Choice of Entity LEARNING OBJECTIVES INTRODUCTION MODULE 1 CHAPTER 1

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1 1.1 MODULE 1 CHAPTER 1 Choice of Entity This chapter examines one of the most critical decisions that a business can make: deciding on the entity classification under which it will operate as a business. Although federal taxes are a critical factor in making that decision, they are often not the only factor. How well tax advantages mesh with business law advantages, not to mention the economic realities of a particular business or industry, may all become essential considerations before an intelligent choice-of-entity decision may be made. This chapter outlines each type of business entity found under U.S. business law statutes: the sole proprietorship, the corporation, the partnership, the limited partnership, and the limited liability company. After this snapshot, the chapter then examines each entity in detail, with special focus on federal tax considerations. Within this examination, special emphasis is given to cutting edge tax developments in choice-of-entity practice, including reasons behind the tremendous surge in choosing the limited liability company (LLC) and disregarded entities. LEARNING OBJECTIVES Upon completion of this chapter, you will be able to: Identify the different types of entities available to U.S. businesses; Understand the basic federal tax law applicable to each type of entity; Recognize the strengths and weaknesses of each type of entity; Understand the reasons behind the recent up-tick in LLC formations; Determine when disregarded status is effective; and Identify recent major tax law changes that affect choice-of-entity decisions INTRODUCTION Starting or acquiring a new business requires deciding what business form to use. A business entity is the legal form of the business. The entity may be as simple as a sole proprietorship or as complicated as a large multinational corporation. The choice of entity is often primarily driven by tax considerations: the entity classification that a business venture chooses may significantly affect its tax treatment under federal, state, local, and (in some cases) foreign laws. Therefore, it is crucial to understand tax treatment before an advisor recommends a choice. Top_Fed_07_book.indb /15/2006 2:41:08 PM

2 1.2 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE In the United States, a number of business entity choices are available to an entrepreneur: Sole proprietorship; Corporation (this may include the traditional C corporation or the S corporation, which is a passthrough entity); General partnership; Limited partnership; Limited liability partnership (LLP); Limited liability limited partnership (LLLP) (not available in all states); and Limited liability company (LLC). No single form of business entity is ideal for all businesses in all situations. No blanket rule applies, although clearly certain industries gravitate toward certain forms (statistics are noted later in this chapter). Each of the major business entity choices available under state law (i.e., sole proprietorship, partnership, limited partnership, corporation, and LLC) has advantages and disadvantages. Two of the most significant factors to consider when choosing the best business form are: Liability for business obligations (how limited liability will be); and Impact of federal taxes. Other factors, however, are also significant, such as formality, flexibility, and the cost of forming and operating the business. To complicate consideration of the impact of federal taxes is the check-thebox option recently introduced into the federal tax law. Under check-the-box, within certain parameters a business may operate legally as one type of entity while being allowed to select tax treatment normally applied to another type of entity. More about this later. SOLE PROPRIETORSHIP Formation A sole proprietorship is formed simply by beginning business. The sole proprietorship has no independent legal existence. A proprietor is not required to enter any agreements or file any documents in order to create the proprietorship. The sole proprietor simply starts to conduct business. However, a sole proprietorship may be required to register its name if it intends to use an assumed name. Most small businesses operate as sole proprietorships. The sole proprietorship is the most basic and informal form of conducting a business. A sole proprietorship is a one-owner business. This business form cannot be used if there is more than one owner. Although a sole proprietorship may have a Top_Fed_07_book.indb /15/2006 2:41:08 PM

3 MODULE 1 CHAPTER 1 Choice of Entity 1.3 number of employees, it can only have one owner. That owner is typically the driving force behind the business. Capital Structure The sole proprietorship does not have a capital structure independent of its owner. The sole proprietor may borrow money to fund the business venture. The proprietor may deduct the interest expense incurred if the interest expense is allocable to a trade or business. The interest expense must relate to a debt incurred by the trade or business. The tax law recognizes this identity of the business with its owner. All profits and losses from the business, including the computations of income and expense that are relevant to profits and losses, are reflected with personal income, deductions, and credits on a single individual Form 1040 income tax return of the owner. Profits and losses from the business generally are reported on Schedule C, Form Check-the-Box as Applied to Sole Proprietorship The check-the-box regulations have simplified the entity classification process. They have also simplified the ability of businesses to receive the benefits of limited liability and passthrough taxation. Prior to these regulations, individual business owners had to incorporate and elect S corporation status to receive the benefit of limited liability and passthrough taxation. Under the check-the-box regulations, a single-member limited liability company (LLC) may be taxed as either a corporation or a sole proprietorship, at the election of its owner. A single-member LLC is taxed as a sole proprietorship by default if it does not elect to be taxed as a corporation. The owner will thus enjoy the benefits of limited liability, passthrough taxation, and easy filing requirements. Treatment of Income and Losses A sole proprietor reports income or loss on Form 1040, Individual Federal Income Tax Return, Schedule C, Profit or Loss from Business. If the proprietor reports a loss on Schedule C, the amount reported offsets the proprietor s other income reported on Form If he has a business loss of $20,000 and wages of $100,000 as an employee for someone else, the loss offsets the wages or any other income reported on Form The only exception to this all-in-one-pot approach is the determination of employment taxes. EXAMPLE Cindy Gross has a Schedule C loss of $15,000. She has wage income of $75,000. She has no other income or loss. Her adjusted gross income for income tax purposes thus is $60,000. Cindy s share of Social Security tax, however, is based on the full $75,000 amount of her salary. Top_Fed_07_book.indb /15/2006 2:41:08 PM

4 1.4 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE A proprietor can deduct a capital loss realized from the sale of a business asset, as well. A proprietor reports a capital loss on Form 1040 Schedule D, Capital Gains and Losses. The proprietor offsets capital gains with capital loss. If the capital loss exceeds the proprietor s capital gains (whether from the business, investments or otherwise), the deduction of the capital loss is limited to $3,000 ($1,500 for those individuals filing under the married filing separately status). A loss in excess of $3,000 can be carried over to subsequent years indefinitely until it is used up. Self-Employment Tax A sole proprietor is subject to self-employment tax of up to 15.3 percent on the net income of the sole proprietorship reported on Schedule C. Selfemployment tax comprises two components. Together they are frequently called Social Security taxes: The first component is a 12.4 percent tax on self-employment income for old age, survivors, and disability insurance (OASDI), which is subject to a dollar cap that is adjusted each year. The second component is a 2.9 percent tax for Medicare, which is not subject to a dollar cap. A sole proprietor is not subject to Federal Unemployment Tax (FUTA). However, a sole proprietor is required to pay FUTA if the proprietor has employees. The FUTA tax is 6.2 percent of the first $7,000 of each employee s salary. The proprietor is also subject to state unemployment tax but receives a credit for FUTA. The sole proprietor reports self-employment earnings on Form 1040 Schedule SE. The proprietor must file Schedule SE, Self-Employment Tax, and pay self-employment taxes if the net earnings from self-employment were $400 or more. The sole proprietor can deduct one-half of the self-employment tax as an adjustment to income on Form Tax Identification Numbers A sole proprietorship must have an employer identification number (EIN) if one of the following applies: It has employees; It has a qualified retirement plan; or It files returns for excise taxes. Employment of Other Individuals The sole proprietor must collect information about employees entitlement to withholding exemptions by requiring an employee to complete Form W-4, Employee s Withholding Allowance Certificate. The employer must withhold income taxes from each employee s salary based on the with- Top_Fed_07_book.indb /15/2006 2:41:08 PM

5 MODULE 1 CHAPTER 1 Choice of Entity 1.5 holding exemptions claimed. He must withhold the employee s portion of FICA (Social Security) and pay the employer s share of FICA, FUTA, state unemployment taxes, and workers compensation premiums. The proprietor must remit the amounts withheld at the appropriate times and file the required withholding returns. STUDY QUESTIONS 1. The sole proprietor reports capital loss deductions using: a. Schedule C b. Schedule D c. Schedule SE d. Direct entries on Form Under what circumstance would a sole proprietor not require an EIN? a. Reporting employee wages and withholding from the proprietorship b. Making contributions to a SIMPLE plan c. Declaring itself as a sole proprietorship on its first-year return d. Reporting excise taxes NOTE Answers to Study Questions, with feedback to both the correct and incorrect responses, are provided in a special section beginning on page C CORPORATIONS Corporations are creatures of the law, acquiring their status and authority solely from the government. With few exceptions, authority over corporations (and other business entities) is the responsibility of the states. Thus, virtually all private corporations are organized, or chartered, pursuant to the laws of incorporation and governance of a particular state. Most large businesses are organized for tax purposes as regular or C corporations. A C corporation is a corporation subject to Subchapter C of the Internal Revenue Code. A C corporation must be a separate entity created as a corporation pursuant to state law. C corporations feature limited liability for owners, a flexible capital structure, and ease of transferability. However, there is potential for double taxation at the corporation and shareholder levels: once to the corporation when the income is earned, and then again to the shareholder-owner when that income is distributed to him or her as a dividend. Top_Fed_07_book.indb /15/2006 2:41:09 PM

6 1.6 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Types of C Corporations State laws generally provide for corporations in three varieties: Publicly held and closely held corporations (in which stock is either publicly traded or privately held); Membership corporations (in which ownership is limited to group membership); and Professional corporations (in which membership is restricted to certain licensed professionals). Tax Implications of Creating or Acquiring a Corporation The initial shareholders usually contribute cash or property to the corporation in exchange for shares in the corporation. The corporation does not generally recognize gain or loss upon issuance of its stock. The shareholder does not recognize gain or loss if the shareholder purchases the stock with cash. Although a taxpayer is generally required to recognize gain or loss upon the sale or exchange of property, there is an exception for acquiring stock. Code Sec. 351 provides an exception for transfers of property (including cash) in exchange for stock. COMMENT An exchange of property for stock under Code Sec. 351 is called a Section 351 exchange. EXAMPLE Victor Smith contributed land worth $500,000 in exchange for a 100 percent interest in Smith Inc. The land has an adjusted basis of $100,000. The exchange qualifies as a Section 351 exchange. Smith is not required to recognize any gain on the transaction. He has a basis of $100,000 in Smith Inc. stock received in the exchange. Code Sec. 351 Requirements Code Sec. 351 provides that the transferor (the stock purchaser) recognize no gain or loss if two factors are present: The property must be transferred to the corporation solely in exchange for stock; and The transferors (stock purchasers) must control the corporation immediately after the exchange. For Sec. 351 to apply, the exchange also must have a valid business purpose and the corporation must not be an investment company. Top_Fed_07_book.indb /15/2006 2:41:09 PM

