Basis/Distributions for Pass-Through Entities: An IRS Hot Spot

With the advent of the electronic matching of K-1 information with items on partners’ and S Corporation shareholders’ returns, the IRS is scrutinizing the basis that owners have in these entities and the transactions in which the computation of basis is required, more closely than ever. This course addresses the rules that are used to determine basis for partnerships and S Corporations and puts the computation of basis in the contexts that often come under scrutiny – loss limitations, distributions and sales of an interest, among others. Learn the crucial rules for computing the adjusted basis and the tax treatment of distributions of pass-through entities such as partnerships and S Corporations. Focus on the computation of the basis and the at-risk amount for these entities. Become familiar with the correct allocation of liabilities among partners, the types and amounts of income that can result from distributions and sales of interests and the basis of assets distributed from passthrough entities.

• Compute the basis of a partnership interest or S Corporation stockholding
• Determine the amount and the character of income or loss the partner or shareholder should recognize because of distributions of property or money
• Apply the basis, at-risk and passive activity loss limitations to pass-through losses from partnerships, LLCs and S Corporations
• Evaluate the tax treatment of sales of either partnership interests or S Corporation stock
• Adjust the basis of partnership or LLC property following certain distributions and transfers of interests in the entity

Prerequisite:  Experience in business taxation

Tax Consequences of Formation of Partnerships, LLCs, and S Corporations

Learning Objectives

After completing this chapter, you should be able to

• Determine the tax basis of assets transferred to a partnership, LLC or S Corporation at formation;
• Understand the tax consequences of a transfer of liabilities to a partnership, LLC or S Corporation in connection with property transfers at formation;
• Analyze the tax consequences of the exchange of an interest in a partnership or LLC for services.

Introduction

As far back as the year 2000, the IRS recognized that there has been a business trend toward using pass-through entities (partnerships and S corporations) for small and medium size businesses in lieu of sole-proprietorships and corporations. Between 1995 and 1999 partnership filings grew by 26% and S corporation filings grew by 29% (IRS Publication 3744, IRS Strategic Plan, Fiscal Year-2005). At the time, the IRS noted that research efforts suggested that K-1 income or losses reported by partners or beneficiaries from partnerships were not accurate in approximately 15% of the cases reviewed. As a result of these factors, beginning in 2002 the IRS changed its processing procedures and began processing and matching 100% of K-1s. As a result, CPAs have since seen many more clients who had received notices from the IRS that the information on the client's return did not match up with the information on the K-1 sent out by the partnership or S corporation.

Many of the taxpayers who receive such notices have accurately reported their income, but are the victims of glitches in the reporting and monitoring systems. For example, as of March 31, 2006, the IRS had issued 71,000 notices to taxpayers questioning whether they had properly reported their income from Schedule K-1 for tax year 2003. According to the IRS, many notices could have been avoided if taxpayers and/or their preparers had ensured documentation was provided to show offsets they had taken against income related to Schedules K-1, and if they had ensured their Schedule K-1 entity information was accurate when the Schedules K-1 were originally filed. The percentage of such cases in which a notice is issued and the IRS auditor finds that no change to the taxpayer's tax liability is required is fairly high. As of March 31, Some of the major causes of errors in reporting partnership and S corporation income are (1) improperly applying the passive activity rules and (2) improperly applying the basis and at-risk limitations. In fact, in News Release 2005-34 the IRS acknowledged the scope of the problem in these areas by offering the following two tips to recipients of Schedules K-1:

• Avoid netting or combining income against separately stated losses or expenses. Refer to Form 8582, Passive Activity Loss Limitation, for instructions on properly deducting passive activity losses. Ordinary business income should be reported separately from other related deductions, such as unreimbursed partnership expenses or Section 179 expenses. Refer to the Schedule E instructions for information on properly accounting for deductions related to Schedule K-1 income.
• Report deductible "At Risk" or Basis Limitation losses carried forward from prior years on a separate line from current year transactions. Do not combine (net) them with any current year amounts.

The importance of these issues in the audit of a partnership or a partner can be deduced from the priority given them in the IRS's Partnership Audit Technique Guide, where many of these issues are covered in Chapter 2 - Capital Accounts, Basis, and Liabilities. Following are just a few of the examination techniques outlined in that chapter:

1. "Request a basis calculation, if it appears that there is insufficient basis for losses, distributions, etc."
2. "Review the Schedule M-2 to ensure it reflects the changes in the partnership capital accounts. The Schedule M-2 would reflect the amount of cash or the net FMV of property contributed during the year. It is also increased for the allocation of partnership income, including tax-exempt income or gain. It is decreased for any cash distributed to a partner. Remember that cash distributed in excess of outside basis is a taxable gain. IRC section 731(a). It is also decreased for the net FMV of property distributed."
3. "Reconcile the partner's share of items on Schedule K with the partner's Schedule K-1."
4. "Determine if there was IRC Section 704(c) property contributed to the partnership. The book capital accounts and the tax capital accounts should reflect a different value for the contributed property."
5. "Review subsequent transactions to determine if the pre-contribution gain or loss should be recognized."

1. Partnership agreement and all amendments;
2. Partnership books and records (that is, working trial balance, depreciation schedules, income statements, balance sheets, general ledger, etc.);
3. Prior and subsequent year partnership tax returns;
4. Current year financial statements;
5. Partnership book capital account calculations;
6. Partner basis calculations (if the quick test reveals lack of basis);
7. Copies of all loan documents including, but not limited to, promissory notes, deeds of trust, mortgages, loan payment histories, loan guarantees, and/or loan indemnification agreements;
8. Calculations of adjusted basis in property contributed; and
9. Proof of ownership by the partnership in property contributed.

