S condition Flunk 3-year passive income testFlunk 3-year passive income test

>25% Gross receipts test and >25% Gross receipts test and Have C corporation E&PHave C corporation E&P

Possible IRS relief

Re-Election of S Status

5-year rule precludes reecection for five years

Involuntary TerminationClose of PartnershipTax Year

Sale of Sale of >> 50% capital within 12 months 50% capital within 12 months Partership ceases to do businessPartership ceases to do business Loss of tax attributesLoss of tax attributes