7 MODULE 1 CHAPTER 1 Choice of Entity 1.7 Further, the transfer of services is not considered a transfer of property that will be tax free under Section 351. The prohibition applies both to services rendered in the past and those to be rendered in the future. The transferor of the services must recognize income on the receipt of stock to the extent of the fair market value of the stock received. Treatment of Income and Losses A C corporation is a separate legal entity that files its tax returns separate from its owners. The corporation reports its income or loss on its income tax returns. The income or loss does not pass through to the corporate shareholders. The corporation may carry over its net operating losses to offset past or future corporate income. A shareholder can only claim a loss upon the sale of his or her stock in the corporation. COMMENT A client should consider starting a new business as a sole proprietorship, S corporation, or partnership. This enables use of losses generated in the early stages of the business. Once the business is profitable and perhaps looking to expand, it can be incorporated. Through incorporation, it can take advantage of benefits such as limited liability, ease of transferability, and a flexible capital structure. Section 1244 Stock If the corporation and shareholders qualify, the corporation may issue Section 1244 small business stock at its inception. When an individual s investment in a corporation becomes worthless, the loss is typically treated as a capital loss. If an individual incurs a Section 1244 stock loss, however, the individual can claim an ordinary loss of up to $50,000 as a single taxpayer. A loss of up to $100,000 can be claimed by married taxpayers filing a joint return in any taxable year. If an individual s loss exceeds the Section 1244 ceiling, the remaining loss is treated as a capital loss. Generally, an individual will have a carryover basis in the stock equal to the money and basis of the property contributed when the stock was originally acquired. In order to qualify as Section 1244 stock, the stock must have been issued when the corporation was a small business corporation. A corporation will qualify as a small business corporation if the money and other property received for stock, contributions to capital, or paid-in surplus does not exceed $1 million. If property is contributed, its value is based on adjusted basis reduced by any liability to which it was subject at the time of contribution. Code Sec applies to individual taxpayers who were original investors in the corporation. If the original shareholder sells stock or gives it as a gift, the stock will not qualify as Section 1244 stock in the transferee s hands. Nor will it Top_Fed_07_book.indb /15/2006 2:41:09 PM

8 1.8 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE qualify as Section 1244 stock if the shareholder transfers it to a trust or estate. A corporation s stock is not Section 1244 stock if the corporation derives more than 50 percent of its gross receipts from certain sources. It does not qualify if more than 50 percent of the gross receipts are from royalties, rents, dividends, interest, annuities, and stock or security sales. The testing period is the five taxable years immediately preceding the year in which the loss was sustained. For corporations in existence for less than five years, the testing period is the corporation s taxable years preceding the loss year. Employment As an employer, a corporation must collect information about employees entitlement to withholding exemptions by requiring an employee to complete Form W-4, Employee s Withholding Allowance Certificate. It must withhold income taxes from each employee s salary based on the withholding exemptions claimed. It must withhold the employee s portion of FICA (Social Security). It also must pay the employer s share of FICA, FUTA, state unemployment taxes, and workers compensation premiums. The corporation must remit the amounts withheld at the appropriate times and file the required withholding returns. Small corporations generally employ shareholder-owners. Typically, corporate founders are employed in newly formed corporations. The owners can decrease the effect of double taxation by payment of compensation to themselves that, if reasonable, is a deductible expense of the corporation. A corporation is allowed a deduction for ordinary and necessary salary expenses paid or incurred during a taxable year in carrying on any trade or business. Reasonable compensation is the amount that would ordinarily be paid for like services for like enterprises under like circumstances. A deduction for compensation taken by a corporation will be disallowed if the amount is unreasonable. However, that does not necessarily mean that the IRS cannot also claim that the recipient of unreasonable compensation still realizes wage income. COMMENT Ever since 2006, when dividend income has been treated as capital gains for purposes of determining the rate of tax on it (generally, the 15 percent rate), an additional consideration has developed in choice-of-entity decision making. The double tax of the traditional C corporation is now reduced to a regular income bracket tax and only a 15 percent tax, which is more than half of the likely regular income tax rate of its owner. As a result, the prior incentive to remove earnings from a corporation by way of higher-than-market compensation was been significantly removed. Top_Fed_07_book.indb /15/2006 2:41:09 PM

9 MODULE 1 CHAPTER 1 Choice of Entity 1.9 STUDY QUESTIONS 3. Which of the following is not an advantage of the C corporation entity choice? a. Passthrough of losses and deductions to shareholders b. Ease of transferring property c. Flexible capital structure d. Limited liability for its owners 4. Owners of small corporations can reduce the effect of double taxation by: a. Starting the business immediately as a C corporation rather than using another entity type b. Issuing additional Section 1244 stock c. Withdrawing reserve capital regularly from corporate accounts d. Paying themselves a reasonable compensation that the corporation deducts as a corporate expense S CORPORATIONS Formation and Organization S corporations have become increasingly popular both for the newly incorporated businesses and for the existing C corporations. C corporations can elect to convert to an S corporation. In fact, statistically there have been a significantly grater number of conversions to S corporations than there have been new incorporations immediately electing S corporation status. S corporations are small business corporations organized under Subchapter S of the Code. An S corporation combines the business and legal characteristics of a C corporation with many federal income tax characteristics of a partnership. The S corporation election is available only to businesses that comply with certain requirements. Large and public corporations generally cannot elect S corporation status because of the 100-shareholder limit, as well as the single class of stock requirement. Among other businesses, however, the S corporation is often the entity of choice. The S corporation and the other passthrough entity the partnership have been running a close race in popularity. Although partnerships have had the edge in some years, Congress itself has recognized the value of the S corporation for small business. To keep the S corporation as a viable option, Congress has made the S rules more liberal, both in terms of qualification and operation. This Congressional boost principally started with the Small Business Tax Act of 1996, but additional changes have been steadily made almost every other year since then. Top_Fed_07_book.indb /15/2006 2:41:09 PM

10 1.10 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Qualification as a Small Business Corporation An S corporation is defined as a small business corporation for which an S corporation election is in effect for the tax year. A corporation is eligible to elect and be taxed as an S corporation only if it qualifies as a small business corporation. Checklist: Small Business Corporations A corporation qualifies as a small business corporation only if all the following requirements are met: It is not an ineligible corporation (insurance companies, possessions corporations (such as those operating in Puerto Rico), IC-DISCs, and taxable mortgage pools being examples of those ineligible); No more than 100 shareholders; All shareholders are individuals, estates, certain trusts, or qualifying tax-exempt entities; No shareholder is a nonresident alien shareholder; and No more than one class of stock exists. A corporation not only must meet these requirements in order for its shareholders to elect S corporation status, but the S corporation must continue to meet the requirements thereafter. The latter principle creates a danger: If the ongoing S corporation is not constantly monitored for eligibility, it can fall into regular, C corporation status with the attendant unplanned tax results. Although organizations have a recourse asking the IRS for a waiver and a chance to cure ineligibility that remedial opportunity is generally only at the discretion of the IRS. Check-the-Box and S Corporation Status Business entities that are not automatically classified as corporations may elect to be treated as a corporation on Form 8832, Entity Classification Election. The entity electing to be treated as a corporation can then elect S corporation status by filing Form 2553, Election by a Small Business Corporation. If an eligible entity elects S corporation status on time, it will be treated as having properly elected classification as an association taxable as a corporation. Qualified Subchapter S Subsidiary An S corporation can own another S corporation as a subsidiary if the subsidiary otherwise qualifies as an S corporation. Although the S corporation is confined to small business corporations, the small in the requirement speaks to the number of shareholders (a maximum of 100) and capital structure (a single class of stock) rather than to the dollar amount of assets within the corporation. Nowhere is this more apparent than in the qualified Subchapter S subsidiary (QSub) situation. The QSub rule allows Top_Fed_07_book.indb /15/2006 2:41:10 PM

11 MODULE 1 CHAPTER 1 Choice of Entity 1.11 a growing business with a need for independent subsidiary operations not to be foreclosed from retaining S status. A subsidiary qualifies as an S corporation if: The parent corporation s shareholders hold the subsidiary s shares directly; 100 percent of stock is owned by the parent (to prevent circumventing the 100-shareholder rule among other goals); and The parent elects qualified subchapter S (QSub) status for the subsidiary. The separate existence of a QSub is ignored for tax purposes. The assets, liabilities, and items of income, deduction, and credit of a QSub are treated as those of the parent corporation. A QSub election results in a deemed liquidation of the subsidiary into the parent. An S corporation may elect to treat an eligible subsidiary as a QSub by filing Form 8869, Qualified Subchapter S Subsidiary Election. A QSub election is effective on the date specified on the election form. Making the S Corporation Election A small business corporation must make an election to be taxed as an S corporation. The corporation makes an election by filing Form 2553, Election by a Small Business Corporation. The election must be signed by a person authorized to sign the corporation s tax return. All shareholders on the date of the election must consent to the election. The required consent may be provided on the Form 2553 or on a separate statement attached to the election. Once made, an election continues until a disqualifying act or attribute arises, or the shareholders affirmatively elect out of S status. Treatment of Income or Losses An S corporation is a passthrough entity (also known as a flow-through entity). Any income or loss related to the operation of the corporation flows through to the shareholders. Shareholders report their allocable share of the income or loss on their tax returns. If the S corporation has a loss, the loss is generally available to offset the shareholder s other income. A shareholder may not be able to claim a loss in a current year if the loss is prohibited under the passive activity loss rules. Nor may the shareholder claim a loss if he or she lacks sufficient basis in the stock. EXAMPLE Fred Ames owns stock in an S corporation. The S corporation reported a loss of $200,000. Ames s pro-rata share of the loss was $25,000. Ames will claim the loss on his individual return. Ames will be allowed to claim his entire pro-rata loss provided he is not otherwise limited by basis limitations, at-risk rules, and passive activity loss rules. Top_Fed_07_book.indb /15/2006 2:41:10 PM

12 1.12 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE S corporations that had been operating as C corporations for a number of years before switching also must retain certain carryover tax attributes from their C corporation days that can produce a tax liability at the corporate level before passthrough rules are triggered. This adds another layer of complexity that points to having an initial strategy under which status as a C or an S corporation is evaluated from the start, rather than after the business has been operating for several years as an incorporated entity. If a shareholder sells S corporation shares at a loss, he or she will be able to claim a loss. An individual shareholder can claim a capital loss in any given year to the extent of any capital gains plus $3,000. Employment An S corporation typically must employ individuals, including active owners, to work for the corporation. It must collect information about the employees entitlement to withholding exemptions by requiring each employee to complete Form W-4, Employee s Withholding Allowance Certificate. As the employer, the S corporation must withhold income taxes from each employee s salary based on the withholding exemptions claimed. It also must withhold and pay Social Security taxes. Employment of Shareholder-Owners S corporations generally employ shareholder-owners. Typically, corporate founders are employed in newly formed corporations. A corporation is allowed a deduction for ordinary and necessary expenses paid or incurred during a taxable year in carrying on any trade or business. Ordinary and necessary business expenses include a reasonable allowance for salaries or other compensation paid to shareholder employees for services actually rendered. S corporation income allocated to a shareholder is not subject to self-employment tax. Thus, S corporations and their shareholders often attempt to minimize wage payments in order to minimize employment tax. An S corporation may be challenged if it pays a shareholder unreasonably low wages relative to the services performed. STUDY QUESTIONS 5. Which of the following is not allowed to be a shareholder of an S corporation small business corporation? a. Qualifying tax-exempt entities b. Nonresident aliens c. Estates d. All of the above are allowed as types of small business corporation shareholders Top_Fed_07_book.indb /15/2006 2:41:10 PM

