Module 22 Operations of Flow- Through Entities. Menu (1) 1. Definition of a flow-through entity 2....
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Transcript of Module 22 Operations of Flow- Through Entities. Menu (1) 1. Definition of a flow-through entity 2....
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
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
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
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