As can be seen from the above items, an audit of a partner or partnership can involve some very complicated issues and items. This first chapter of this course will help CPAs meet their client's needs in this area by introducing them to the rules concerning (or refreshing their knowledge of) the correct computation of gain, loss, and basis in partnership formation. In most cases the partner's basis of the assets (including money) contributed to the partnership will carry over to become the partner's basis in the partnership interest. This computation can of course be complicated if the partner does not have adequate records to substantiate the basis of the assets that were contributed. Changes to the basis of the asset before its contribution, such as depreciation or improvements, must also be taken into account and documented in order to provide support for the partner's basis in the partnership interest. Any of the partner's liabilities assumed by the partnership must be subtracted from the partner's basis in the partnership, so the correct amount of those liabilities must also be recorded and substantiated. The partner's share of the partnership liabilities will increase her basis in her partnership interest. In some cases the calculation of that share involves a fairly complicated series of hypothetical steps, and begins with the partner's balance in her capital account.

Chapter 2 explains the treatment of distributions from partnerships. With 100% matching of K1's in effect, these distributions are more and more likely to be scrutinized by the IRS. Like contributions to partnerships, distributions are often nontaxable transactions. However, distributions can present situations where the computation of the basis of distributed assets is difficult at best. Different rules sometimes apply if cash or unrealized receivables are distributed than apply if other types of assets are distributed. Taxable distributions can result if the The limitations on the deductibility of partnership losses by partners are addressed in Chapter 3. Since many partners invest in partnerships in anticipation of certain tax benefits, the limitations on the ability to deduct partnership losses are often critical, but sometimes overlooked by partners. Chapter 3 begins with an explanation of how the amount of partnership losses a partner can deduct is limited to the basis (including the partner's share of liabilities) that he has in the partnership. Any losses not allowed under this rule are carried over indefinitely, until more basis in the partnership interest is acquired by the partner. Similarly, any losses that pass the basis limitation are only deductible to the extent that the partner is at-risk with respect to the partnership, and any suspended at-risk losses are also carried over until the partner can become more at-risk with respect to the partnership. Finally, any losses from a passive activity, including partnerships in which the partner does not materially participate, are deductible only up to the partner's passive income from other sources.

The correct allocation of recourse and nonrecourse debt, crucial in determining the basis of a partner's partnership interest and therefore the amount of partnership losses she can deduct, is examined in Chapter 4. The calculations associated with adjustments to the basis of partnership property when a Code Section 754 election is in effect are explained in Chapter 5. Chapter 6 covers in detail the tax consequences of the sale of a partnership interest. Frequently a partner will report only capital gain on the sale of a partnership interest, and will be surprised to learn that they also must recognize ordinary income as well.

Chapters 7 and 8 cover some of the same types of issues as the first six chapters, only they cover them as they relate to S corporations rather than partnerships. Partnerships and S corporations are both pass-through entities, but the tax treatment of various transactions for the two entities can be treated very differently, depending on the transaction involved. The basis of S corporation shares, for instance, carries over from the basis of the assets contributed by the shareholder just as in Subchapter K, but under Subchapter S, stock basis does not include the shareholder's share of the S corporation's liabilities. Similarly, the distribution of appreciated property from an S corporation to a shareholder is generally a fully taxable transaction, whereas most distributions from partnerships are nontaxable transactions.

This chapter begins with an overview of the consequences of formation of a pass-through entity. We begin with a discussion of the tax consequences associated with formation of a partnership. These consequences are then compared to those associated with formation of an S corporation. Finally, the chapter discusses the tax consequences arising when a partner or shareholder receives his/her interest in the entity in exchange for services.

Determination of Basis in the Partnership Interest

General

The rules governing the determination and subsequent adjustment of a partner's basis in her partnership interest are generally straightforward. Consistent with the provision in Section 721 that no gain or loss is recognized upon a transfer of property to a partnership in exchange for an interest in the partnership, Section 722 provides that a partner takes an initial basis in her partnership interest equal to the amount of money and the basis of property contributed. Section 723 provides that the partnership takes a carryover basis in property contributed. 1 Thus, initially, the partnership's aggregate basis in its assets is equal to the sum of the partners' basis in their partnership interests. The same provisions apply to limited liability companies electing to be taxed as partnerships.

Effect of Entity Operations

The results of subsequent partnership operations are reflected in each partner's basis. Section 705 provides that a partner's basis is increased by her share of partnership income, both taxable and nontaxable. The positive adjustment for nontaxable income is necessary to maintain its taxexempt status; otherwise such income would later be converted to taxable income in the form of gain from disposition of a partnership interest. A partner's basis in her interest is also increased by subsequent contributions of cash and/or property. Finally, basis is increased by the excess of percentage depletion over an asset's cost in order to preserve the deductibility of percentage depletion.

Basis is decreased by the partner's share of subsequent partnership taxable losses. A partner's basis is further decreased by her share of partnership nondeductible expenditures, for the same reason that nontaxable income increases basis. Basis is also decreased by the amount of money, and the basis to the partner, under Section 732, of any property subsequently distributed. Finally, basis is decreased by the deduction of depletion, determined at the partner level, to the extent of the cost of the depletable property.

Thus, the basis computation maintains account of a partner's tax investment in the partnership. Basis represents the amount of a partner's potential loss in the event the partnership's assets become completely worthless. Additionally, it represents the tax cost of the partnership interest for purposes of determining gain upon disposition.

¹ An exception to these rules provides that, where the partnership would be treated as an investment corporation were it incorporated, §721 does not apply. Consequently, the contributing partner does recognize gain and takes a FMV basis in her interest. The partnership's basis in its assets is increased by any such gain recognized by the partner.

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