13 MODULE 1 CHAPTER 1 Choice of Entity Unlike the IRS position on reasonable compensation for shareholderowners of C corporations, S corporations are allowed to pay S corporation shareholder-owners unreasonably low wages relative to services performed because the profits and losses of the S corporation pass through to the shareholders anyway. True or False? GENERAL PARTNERSHIPS A partnership is an unincorporated joint undertaking by two or more persons to carry on a business, financial operation, or venture as co-owners for profit. For tax purposes, it is also known as a passthrough entity, which means that the entity itself is not taxed and that tax liability passes through to the individual partners, members, or shareholders of the entity. Passthrough entities are generally classified as either partnerships or S corporations for federal tax purposes, even though state law provides for other forms of entity organization, such as the limited liability company (LLC) or limited liability partnership (LLP). The other forms of entities are generally taxed as partnerships, unless the entity elects otherwise, or in the case of a singlemember LLC, disregarded as an entity separate from its owner. Although an S corporation is the other passthrough entity for tax purposes, the two types have differences as well as similarities both for tax purposes and for the application of state and local law. A business undertaken by two or more members is, by default, a partnership for federal income tax purposes. There are no formal legal requirements to establish such a partnership: a general partnership. Thus, individuals or entities involved in a joint business or financial undertaking may inadvertently form a partnership. They will be subject to partnership filing and other federal income tax provisions governing partnerships. Minimum requirements to establish a partnership, under both tax and state/local law, call for a partnership to: Engage in the active conduct of a business; Operate with a profit motive; and Have two or more owners. Check-the-Box Rules Because both a corporation and a partnership share all three of the mandatory characteristics, they must be otherwise distinguished for federal tax purposes. The check-the-box rules simplify the determination of whether an entity is a partnership or a corporation for federal tax purposes. Formerly, the courts or IRS would look at the attributes of a business association to determine whether it more closely resembled a corporation or partnership. The current check-the-box rules provide that an unincorporated business Top_Fed_07_book.indb /15/2006 2:41:10 PM

14 1.14 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE with two or more members is taxed as a partnership automatically and by default. If the business does not want to be taxed as a partnership, it simply must elect to be taxed as a corporation. COMMENT Generally, but not always, state tax laws will follow a federal tax determination of tax status. However, state business law rules generally control nontax treatment of a partnership or corporation; check-the-box status will have no impact in that respect. Partnership Agreements Not Required, But Advisable Although a partnership agreement is not required to create a general partnership, a partnership agreement is advisable. Among the partners, the partnership agreement controls except under certain circumstances. The partnership agreement governs the activities of the partnership and of the partners with each other. It spells out any special allocations of income, deductions, gains, losses, and credits to the partnership for tax purposes. It governs the: Withdrawal of a partner; Death of a partner; or Restrictions on the sale of a partnership interest to a new partner. Legal and Ownership Status of General Partnerships The Uniform Partnership Act defines a partnership as an association of two or more persons to carry on as co-owners a business for profit. A general partnership can be formed in writing or orally. A group of individuals or entities may form a partnership by commencing to do business consistent with a partnership model. A partnership model generally involves two or more individuals actively involved in a business for profit. Like a corporation, a partnership is a separate legal entity. It can sue and be sued, hold real and personal property, and conduct business independently of its partners. Although each partner owns a partnership interest, no partner owns specific assets of the partnership. Unlike a corporation or limited partnership, a general partnership is not required to make any filing with the state. The partnership as an entity. A partnership is both an entity and an aggregation of partners. It operates as an entity for purposes of determining amount, character, and timing of income, deductions, gains or losses, and credits generated by the partnership. Once the partnership s gains and losses are determined, the partnership functions as a conduit (passthrough), with each partner being taxed on the partner s share of income. Although a partnership is not a taxable entity, it determines the amount and character of taxable items passed through to the shareholders. The Top_Fed_07_book.indb /15/2006 2:41:10 PM

15 MODULE 1 CHAPTER 1 Choice of Entity 1.15 partnership makes elections about accounting methods, depreciation methods, and amortization of organization and start-up costs. It also may elect optional adjustments to the basis of partnership property or treatment as an electing large partnership. The partnership as an aggregate of individuals. A partnership is also an aggregate of individual partners. As an aggregate, the partnership is treated as a group of individuals each of whom owns an interest in the partnership. Each partner reports and pays tax on her allocable share of the partnership s income, gain, loss, deductions, and credits. The partnership reports each of these items to each of the individual partners on Form 1065, U.S. Return of Partnership Income, Schedule K-1. How Partnerships Acquire and Dispose of Property Contribution of property to a partnership. Neither the partnership nor any partner is required to recognize a gain or loss when a partner contributes property to a partnership in exchange for an interest in the partnership. When a group of individuals or entities forms or buys a partnership, they generally contribute property (including money) in exchange for a partnership interest. If a partner contributes appreciated property in exchange for a partnership interest, the contributing partner is not required to recognize a gain on the transaction. Partner s basis in partnership interest. A partner s basis in the partnership is the same as the basis of the property contributed. If a partner contributes property subject to a liability in exchange for partnership interest, his or her basis is reduced to the extent the partner is relieved of the liability. If the liability exceeds the basis in the partnership interest, he or she must recognize gain to the date of the exchange. Treatment of Income and Losses A partnership is a passthrough entity. As is the case with the S corporation (the other passthrough entity for federal tax purposes), any income or loss related to the operation of the partnership flows through to the partners. However, there are differences in passthrough treatment between a partnership and an S corp, particularly the unique availability of special allocations for partnership interests. Partners will report their allocable share of income or loss on their separate tax returns. (As in an S corp, that income or loss must be realized even though no money may actually be passed on to the partner at that time.) A loss is generally available to offset the partners other income. A partner may not be able to claim a loss in a current year if he or she lacks sufficient basis in the partnership. A partner may not claim a loss even if he or she has sufficient basis Top_Fed_07_book.indb /15/2006 2:41:11 PM

16 1.16 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE if prohibited under the at-risk rules. Nor may a partner claim a loss if prohibited by the passive activity loss rules. If a partner sells a partnership interest at a loss, the partner will be able to claim a capital loss. Partner s Self-Employment Tax An individual general partner is subject to self-employment tax on his or her distributive share. The general partner is subject to self-employment tax of up to 15.3 percent of his or her distributive share of partnership income. This distributive share of partnership income is reported as net earnings from self-employment on Form 1065, U.S. Return of Partnership Income, Schedule K-1. STUDY QUESTIONS 7. A partnership agreement may dictate all of the following partnership governance issues except: a. Special allocations of income and deductions b. Procedures in case of the withdrawal or death of a partner c. Restrictions on the sale of partnership interests d. All of the above are specified in the partnership agreement 8. A partner s basis in property he or she contributes to the partnership in exchange for a partnership interest: a. Is reduced by the amount of liability for which the contributing partner is relieved, but the partner recognizes no gain by contributing appreciated property b. Does not affect basis in the partnership interest, regardless of the type of contribution; partners make equal contributions for equal portions of the partnership s assets and liabilities separate from basis in the property c. A partner s contribution does not affect his or her split of the total interests in the partnership; basis in property contributed is unrelated to the partnership interest d. Is affected only when he or she contributes noncash property LIMITED PARTNERSHIPS A limited partnership differs from a general partnership in that the liability of one or more of the partner s liability for partnership obligations may be limited. Only the general partner in a limited partnership is fully liable. A limited partnership is responsible for all of its own obligations. A limited partner is not liable for the obligations of a limited partnership unless he or she is also a general partner. Under Delaware law, a limited partnership or domestic limited partnership is a partnership formed by two or more persons. It has at least one general Top_Fed_07_book.indb /15/2006 2:41:11 PM

17 MODULE 1 CHAPTER 1 Choice of Entity 1.17 partner and one or more limited partners. A limited partnership may carry on any lawful business, purpose, or activity, whether or not for profit, except for insurance and banking. A limited partnership is governed by both state statute and the partnership agreement. Before the limited partnership can come into existence, it must file with the state in which it is to be organized. Once the limited partnership has been formed through an appropriate filing, the operative document is the limited partnership agreement. State limited partnership law merely provides fallback or default provisions in areas where the limited partnership agreement is silent. Thus, as a general matter, the provisions of the limited partnership agreement are important and the courts tend to defer to those agreements. A limited partnership does not pay tax, but it does compute income, deductions, and credits on an annual basis. Information about the business is reported to the IRS on Form 1065 and to the individual partners on separate Schedules K-1. The partners report the partnership income on their own returns and pay any taxes due based on their own tax rates. Requirement of a General Partner Each limited partnership must have at least one general partner. The general partner may be an individual, a corporation, or other legal entity, domestic or foreign. The general partner may also (but need not) be a limited partner. Unlike a limited partner, the general partner of a limited partnership is generally responsible for all of the partnership s debts and obligations. Limited Liability of Limited Partners A limited partner is generally not liable for the obligations of a limited partnership unless he or she is also a general partner. The limited partner may also be liable if he or she participates in the control of the business. This is a critical aspect of a limited partnership. Limited partners generally invest in the business, expecting to receive a share of the profits. They usually do not actively participate in the day-to-day operations of the limited partnership. LIMITED LIABILITY LIMITED PARTNERSHIP Limited liability limited partnerships (LLLPs) are similar to LLPs to the extent that states have amended their limited partnership statutes to permit limited partnerships to register as LLLPs, thereby providing the general partners a limitation on vicarious liability. About half of the states, including Delaware, allow the formation of LLLPs. In Texas and Arkansas, for example, these entities are known as registered limited liability partnerships. These partnerships are a form of limited partnership that extends liability protections to general partners as well as the limited partners. In a registered or limited liability limited partnership, no general or limited partner is liable for the partnership s obligations created solely by another partner s malfeasance. Top_Fed_07_book.indb /15/2006 2:41:11 PM

18 1.18 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Creation of a limited liability limited partnership is not materially different from creation of a limited liability partnership. In Delaware, a statement of qualification must be filed. An annual report must be filed and an annual fee must be paid. The partnership must have as the last words or letters of its name the words Limited Liability Limited Partnership, or the abbreviation L.L.L.P. or LLLP. STUDY QUESTIONS 9. Unlike a general partnership, a limited partnership is governed by both its partnership agreement and state statute. True or False? 10. The main difference between the general partner and limited partners of a limited partnership is: a. The split in the partnership interests, which gives the general partner a greater share of pro-rata income and liabilities b. The chronological order of becoming partners; the general partner always has the most seniority in the group c. The embodiment of the partners: General partners are individuals, whereas limited partners are corporations or other legal entities d. Liability for debts and obligations, which rests with the general partner LIMITED LIABILITY COMPANIES A limited liability company (LLC) is a business entity created under state law. Every state and the District of Columbia have LLC statutes that govern the formation and operation of LLCs, which are a hot recent favorite entity type. An LLC has the characteristics of both a corporation and a partnership. Like a corporation, the owners (referred to as members) are usually not personally liable for the debts and other obligations of the LLC. Like a partnership or sole proprietorship, an LLC has great flexibility in the way it operates and does not need to follow corporate formalities, such as holding special and annual meetings with shareholders and directors. An LLC has the flexibility to decide whether to be taxed as a partnership, C corporation, or in the case of a single-member LLC to be disregarded as an entity for federal tax purposes. If an LLC chooses to be taxed as a partnership or S corporation, or if a single-member LLC elects to be disregarded as an entity, the LLC profits and losses are reported on the member s personal federal income tax return. Most multimember LLCs choose to be taxed as a partnership, and most single-member LLCs elect to be disregarded as an entity for federal tax purposes. Top_Fed_07_book.indb /15/2006 2:41:11 PM

19 MODULE 1 CHAPTER 1 Choice of Entity 1.19 Under check-the-box, a multimember LLC usually is taxed as a partnership by default; but the entity may elect to be taxed as an association by checking the box. The two choices for a single-member LLC are generally disregarded entity or association. Advantages of LLCs The main advantage of an LLC is that its members are not personally liable for the debts of the business, vicariously or otherwise. Members of LLCs enjoy the same protections from personal liability for business obligations as shareholders in a corporation or limited partners in a limited partnership. Unlike the limited partnership form, which requires at least one general partner who is personally liable for all the debts of the business, no such requirement exists in an LLC. A second significant advantage is the flexibility of an LLC to choose its federal tax treatment. Under the check-the-box rules, an LLC can be taxed as a partnership, C corporation, or S corporation for federal income tax purposes. A single-member LLC may elect to be disregarded for federal income tax purposes or taxed as an association (corporation). Appeal of LLCs Versus S Corporations In addition to liability protection and tax flexibility, LLCs may be useful in the many circumstances where S corporation status is impractical or unavailable. LLCs are not subject to restrictions on the number and types of shareholders or the one-class-of-stock limitation as are S corporations. Another favorable characteristic of LLCs is that their members have flexibility to allocate income or loss on a basis other than according to each member s percentage interest in the LLC (using the rules for taxation of partnerships). In an S corporation, all income allocations must be based strictly on the stock ownership interest of each shareholder (the one-class-of-stock rule). When LLCs Are Used LLCs are typically used for entrepreneurial enterprises with small numbers of active participants, family and other closely held businesses, real estate investments, joint ventures, and investment partnerships. However, almost any business that is not contemplating an initial public offering (IPO) in the near future should consider using an LLC as its entity of choice. Deciding to convert an LLC to a corporation later generally has no federal tax consequences. This is rarely the case when converting a corporation to an LLC. Therefore, when in doubt between forming an LLC or a corporation, for tax considerations it is usually wise to opt to form an LLC. Characteristics Under State Statutes Most states tax LLCs as passthrough entities the same way they are taxed under federal law. This means that in most cases, passthrough treatment is Top_Fed_07_book.indb /15/2006 2:41:11 PM

20 1.20 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE allowed and corporate entity-level income taxes can be avoided. A state may impose other taxes on LLCs, however, such as a franchise tax, business and occupation tax, or other registration fees. The fees vary by state. Most state statutes permit LLCs to have a perpetual life. Modern LLC statutes, commonly known as flexible statutes, also permit less than unanimous consent of the members to continue the business if certain events occurred and allowed members to transfer their ownership interests. States that base their LLC statutes on earlier federal tax law may place limits on the life of an LLC. Before the check-the-box regulations, an entity could only be taxed as a partnership if it lacked continuity of life. To conform to this rule, the statues required either the articles of organization the document filed with the respective secretary of state or the operating agreement to provide that the LLC would have a life span limited to no more than 30 years. The LLC documents also had to provide for the unanimous consent of the members to continue the business of the LLC if certain events, such as a member s death occurred, or to transfer an ownership interest in an LLC to a third party. COMMENT Early LLC statutes were designed to comply with what was known as the Kintner regulations, which were a response to the decision in U.S. v. Kintner (216 F.2d 418 (9th Cir. 1954)). The four corporate characteristics identified in the Kintner regulations were: (1) continuity of life, (2) centralization of management, (3) liability for entity debts limited to entity property, and (4) free transferability of interests (former Treas. Reg. sec ). The effect of the regulations generally was to classify an unincorporated entity as a partnership if it lacked any two or more of the four corporate characteristics. Therefore, early state LLC statutes were drafted so that any LLC organized under the statute lacked two of the four characteristics. Once the check-the-box regulations were promulgated in December 1996 and the new choice of entity rules were put in place, it was no longer necessary for an LLC to lack two of the four characteristics, and, therefore, state LLC laws were made to be more flexible. LLC Federal Tax Implications An LLC is not a federal tax entity. LLCs are not specifically mentioned in the tax code, and there are no special IRS regulations governing the taxation of LLCs comparable to the regulations for C corporations, S corporations, and partnerships. Instead, LLCs make an election to be taxed as a particular entity (or to be disregarded for tax purposes) by following the check-the-box business entity classification regulations. The election is filed on Form 8832, Entity Classification Election. The IRS will assign an entity classification by default if no election is made. A taxpayer who doesn t mind the IRS default entity classification does not necessarily need to file Form Top_Fed_07_book.indb /15/2006 2:41:12 PM

21 MODULE 1 CHAPTER 1 Choice of Entity 1.21 Check-the-Box The check-the-box regulations outline a step-by-step analysis for determining the appropriate federal tax classification of an entity. A few types of entities are required to be taxed as corporations (state law corporations, certain foreign entities, and insurance companies, among others). Other entities, including LLCs, can elect one of several types of entities depending on whether the entity has only one member or more than one member. An LLC with more than one member can elect the three entity tax treatments: Partnership; Corporation; or S corporation (accomplished by electing to be taxed as a corporation, then filing an S corporation election). An LLC with only one member can elect: Disregarded entity; Corporation (e.g., regular C corporation, personal holding company, personal services corporation, or professional corporation); or S corporation (accomplished by electing to be taxed as a corporation, then filing an S corporation election) Default status. The IRS will assign these classifications if no entity election is filed for an LLC (the default rules): Any business entity that is not a corporation is classified as a partnership; and Any entity that is wholly owned by a single person will be disregarded as an entity separate from its owner (taxed as a sole proprietorship). Statistically, an LLC with more than one member will elect to be taxed as a partnership, whereas a single-member LLC will elect to be disregarded and taxed as a sole proprietorship. General Partnership Taxation Rules LLCs with multiple members generally elect to be taxed as partnerships. Information about the business is reported to the IRS on Form 1065 and to the individual partners on separate Schedules K-1. The partners report the partnership income on their own returns and pay any taxes due based on their own tax rates. How Partners Report Partnership Items Each LLC partner receives a Schedule K-1 showing the partner s share of both bottom line partnership income plus a share of each item required to be separately stated (credits, capital gain, etc.). The partner reports all of these items on his or her own tax return for the tax year in which the partnership s Top_Fed_07_book.indb /15/2006 2:41:12 PM

22 1.22 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE tax year ends. The character of items passed through to the partners (capital vs. ordinary; long term vs. short term) is determined at the partnership level. Self-Employment Tax The IRS has not yet conclusively determined whether distributive shares received by LLC members are subject to self-employment tax. LLC members may be subject to self-employment tax if their interest is more analogous to a general partnership interest than to a limited partnership interest. LLC members are not subject to self-employment tax if their interests are viewed as comparable to limited partnership interests. Net earnings from self-employment derived by an individual are generally subject to self-employment tax. General partners are subject to self-employment tax on their distributive shares of income from the partnership s trade or business. In contrast, the distributive share of a limited partner is generally excluded from the self-employment tax, except to the extent that this share is a guaranteed payment. A guaranteed payment is an amount paid to a partner for services rendered to or on behalf of the partnership, paid without regard to the income of the partnership. Comparative Advantages and Disadvantages of LLCs Historically, the limited partnership and the S corporation have been the entities of choice for those seeking both limited liability and passthrough taxation. Entrepreneurs and their advisors have always recognized, however, that these traditional choices were imperfect in operation. Increasingly, the relatively new LLC, providing both limited liability and passthrough taxation without the operational drawbacks has become the entity of choice for many new entrepreneurs. LLCs versus C corporation. Corporations have vastly more legal and accounting rules than other entities; therefore, startup services of lawyers and accounts are expensive. Thus, the LLC, rather than the corporation, presents a better choice for the small business owner. This is mainly because the LLC is generally a lower-cost, simpler alternative to the corporation. The LLC is the fastest growing business form in the United States in large part because it offers the best of both worlds limited liability, as is the case of the C corporation, but passthrough taxation, as is the case of the partnership. This avoids the double taxation problem that confronts a regular C corporation. LLC versus S corporation. The S corporation has often been the traditional entity of choice for operating a closely held business, but the LLC possesses clear tax and nontax advantages over the S corporation, whose use is severely hampered by an assortment of restrictions. The LLC, with its offer of more complete passthrough tax treatment and its greater operational flexibility, thus threatens to replace the S corporation as the entity Top_Fed_07_book.indb /15/2006 2:41:12 PM

23 MODULE 1 CHAPTER 1 Choice of Entity 1.23 of choice for the closely held business. Unlike an S corp, an LLC is not restricted to a maximum number of members or a single class of stock or membership interest. Moreover, if an S corporation inadvertently breaks one of these rules, it loses its S corporation status and is then taxed as a C corporation, thus triggering double taxation. On the other hand, the main advantage of an S corporation over an LLC is that LLCs are still relatively new creatures from the tax law standpoint. There is not a lot of case law to study regarding some of the finer points of LLC organization. LLC versus limited partnership. Although tax considerations are not likely to determine the choice of entity between an LLC classified as a partnership and a limited partnership both are then subject to the federal partnership tax rules it is important to recognize that the LLC is fundamentally a different type of entity. Most partnership tax provisions are easily applied to the LLC, but significant unresolved federal tax issues do remain, primarily arising out of two crucial differences between a partnership and an LLC. First, there is no distinction among LLC members comparable to the distinction between general and limited partners. In a partnership, at least one member (the general partner) is always liable for the debts of the entity. In the LLC, no member is liable for the obligations of the entity. Second, LLC members generally can participate in the management of the LLC s business (unless such management is vested in a designated group of managers), whereas limited partners generally are prohibited from taking an active management role in the partnership. Forming an LLC To form an LLC, organizers must file articles of organization, or a comparable state document, with the appropriate state agency. (For convenience, the term articles of organization is used here to refer to the document required to be filed with the appropriate state agency.) Organizers should check their state statute to determine what has to be included in the articles of organization in their state. Generally, the articles will include, at a minimum, the name of the LLC, the name and address of its registered agent and its principal place of business. The manner in which members of LLCs contribute capital to the entity, the form that the contribution can take, the responsibility members have for their promised contributions, and the repayment of contributions are issues addressed in every state s LLC statutes. The LLC s Type of Business There are a number of factors that businesspeople should consider in choosing where (and whether) to form an LLC. However, the primary issue is Top_Fed_07_book.indb /15/2006 2:41:12 PM

24 1.24 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE whether the state(s) in which the LLC will operate allows the business to organize as an LLC. Some states do not allow certain professions to operate as an LLC. For example, California does not allow some professionals, such as financial institutions, insurance companies or trust companies, to operate as LLCs. Delaware, Arizona, and a few other states also prohibit banks and insurance companies from organizing as LLCs. In a few states, lawyers and law firms may not operate as LLCs. Although prohibitions such as these are becoming increasingly rare, the state s rules are something that every business should consider before finalizing the entity choice. STUDY QUESTIONS 11. Generally, domestic business entities that are not corporations will be automatically treated as for tax purposes if they have two or more owners, or will be if they have only one owner. a. C corporations; S corporations b. Limited liability companies; S corporations c. C corporations; limited liability companies d. Partnerships; disregarded entities 12. All of the following are comparative advantages of LLCs as an entity form over S corporations for closely held businesses except: a. No restrictions on the number of members b. More universal acceptance of the LLC entity form c. May have multiple classes of membership interests d. Does not need to elect LLC status with the IRS LATEST DEVELOPMENTS: OTHER HOT TOPICS IN CHOICE OF ENTITY Choice of entity continues to be a developing area, not only from the perspective of new strategies and techniques, but also in the development of new case law and IRS guidance that interpret or react to these changes. The past year has seen several important developments that should be folded into the general decision surrounding choice of entity, both selecting the entity upon the formation of the business and making an evaluation of whether an ongoing entity should change forms. Dual-Chartered Entities In February of 2006, the IRS issued a final regulation that clarifies classification of entities organized in more than one jurisdiction. The final regulation Top_Fed_07_book.indb /15/2006 2:41:12 PM

25 MODULE 1 CHAPTER 1 Choice of Entity 1.25 also provides transitional relief for those dual-chartered entities. The final regs provide that a dual-chartered entity will be deemed: A corporation for all federal tax purposes if, within at least one jurisdiction, the entity s organizational form would cause the entity to be classified as a corporation pursuant to Treas. Reg. Sec (b); and A domestic corporation if the entity is organized as an entity under U.S. federal or state law. The clarification allows for the elimination of definitions for resident foreign corporation, nonresident foreign corporation, and nonresident partnership. Transition relief. The regulation provides the following transition relief: Any dual-chartered entity organized before August 12, 2004, will be governed by the preexisting regulation; Any business that had not been dual-chartered by August 12, 2004, is required to apply the final regulation from that date forward; and Any dual-chartered entity existing on August 12, 2004, is required to begin applying the final regulation as of May 1, Qualified Personal Service Corporations In March of 2006 the Tax Court allowed an accounting firm to avoid qualified personal service corporation (QPSC) status related to the company s decision to create an in-house separate entity that provided financial services (Lykins, T.C. Memo ). The court determined that a corporation providing investment and accounting services was not a qualified personal service corporation and, thus, was not subject to the 35 percent flat tax. QPSC status, and its unwanted flat 35 percent tax rate, may be imposed on any corporation involved in any one of eight service business types: accounting, healthcare, law, engineering, architecture, actuary, performing arts, or consulting. If the service is not on the list, it cannot put the business into QPSC stats. A business is also only a QPSC if it is trapped under both of the following Code Sec. 448(d)(2) tests: Ownership: Any employee performing one of the listed services must substantially own all of the company s stock; and Function: A company s function must involve substantially all of any services enumerated in Code Sec The corresponding treasury regulation defines the term substantially all as meaning that at least 95 percent of employee efforts involve one of the enumerated services. Top_Fed_07_book.indb /15/2006 2:41:13 PM

26 1.26 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Although the corporation before the Tax Court was left with the accounting business after the split-off of its investment advisory business, it continued to pay the wages, benefits and taxes of the employees of the split-off investment business. Thus, it was treated as providing both accounting and investment services. Because less than 95 percent of the time of the corporation s employees was spent on the accounting services, substantially all of the corporation s activities were not performed in a qualifying field and the function test of the qualified personal service corporation definition was not met. C Corporation and Sole Shareholder Are Different In May of 2006 a taxpayer fought a losing bid to convince the Tax Court that he should be reimbursed litigation costs incurred by a C corporation of which he was part owner. The case before the Tax Court involved an underlying matter in which a C corporation paid litigation costs incurred by the taxpayer who owned 40 percent of the corporation. The taxpayer appealed a determination that the payments were not constructive dividends as argued by the taxpayer, but instead were loans. The Tax Court rule that the C corporation s separate entity status meant that the corporation, not the taxpayer, incurred the litigation cost. Joint and Several Liability of Partners In a case that spotlights a risk associated with partnership taxation, the Tax Court ordered a taxpayer to pay taxes on earnings his partner had siphoned off to surreptitiously begin a competing business (Burke, T.C. Memo ). The case involves a taxpayer attorney-cpa who ended a three-year partnership with an individual who he suspected had stolen partnership funds. The partnership was dissolved and all partnership receipts were placed in escrow pending a determination of proper allocation. The innocent partner-taxpayer claimed that he did not have a distributive share to report because his partnership income had been frozen. The Tax Court, however, saw it differently. It held that each partner is liable for income tax on his distributive share of partnership income, regardless of whether the income is distributed; or is undistributed pursuant to a partnership agreement; or whether a distribution fraudulently violates a partnership agreement. The court ruled that the partnership had earned and realized the income, and that there was nothing conditional or contingent regarding the receipt of the partnership s income. The occurrence of fraud by a partner does not serve to shield other partners from recognizing a proportionate share of passthrough partnership income. Top_Fed_07_book.indb /15/2006 2:41:13 PM

27 MODULE 1 CHAPTER 1 Choice of Entity 1.27 Pending Legislation Small Business Tax Flexibility Act. In the last year, representatives in Congress have introduced House and Senate versions of a measure designed help start-up small business owners meet their tax obligation by using a taxable year most suitable to their business cycle if they earn less than $5 million during the tax year. The Small Business Tax Flexibility Act was introduced in October of 2005 by Rep. Clay Shaw (R-FL), a senior member of the House Ways and Means Committee and Rep. John Tanner (D-TN). A Senate version (S. 2462) was introduced in March of 2006 by Sen. Olympia Snowe (R-ME). Both bills remain before legislative committees. Until 1986, business could elect several taxable year-end dates. In 1986 Congress passed legislation that requires partnerships and S corporations many of which are small business to adopt a December 31 year-end. Supporters of the measures include the American Association of Certified Public Accountants, which has argued that the current restriction unreasonably compresses workload on CPAs and other return preparers who now must squeeze all of their work for partnerships and corporations and individuals during the months between December and April of each year. Small business expensing. In February of 2006 Sen. Snowe, along with five cosponsors, introduced legislation (S.2287) to amend the Tax Code to increase from $100,000 to $200,000 the dollar amount of new investments a small business will be able to expense. The matter remains before the Senate Finance Committee. STUDY QUESTION 13. The terms of the Small Business Tax Flexibility Act would benefit accountants by: a. Allowing sole proprietors to elect a fiscal tax year b. Spreading out the period during which accountants prepare partnership and S corporation returns in different seasons than individuals returns c. Combining preparation and filing of several types of tax returns and payments that businesses now must file separately d. All of the above are part of the legislation benefiting accountants Top_Fed_07_book.indb /15/2006 2:41:13 PM

28 1.28 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE A LOOK AT THE STATS Statistical data on choice of entity is important for two reasons. It gives a business advisor a point of reference based on what others are choosing in determining how a particular business will be taxed and, more generally, how it will fit into the business community. Second, it is what the IRS uses to help allocate its guidance, audit, and other resources. The IRS is generally about two years behind in gathering and making public detailed statistical information for any tax year based upon the returns filed for that year. So, for example, the latest detailed data released in 2006 covers primarily the 2003 tax year, for which returns were filed in One exception is the information on sole proprietorships, for which detailed 2004 statistics recently have been released. The IRS also issues a limited amount of preliminary statistical data on later tax years. Because the IRS itself needs this data to forecast and allocate its own resources, it is not surprising to find this data buried in projection reports. The latest of these reports is titled Fiscal Year Return Projections for the United States: That report gives return estimates based on category of business tax return for tax year 2005 as well as projections through IRS Projections The IRS projects that the next several years should add significant increases to the numbers of tax returns filed by partnerships, S corporations, and unincorporated businesses owned by individual taxpayers. In the Fiscal Year Return Projections report, the IRS forecasts a number of tax return statistics to provide a basis for IRS workload estimates and resource requirements. A glance at the partnership, corporation (including S corporation) and individual business categories show what choice-of-entity decisions the IRS forecasts that taxpayers will make over the next seven years. For partnership returns: Total partnerships. A 37 percent increase from 2,863,200 in 2006 to 3,909,000 in Partnerships; small business/self-employed. A 36 percent increase from 2,772,100 in 2006 to 3,782,400 in Partnerships; large and mid-sized business. A 39 percent increase from 90,700 in 2006 to 126,100 in Partnerships; tax-exempt/government entities. A 67 percent increase from 300 in 2006 to 500 in For corporate filings, including S corporations: Corporation income tax total. An 18 percent increase from 6,225,100 in 2006 to 7,349,300 in Top_Fed_07_book.indb /15/2006 2:41:13 PM

29 MODULE 1 CHAPTER 1 Choice of Entity 1.29 Corporations; small business/self-employed. An 18 percent increase from 2,772,100 in 2006 to 3,782,400 in Corporations; large and mid-sized business. A 13 percent increase from 82,200 in 2006 to 93,000 in Corporations; tax-exempt/government entities. A 5 percent increase from 8,400 in 2006 to 7,900 in S corporation (Form 1120S). A 34 percent increase from 3,875,000 in 2006 to 5,194,400 in For tax returns of individuals reporting business activity on personal tax forms: Individual; small business/self-employed. A 28 percent increase from 40,993,900 in 2006 to 52,516,200 in According to the IRS report, the S corporation is forecast to remain king of the hill and the tax entity of choice for small businesses. Projections indicate that 5.2 million S corporations will operate by 2013 (most of which will be small businesses). In comparison, partnerships for small business/self-employed come in a distant second, with around 3.8 million partnerships projected. Sole Proprietorships According to an IRS Statistics of Income Division report, for Tax Year 2004 (the most recent year that comprehensive historical data has been made publicly available) approximately 20.6 million individual income tax returns reported nonfarm related sole proprietorship business activity. Of the $1.13 trillion total for sole proprietorship business receipts in 2004, the IRS, using receipts as a measure of business size, reported the following on category leaders: construction, 17.4 percent ($198.4 billion); retail trade, 16.4 percent ($187.1 billion); and professional, scientific, and technical services, 12 percent ($137.7 billion). The professional, scientific, and technical services sector had the largest percentage of sole proprietorship profits (23 percent). The sector s total profit was $56.9 billion. The sector with the second largest profits was healthcare and social assistance ($42 billion). S Corporations According to an IRS Statistics of Income Division report, for 2003 (the most recent year that comprehensive historical data has been made publicly available) the S corporation was the most popular corporate entity choice. The report details that approximately 3.3 million S corporation returns were filed. The IRS reports that, since 1986, S corporation filings have increased at an annual rate of 8.8 percent. Top_Fed_07_book.indb /15/2006 2:41:13 PM

30 1.30 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE In 2003, approximately 343,000 corporations elected S corporation status for the first time, the IRS reported. Of the total electing S corporation status for the first time, approximately 253,000 businesses were newly incorporated; the remaining 90,000 businesses had converted from taxable corporation status to S corporation status. The four industrial sectors that accounted for the majority of total reported S corporation net income were wholesale and retail trade (41.5 percent); construction (14.7 percent); manufacturing (12.1 percent); and professional, scientific, and technical services (6.7 percent). Partnership According to an IRS Statistics of Income Division report for 2003 (the most recent year that comprehensive historical data has been made publicly available) approximately 2.3 million partnerships filed returns. Total receipts from operations and investments were $3.2 trillion. The manufacturing sector reported the largest total receipts of any sector ($524.1 billion), followed by the finance and insurance sector ($494.6 billion). Partners in the finance and insurance sector received 39.9 percent of the total income available for allocation reported for all partnerships, the largest share received by any sector. The real estate and rental and leasing industry sector; and the professional, scientific, and technical services sector, respectively, received 23.2 percent and 14.1 percent of the total income available for allocation reported by all partnerships in Historically, partnerships classified in the real estate and rental and leasing sector dominate the statistics for both the number of partnerships and partners, the IRS reported. For 2003, the sector included 45.5 percent of all partnerships and 41.7 percent of all partners. Additionally, partnerships in this sector accounted for 17.1 percent of total partnership net income, and 24.7 percent of total assets for all partnerships. LLCs as Partnerships LLCs represent the largest partnership entity type, a meteoric rise considering they did not exist until a few years ago. In 2003, there were slightly more than 1 million limited liability companies, making LLCs, for the second consecutive year, the most prevalent partnership entity type. Even though LLCs were the most prevalent type of partnership, limited partnerships still reported the largest share of overall partnership profits. Regarding total LLC category assets, the finance and insurance sector had the largest share (42 percent), followed by the real estate and rental and leasing sector (29.5 percent). The real estate and rental leasing sector accounted for the largest share of general partnerships (40.3 percent); limited partnerships (57.4 percent); and limited liability companies (44.7 percent). Top_Fed_07_book.indb /15/2006 2:41:13 PM

31 MODULE 1 CHAPTER 1 Choice of Entity 1.31 S Corporations versus Partnerships A Treasury Inspector General for Tax Administration (TIGTA) report concludes that S corporations and partnerships are the fastest growing segments of taxpayers filing federal returns. Between January 2000 and December 2004, the number of S corporations and partnership returns processed annually by the IRS increased from 4.96 million to 6 million (a 21 percent increase), the report stated. The IRS, meanwhile, is projecting that by 2012, the annual number of processed S corporation and partnership returns will increase to 8.49 million (a 42 percent increase from 2004). The study found that the increase in the number of S corporation returns processed from 2000 through 2004 continued a trend that began in 1997; the year that S corporations became the most common type of corporate entity that filed tax returns. The 3.5 million S corporation returns processed in 2004 represents a 21 percent increase from the 2.89 million S corporation returns processed in The study concluded that 1990s-era favorable legal and regulatory changes contributed to make partnerships the fasting growing segments of all filers. Specifically, the changes involved state government creation of limited liability companies (LLCs) and limited liability partnerships (LLPs); and the federal government s issuance of a simplified method of entity choice: the check-thebox regulations. STUDY QUESTIONS 14. According to the IRS Fiscal Year Return Projections report, which type of business will be most common (judging by the number of tax returns filed for that entity type) by 2013? a. Individual small business/self-employed b. S corporation c. Partnership d. None of the above 15. Which type of partnership reported the largest share of overall partnership profits in 2003? a. LLCs b. Limited partnerships c. General partnerships d. LLLPs Top_Fed_07_book.indb /15/2006 2:41:14 PM

32 1.32 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE CONCLUSION This chapter introduced the myriad factors to consider when an organization makes an entity choice. Those factors include distinguishing different entity types, understanding the federal tax law applicable to each entity type, being aware of the strengths and weaknesses of each entity type, and being knowledgeable of recent tax law changes affecting entity choices. It is hoped that the chapter s discussion of those factors will provide a sound base of knowledge related to business entity choice. Top_Fed_07_book.indb /15/2006 2:41:14 PM

33 2.1 MODULE 1 CHAPTER 2 Like-Kind Exchanges This chapter was prepared to guide you through effective use of the taxdeferral techniques available under Code Sec. 1031, like-kind exchanges. The focus is both on the new developments taking place in this dynamic area and on new twists on recurrent issues that lately have been giving either taxpayers or the IRS particular trouble. LEARNING OBJECTIVES Upon completion of this chapter you will be able to: Determine how to qualify for a like-kind exchange of property; Calculate the basis, gain, and loss resulting from a like-kind exchange; Recognize how to structure like-kind exchange transactions with related parties; Determine when and how to use a qualified intermediary to facilitate an exchange; Understand the basic principles of reverse exchanges; and Analyze special issues that arise with like-kind exchanges and partnerships. INTRODUCTION The purpose of the like-kind exchange provisions under Internal Revenue Code Sec is to encourage capital reinvestment in productive or investment assets by allowing taxpayers to exchange obsolete assets for replacement investments without paying tax on the gains. Like-kind exchanges provide several advantages to taxpayers, such as deferral of capital gains taxes and the ability to upgrade property at lower cost. However, compliance issues in structuring like-kind exchanges have become more complex as the law in this area has become more voluminous. This chapter highlights the basic requirements for like-kind exchanges, as well as those recent developments in this area that have served both to help many astute taxpayers and to trap many more unsuspecting ones. Among the key questions that should be addressed by those considering like-kind exchanges are: What happens to basis? What are the gain or loss consequences? What types of property can be exchanged? Top_Fed_07_book.indb /15/2006 2:41:14 PM

34 2.2 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE What are the differences in treatment for personal and real property? What are the consequences of receiving boot? How long must the property be held and for what purpose? What are the rules for related parties engaging in like-kind exchanges? What are the requirements for using a qualified intermediary (QI)? How to structure deferred and reverse exchanges? What are some special issues related to partnerships and how to resolve them? WHAT IS A LIKE-KIND EXCHANGE? A like-kind exchange is a transaction under which one business or investment property is traded for another property sufficiently similar that the transaction is disregarded, either in whole or part, as a taxable event. This nonrecognition treatment requires the property owner to defer a gain or loss realized on the exchange of the business or investment property until the property (or its like-kind replacement) is sold for cash or exchanged for non-like-kind property. This deferral of tax is accomplished by carrying over the owner s tax basis in the property relinquished to the property received (with adjustment made for any cash or non-like-kind property paid or received). Any taxpaying entity, be it an individual, corporation, trust, estate, or partnership, may engage in a Code Sec like-kind exchange. For an exchange to qualify for nonrecognition treatment under the like-kind exchange rules, the following requirements must be met: Property must be held for use in a trade or business or for investment purposes (but excluding inventory, stocks, and certain others); Property must be exchanged for property that is like kind; and Property must be used for productive use in a trade or business or for investment. CAUTION The like-kind exchange rules should not be confused with the general rules applicable to a barter system. Even though a barter system may involve property-for-property exchanges, such exchanges are taxable as far as the IRS is concerned unless they constitute a like-kind exchange. An exchange of services is never a nontaxable like-kind exchange. Property-for-property exchanges are only qualifying like-kind exchanges if they meet the three requirements discussed above: business or investment use before the exchange, exchange constituting like-kind property, and business or investment use after the exchange. Top_Fed_07_book.indb /15/2006 2:41:14 PM

35 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.3 Basis Rules Tax avoidance. The basis rules preserve the gain or loss for a future date when the acquired property will be disposed of in a taxable transaction. In general, the basis of the property acquired in the exchange will be the same as the adjusted basis of the property transferred, with some modifications discussed in more detail later in this chapter. EXAMPLE Investor A wants to end his investment in Apartment Complex X. X is now worth $5 million. If she sells X, however, she must realize $3 million in taxable gain because her tax basis in X is $2 million. At the 15 percent capital gain rate, that s a $450,000 tax bill, leaving only $4.55 million available to reinvest. Instead, A exchanges the X for Apartment Complex Z, also worth $5 million. No tax is due on that like-kind exchange. Rolling exchanges. Although Investor A s tax basis in Z is the $2 million carried over from X, she hypothetically can keep exchanging one apartment complex for another, continuing to defer tax and enabling a higher level of reinvestment. As a bonus, if she holds the property until her death, her estate will receive a stepped-up basis and will owe no income tax at all (assuming the estate tax rules continue to apply). CAUTION The rules for like-kind exchanges are not optional. A transaction that fits the mold of a like-kind exchange, that is, one that complies with all the rules for a like-kind exchange, will be treated as a like-kind exchange for tax purposes, regardless of whether the taxpayer planned for it to be a nonrecognition transaction. In other words, taxpayers must intentionally break the rules for like-kind exchanges if they want to bring a transaction that otherwise would qualify for nonrecognition treatment out of the like-kind exchange rules. A taxpayer may not want a transaction to be classified as a like-kind exchange in order to get a higher basis for the property received. For example, the taxpayer might want a higher basis in the new property in order to gain the right to more depreciation deductions in the future while currently being in a position to offset any gain recognized on the sale of the old property with current or carryover operating losses. More likely still, taxpayers who would be able to recognize a loss on the sale of the old property usually want to recognize those losses as early as possible. Losses, as well as gains, cannot be recognized in like-kind exchanges under those mandatory rules. Top_Fed_07_book.indb /15/2006 2:41:15 PM

36 2.4 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE PRACTICE POINTER The easiest way for most property owners to break the rules and not create a like-kind exchange is to sell the property for cash and then with the cash buy another, similar property. As long as the cash sale and the replacement-property purchase are not locked into one deal, a taxable transaction results that yields either a gain or loss. Recapture in the Gain Rules Some gain (but not loss) must be recognized if recapture of accelerated depreciation, credit, or deductions previously taken is required or to the extent that nonqualifying property is received in the exchange. Losses are not recognized in like-kind exchanges. Boot in the Gain Rules A like-kind exchange does not need exclusively to involve like-kind property or even equal amounts of like-kind property. In fact, the entire transaction need not even have like-kind property predominate. However, to the extent that non-like kind property and/or cash is received in the deal, the taxpayer must recognize any gain otherwise inherent in the like-kind property relinquished to the extent of that boot. Boot can be either cash or property of non-like-kind to the property exchanged. EXAMPLE Smith transfers business furniture X (worth $10,000 and having a basis to Smith of $3,000) and $8,000 cash to Jones for nicer business furniture Z, worth $18,000 (and having a $9,000 basis for Jones). Smith recognizes no gain in the transaction and has a tax basis of $11,000 in the new furniture ($3,000 old basis plus $8,000 cash). Jones, assuming he uses Smith s furniture somewhere in his business, also engaged in a like-kind exchange. The potential gain of $9,000 is taxed to the extent of boot (here, the $8,000 cash). Jones s basis in the furniture formerly belonging to Smith is $9,000, the basis carried over from his former furniture. Timing The exchange need not take place by both parties on the same day. However, if the receipt and relinquishment do not occur on the same day, the property to be received must be: Identified within 45 days after the date of transfer of the relinquished property; and Received on the earlier of 180 days after the date of transfer or the due date for the return for the tax year in which the transfer occurred. Top_Fed_07_book.indb /15/2006 2:41:15 PM

37 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.5 These rules are discussed in more detail in the discussion of deferred exchanges later in this chapter. Multiple Parties There may be more than two parties involved to facilitate a like-kind exchange. Regardless of how many parties are involved, the nonrecognition treatment is always determined by what a taxpayer transfers and receives in an exchange. Therefore, a like-kind exchange may be taxable to one party and not the other. Reporting Requirements Like-kind exchanges must be reported to the IRS. Different forms must be used for capital assets. Capital assets. Taxpayers should use Form 1040, Schedule D, Capital Gains and Losses, to report exchanges of capital assets. Taxpayers must also file Form 8824, Like-Kind Exchanges, with their Schedule D. Other assets. Taxpayers should use Form 4797, Sales of Business Property, to report other exchanges. Taxpayers must also file Form 8824, Like-Kind Exchanges, with their Form CAUTION Because a taxpayer must report a like-kind exchange by filing the relevant forms for the tax year in which the taxpayer transfers the property he or she gives up in the exchange, parties to the same like-kind exchange transaction may have to report the transaction in different years. STUDY QUESTIONS 1. Deferral of tax in a like-kind exchange is accomplished by: a. Exchanging business property for personal-use property or vice versa b. Using only barterable property or services c. Carrying over basis in the property relinquished to the property received d. Using an intermediary to accomplish the transfer Top_Fed_07_book.indb /15/2006 2:41:15 PM

38 2.6 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 2. Why would a taxpayer prefer not to have a transaction classified as a like-kind exchange? a. To avoid immediate taxation on the transaction triggered by classification as a like-kind exchange b. To avoid the higher tax rate applied to gains from like-kind exchanges c. To avoid the nondeductibility of losses resulting from like-kind exchanges d. To recognize a loss on the sale of the property exchanged without the deferral period 3. If both parties to a like-kind exchange do not relinquish their property on the same day, the property to be received must be received either within days of the date of transfer or by the due date for the tax return for the tax year of the transfer, whichever occurs first. a. 30 days b. 60 days c. 120 days d. 180 days NOTE Answers to Study Questions, with feedback to both the correct and incorrect responses, are provided in a special section beginning on page WHAT TYPES OF PROPERTY CAN BE EXCHANGED? Like-kind property is property of the same nature, character, or class rather than same grade or quality. Following are the main rules: Real property may be exchanged even if the properties are not of similar grade or quality; Personal property exchanges must involve nearly identical property; Depreciable tangible personal property is like kind if it is of like kind or of like class; Other personal property must be like kind; and Real property and personal property are not the same class or kind of property. Many businesses and investors have limited opportunities and resources to search for like-kind property for which they can exchange an existing asset. To fill that need, a commercial like-kind exchange industry has developed. Although most such services serve specific business types (for Top_Fed_07_book.indb /15/2006 2:41:15 PM

39 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.7 example, firms specializing in exchanges of investment apartment buildings), some connected with large financial institutions have been setting up fullservice like-kind exchange units to serve a varied corporate clientele. Many of these service businesses are themselves part of the transaction, serving as qualified intermediaries (QIs) (see the discussion of Section 440 later in this chapter). Even for the do-it-yourselfer, however, the chances of finding a suitable property to enable a like-kind exchange has been facilitated by the development of the law over the years to permit delayed like-kind exchanges in several flavors (see the discussion of Section 435 later in this chapter). Excluded Property Certain types of property can never qualify for nonrecognition. These are: Stocks, bonds, notes, or other securities; Stock in trade or other property held in inventory for sale; Partnership interests; Certificates of trust or beneficial interest; and Choses in action (basically, contract rights). Partnership interests. Partnership interests do not qualify for nonrecognition. For this rule, it is irrelevant whether the partnership interest is a general or a limited partnership interest or whether the interests are in the same partnership or in different partnerships. Partnerships that have elected not to be treated as partnerships for tax purposes are not included in this rule. Interests in these types of partnerships are treated as interests in each of the assets of the partnership in determining whether like-kind treatment is available. Choses in action. A chose in action is a personal right not reduced to possession but recoverable by bringing and maintaining a lawsuit. Some rights, however, such as professional sports players contracts, are considered property used in a trade or business and may qualify for nonrecognition. PRACTICE POINTER The IRS has held that trade names are not choses in action because they do not confer a right to recover property or money in a lawsuit. Real Property Real property may be exchanged even if the properties are not of similar grade or quality. For example, improved real estate qualifies as like kind to unimproved real estate. Any number of parcels of real property can be exchanged, and fractional interests may be exchanged for an entire interest in another property. Top_Fed_07_book.indb /15/2006 2:41:15 PM

40 2.8 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE PRACTICE POINTER For like-kind exchange purposes, the fee title to real estate is like kind to a leasehold with 30 years or more to run. Personal Property Personal property exchanges generally must involve nearly identical property. The analysis may be different, however, if the property is depreciable tangible personal property or other personal property. Tangible or depreciable personal property. Depreciable tangible personal property qualifies for like-kind treatment in one of two ways: If the depreciable personal property is exchanged for property that is like kind; or If the depreciable personal property is exchanged for property that is in a like class. Whether tangible personal property is in a like class to another personal property depends on whether the personal properties in the exchange are in the same product class or the same asset class as of the date of the exchange. A property cannot be classified within more than one general asset or product class and property classified within a general asset class cannot also be classified within a product class. Product classes. Product classes (TRC, SALES: 30,102.10) for depreciable tangible personal property are described in the six-digit classes of Sectors 31, 32, and 33 of the North American Industry Classification System (NAICS). Any six-digit NAICS product class having a last digit of 9 (indicating a miscellaneous category) is not a product class for tax purposes. A property that is listed in more than one product class is treated as listed in any one of those classes. The six-digit product class is referred to as the NAICS code. The NAICS Manual can be obtained from the National Technical Information Service, an agency of the U.S. Department of Commerce. If personal property is exchanged for other personal property that is in the same product class, the exchange will qualify for like-kind treatment. General asset classes. Depreciable tangible personal property may be classified into one of 13 general asset classes (TRC, SALES: 30,102.05). If personal property is exchanged for other personal property that is in the same asset class, the exchange will qualify for like-kind treatment. The classes are: Office furniture, fixtures, and equipment; Information systems; Data handling equipment; Airplanes (other than commercial airliners or freight carriers); Top_Fed_07_book.indb /15/2006 2:41:16 PM

41 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.9 Automobiles and taxis; Buses; Light general purpose trucks; Heavy general purpose trucks; Railroad cars and locomotives, except those owned by railroad transportation companies; Tractor units for use over-the-road; Trailers and trailer-mounted containers; Vessels, barges, tugs, and similar water-transportation equipment, except those used in marine construction; and Industrial steam and electric generation and/or distribution systems. Other personal property. An exchange of any other personal property (and depreciable tangible personal property that is not in the same asset or product class as the property being received in the exchange) will be afforded like-kind treatment under a test that is stricter than the one for real property, the properties nature or character must be nearly identical. EXAMPLE A truck must be exchanged for another truck to be like-kind and a passenger automobile must be exchanged for a passenger automobile. A passenger automobile exchanged for a truck will not qualify for like-kind treatment. The IRS recently held that a sports utility vehicle is like kind to a passenger automobile. If the property must be nearly identical, what is the business case for making an exchange at all? There may be several reasons. First, nearly identical may not be good enough for a particular business use. More common, however, is the situation in which the property relinquished doesn t continue to serve a particular business or investment purpose because it is old. The property received in the exchange is usually new or newer. Usually, to make the deal work, cash must be given along with the old property, several items of older property must be exchanged for a single item of new property, or several multiple exchanges take place at once. The most common example of the former situation is an old car trade-in. In that case, the depreciable basis of the vehicle received in the trade-in is equal to the sum of the remaining undepreciated basis of the traded-in vehicle (the carryover basis) plus the additional cash paid for the new vehicle. Intangible personal property. In the case of intangible personal property, like-kind treatment turns on the nature or character of the rights involved, and also on the nature or character of the underlying property to which the intangible personal property relates. Top_Fed_07_book.indb /15/2006 2:41:16 PM

42 2.10 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Foreign Property Property that is deemed to be foreign must satisfy additional requirements in order to be considered like kind to U.S. property. Foreign personal property. Generally, personal property used in the United States and personal property used outside of the United States are not like kind to each other. The test is whether the property is predominantly used outside of the United States for a particular time period. For surrendered property, the predominant use is tested based on the two years ending on the date it is relinquished. For acquired property, the predominant use is tested based on the two years following the acquisition date. If the holding period is less than two years, the actual holding period will determine the predominant use of the property. Some property is deemed not to be used predominantly outside of the United States, despite it being foreign property. This exception comprises property that is used both within and outside the United States but is considered to be used in the United States and includes 12 categories of property excluded from foreign use classification that would require use of the accelerated depreciation system (ADS). Foreign real property. As with domestic real property, the rules for foreign real property differ from the rules for foreign personal property just described. In the case of foreign real property, the rule is straightforward real property located in the United States and real property located outside of the United States are not like kind. Other Types of Property Livestock, natural resources, and unharvested crops also follow a special set of rules in determining whether exchanges of these types of properties qualify for like-kind treatment. Livestock: Livestock of different sexes is not property of like kind. An exchange of male calves for female calves does not qualify as a like-kind exchange. However, as long as the cattle are of the same sex, they do not have to be the same grade. Natural resources: An exchange of an interest in a natural resource for another such interest, or for a fee title to land, qualifies for like-kind exchange nonrecognition treatment if the interests exchanged are both either realty or personalty under the relevant state law and of the same character as defined by federal tax law. State law determines whether the interest is realty or personalty. Unharvested crops: Unharvested crops are part of the land on which they are growing and can be exchanged with the land for other qualifying real property. Tracts of timberland can be exchanged without regard to the quality or quantity of timber growing on the land. Timberland qualifies as like kind to land that is bereft of any crop. Top_Fed_07_book.indb /15/2006 2:41:16 PM

43 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.11 Latest Twists The law on like-kind exchanges continues to evolve. (Some tax practitioners claim that there has been too much evolution and the rules are now so complicated and voluminous that Congress should scrap the entire Code sections and start from scratch but that won t happen soon.) Many of the more recent cases and rulings in the like-kind arena that have been welcomed by practitioners have focused on whether properties were sufficiently similar to be classified as like kind. These cases tend to clarify and illustrate which personal properties are identical enough to be like kind. Unfortunately, however, these cases also reveal a disturbing trend in which exchanges of intangible personal property are becoming less likely to win likekind treatment. Timberland. In a 2005 letter ruling the IRS held that old-growth timberland was like-kind to reproduction timberland of equal value because the age, quality and species of the timber growing on the land did not change the class or kind of the property being exchanges, which was land (Ltr ). It further held that the cutting of the old-growth timberland within two years of the exchange would not result in gain recognition, even though it was a related-party transaction (see the discussion of the related party two-year rule later in this chapter), because it would not be deemed to be a disposition of property within the same transaction within two years. FCC licenses. In another 2005 ruling, the IRS held that an FCC radio license was like kind to a different FCC radio license, finding the differences between the licenses were not differences in nature or character but rather in grade or quality (Ltr ) (IRS Letter Ruling ). In that same year, the IRS and the FCC provided further guidance by issuing a joint coordinated paper holding that FCC licenses can be exchanged in nontaxable like-kind exchanges but that network affiliations and goodwill must be valued and treated separately, recognizing any gain that may be attributed to those intangibles (News-Federal, 2006TAXDAY, (June 09, 2005), Item #I.3). SUV and passenger automobiles. In still another ruling, the IRS clarified to the relief of many businesses that sports utility vehicles and passenger automobiles were like kind to each other (Ltr ). The IRS saw any differences as one of grade or quality but not nature or character. Mines and supply contracts. A 2006 Tax Court decision held that a gold mine was like kind to a coal mine and the supply contracts that went with the mine (Peabody Natural Resources Co. v. Cmmr, 126 TC No. 14). Under New Mexico law, the contracts were equitable servitudes, real property-related interests, and as such were not personal property. Although the Top_Fed_07_book.indb /15/2006 2:41:16 PM

44 2.12 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE court refused to approve a blanket rule that all real property interests are necessarily like kind, they were in this case because the nature or character of the properties was similar. Railroad tracks. In a recent field advice, the IRS Chief Counsel s Office ruled that railroad tracks attached to the land were not like kind to unassembled track components (TAM ). Again, state law was critical in the analysis. The tracks attached to the land were real property under state law, whereas the unassembled tracks were personal property. Intangible personal property. The like-kind property of intangible properties has been at the center of a debate that has lasted as long as Section 1031 itself. The latest developments in this debate have been decidedly against facilitating qualifying like-kind exchanges in the area. In a nutshell, the IRS is moving toward a more restrictive approach to intangibles. Recently, the IRS issued a technical advice memorandum for its field agents that examined several business transactions involving exchanges of business intangibles (TAM ). The results were not encouraging. Under the facts, a taxpayer transferred and acquired tangible and intangible assets held by two of its subsidiaries and claimed like-kind treatment for the intangible assets. The intangible property included patents, trademarks and trade names, unregistered intellectual property, and foreign intangibles. No blanket analysis was permitted. The IRS held that taxpayers could not engage in a blanket like-kind exchange of intangible business assets for other intangible business assets without examining the underlying assets. The multiple property rules (described below) do not apply. Nature and character of rights matter. The IRS further ruled that whether intangible property qualified as like kind was determined under the test that examines the nature and character of the rights involved and the nature and character of the related underlying property. The IRS used the General Asset and Product Classes where applicable to compare the underlying property. Patents. Finding that the nature or character of the rights under a patent does not vary from patent to patent, the IRS found that that prong of the test was met with regards to exchanges of patents for patents. The IRS then held that patents in the same general asset class or product class were like kind. Only one of the patents met this test. Unregistered intangibles. The taxpayer s unregistered intangibles included designs, drawings, trade secrets, secret know-how, and software. All of the unregistered intangibles were offered the same legal protection so they met the first prong of the test the nature and character of the rights involved analysis. Again, in determining whether the underlying property was of the same nature and character, the IRS used the general asset and product Top_Fed_07_book.indb /15/2006 2:41:17 PM

45 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.13 classes and granted like-kind treatment for those assets that were in the same general asset or product class. Trademarks and trade names. Trademarks and trade names are not afforded like-kind treatment. The IRS determined that they were too closely related to the goodwill or going concern value of a business, which is not like-kind property under the regulations. Foreign intangible property. Intangible property of a company outside the United States was not like kind to intangible property of a domestic company. The enjoyment or use test was applied by examining where the property was licensed. Multiple Properties Exchanges of multiple properties can qualify for like-kind treatment. The general property-by-property comparison that is made to compute gain and basis of the property received in the exchange, however, usually does not apply in an exchange of multiple properties. Instead, gain, loss, and basis must be computed for each group of properties that are of like-kind or like class. These transactions are common in exchanges of similar businesses. In such cases, an asset-by-asset comparison is required first to determine whether the like-kind exchange rules apply to the underlying assets; then the assets are divided into :exchange groups so that gain and basis may be computed on a group by group basis. Exchange groups. An exchange group is a group of all the properties transferred or received within a group that are of like-kind or like class. An exchange is considered to be an exchange of multiple properties that requires the exchange group method for gain and basis comparisons if: More than one exchange group is created; or Only one exchange group is created but more than one property is transferred or received within that exchange group. Properties are placed into an exchange group by matching up properties of like kind or like class. Each exchange group consists of the properties transferred and received in the exchange that are of like kind or like class. If a property can be included in more than one exchange group, the property can be included in any of those groups. However, each exchange group must consist of at least one property transferred and one property received in the exchange. Residual group. A residual group must be created when the aggregate fair market value of the properties transferred in all of the exchange groups differs from the aggregate fair market value of the properties received in Top_Fed_07_book.indb /15/2006 2:41:17 PM

46 2.14 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE all of the exchange groups (including liabilities). Practically speaking, there always will be some property falling into the residual group in the case of most multiple-property exchanges. The residual group consists of an amount of money or other property having an aggregate fair market value equal to the difference. Other property refers to property not eligible for like-kind treatment, property transferred that is not-like kind or like class to any property received, and property received that is not like kind or like class to any property transferred. CAUTION Money and property are allocated to the residual group in a specified order the same order used in applying the residual method of allocation as applied to a sale of assets comprising a trade or business. EXAMPLE The IRS uses this illustration (Pub. 544, Sales and Other Dispositions of Assets) to explain the grouping processes: Karen exchanges her business computer A (asset class 00.12) and automobile A (asset class 00.22) for printer B (asset class 00.12) and automobile B (asset class 00.22), both of which she will use in her business. The first exchange group consists of computer A and printer B. It has an exchange group deficiency of $1,050 because the fair market value of printer B ($2,050) is more than the fair market value of computer A ($1,000) by that amount. The second exchange group consists of automobile A and automobile B. It has an exchange group deficiency of $1,050 because the fair market value of automobile A ($4,000) is more than the fair market value of automobile B ($2,950) by that amount. Recognized gain. The amount of gain recognized in an exchange of multiple properties is computed by using a four-step process: 1. Separating the properties transferred and the properties received into exchange groups, 2. Computing the liabilities assumed or relieved in the transaction, 3. Allocating the amounts determined under Step #2 among the exchange groups, and 4. Applying the like-kind exchange rules separately to each exchange group. Top_Fed_07_book.indb /15/2006 2:41:17 PM

47 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.15 EXAMPLE Based on the previous example, Karen realizes gain for the first exchange group of $625 (the $1,000 fair market value of computer A, minus its $375 adjusted basis). The gain recognized, however, is $0, which is the lesser of the $625 gain realized or the $0 exchange group deficiency. For the second exchange group, however, Karen realized a $2,500 gain (the $4,000 fair market value of automobile A, minus its $1,500 adjusted basis). Her gain recognized is $1,050 (the lesser of the $2,500 gain realized or the $1,050 exchange group deficiency). Karen s total gain recognized in the exchange is the sum of the gains recognized with respect to both exchange groups ($0 + $1,050), or $1,050. Basis. The basis of the properties received is computed by: 1. Determining the aggregate basis of properties in each exchange group; then 2. Allocating the basis proportionately to each property in the group in accordance with its fair market value. The total basis of properties received in each exchange group is the sum of: The total adjusted basis of the transferred properties within that exchange group; The recognized gain on the exchange group; The excess liabilities assumed and allocated to the group; and The exchange group surplus (or minus the exchange group deficiency). The total basis of each exchange group is then allocated proportionately to each property received in the exchange group according to the property s fair market value. The basis of each property received within the residual group (other than money) is equal to its fair market value. EXAMPLE The same property applies as in the previous two examples. Because Printer B is the only property received with the first exchange group, the entire basis of $1,425 (determined under the four-step process, above) is allocated to it. The $1,500 basis of the property received in the second exchange group (again, using the four-step process) is allocated to its only asset, automobile B. Top_Fed_07_book.indb /15/2006 2:41:17 PM

48 2.16 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE STUDY QUESTIONS 4. All of the following types of property are acceptable under Code Sec for like-kind exchanges except: a. Depreciable tangible personal property of like class b. Nearly identical personal property c. Fractional interests in real property exchanged for entire interests in other real property d. Real property and personal property of like grade 5. Exchanges of interests in partnerships taxed as partnerships qualify for nonrecognition if the partnership is liquidating. True or False? 6. Creating is required in multiple property exchanges when the fair market value of the properties relinquished does not equal the FMV of properties acquired. a. An exchange group b. A residual group c. A chose in action d. None of the above HELD FOR TRADE, BUSINESS, OR INVESTMENT USE REQUIREMENT To qualify for nonrecognition treatment, taxpayers must have held the transferred property for productive use in a trade or business or for investment. Like-kind property must also be acquired for purposes of holding the property for productive use in a trade or business or for investment. The Held for Requirement, Explained There is no requirement that the property actually be used in a trade or business; it is sufficient that the property be held for that use. However, if the property is not actually used, an intent to use it must be proved and the burden to do so is on the taxpayer and not on the IRS. Property can be held for investment even though the owner intends to sell it at a future date to realize the gain or to exchange the property for like kind. However, property acquired for the sole reason of being exchanged will not meet the requirement. Top_Fed_07_book.indb /15/2006 2:41:17 PM

49 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.17 PRACTICE POINTER The properties in an exchange do not need to be held for the same purposes. In other words, the property a party received in an exchange does not need to be held for the same purpose as the property the party transferred. Property held for investment can be exchanged for property to be held for productive use in a trade or business and vice versa. CAUTION One person s purpose for holding property cannot be attributed to another individual. For example, if a corporation distributes property that it uses in its business to a shareholder, the corporation s productive use is not attributed to the shareholder. Change of purpose. Clearly, property used for personal purposes, such as a taxpayer s principal residence, is not eligible for nonrecognition treatment in a like-kind exchange. However, unlike property that is disqualified because it is statutorily excluded from like-kind exchanges, property disqualified because it does not meet the held for requirement when acquired may qualify later if there is a change in the purpose for which it is held. Homeowner Strategies For planning purposes and maximum tax savings, in some cases, taxpayers may qualify for the homeowner gain exclusion of Code Sec. 121 on the exchange of a principal residence and for nonrecognition from a like-kind exchange (Rev. Proc ). For example, if a taxpayer uses the principal residence for the required period for the gain exclusion and then kept it for investment, it may also qualify for nonrecognition in a like-kind exchange. The IRS updated the revenue procedure that discusses these rules but did not change the general conclusion that the same property may qualify for the homeowner exclusion and nonrecognition treatment under the right circumstances. Top_Fed_07_book.indb /15/2006 2:41:18 PM

50 2.18 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE EXAMPLE Jessica buys a house for $210,000 and uses it as her principal residence from 1995 until From 2000 to 2002, she rents the property and claims depreciation of $20,000 and her adjusted basis in the house is now $190, In 2002, Jessica exchanges the house for $10,000 and rental property with a fair market value of $460,000. Jessica realizes gain of $280,000 ($470,000 less adjusted basis of $190,000). Because she used the residence for at least two of the last five years as required by Code Sec. 121, she will qualify for the gain exclusion up to a maximum of $250,000, as specified in the rules. The other $30,000 of realized gain can be deferred under Code Sec like-kind exchanges. The $10,000 will not have to be recognized because it does not exceed the amount excluded under Code Sec The new basis in the replacement property will be $430,000 ($190,000 adjusted basis plus $250,000 of Code Sec. 121 excluded gain less the $10,000 of cash received). PRACTICE POINTER The same technique may be used for an office-at-home situation in which gain on the home-office portion of the residence may be deferred in a likekind exchange for a similar office-at-home situation in a new residence. CAUTION Property acquired with the intent of immediately exchanging it for like-kind property will not satisfy the held for requirement. The taxpayer must have had the intent to keep the acquired property indefinitely before formulating the intent to exchange it. WHAT HAPPENS TO BOOT? The transfer of nonqualifying property in addition to qualifying property in a like-kind exchange does not render the transaction ineligible for likekind nonrecognition. Instead, the nonqualifying property is treated as boot and gain is recognized to the extent of the boot s fair market value. If the adjusted basis of the boot paid in the exchange is greater than its fair market value, the transferor recognizes a loss on the exchange. Property That May Be Boot Boot may consist of cash, relief from indebtedness, excluded property, or property that is not like kind to the property being exchanged. Top_Fed_07_book.indb /15/2006 2:41:18 PM

51 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.19 EXAMPLE Laura transfers a parcel of real estate with a fair market value of $10,000 and stock with an adjusted basis of $4,000 and a fair market value of $6,000 for another parcel of real estate with a fair market value of $16,000. Laura will recognize $2,000 ($6,000 $4,000) of gain in the exchange because the stock is considered to be boot and gain is recognized to the extent of the gain attributed to the transferred stock. Relief from Liability and Boot In general, if a taxpayer is relieved from a debt, the taxpayer is treated as having received boot to the extent of the liability. EXAMPLE Isabel exchanges farmland subject to a mortgage of $90,000 for other land that is not encumbered by liabilities and some stock worth $4,000. Isabel receives boot in the amount of $94,000 from the relief from the $90,000 mortgage indebtedness and the $4,000 worth of stock. If an exchange involves the reciprocal assumption of mortgages or reciprocal transfer of property subject to mortgages, the taxpayer is permitted to offset the amount of debt relief by the amount of debt assumed. In that case, the taxpayer will have boot from the relief of liability only to the extent that the taxpayer s debt relief is greater than the debt incurred. EXAMPLE George exchanges property subject to a $100,000 mortgage and cash of $40,000 for like-kind property subject to a $60,000 mortgage. George has no boot and recognizes no gain on the exchange because his relief from indebtedness of $100,000 is completely offset by the $40,000 in cash paid and the assumption of the $60,000 mortgage. Multiples Properties and Boot Allocation. Boot must be allocated among the properties in cases where multiple properties and boot are exchanged. The allocation must be done in order to determine the amount and character of gain on the transfer. Transfer of trade or business. When an exchange constitutes the transfer of a trade or business, taxpayers must use a residual method of allocation for property not treated as transferred for the like-kind assets, and the allocation must be reported to the IRS. The residual method requires that the consideration received is allocated: Top_Fed_07_book.indb /15/2006 2:41:18 PM

52 2.20 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 1. To cash; 2. Then to marketable securities in proportion to their fair market value; 3. Then to assets other than amortizable intangibles in proportion to their fair market value; and 4. Lastly to goodwill and going concern value. BASIS RULES The basis rules are straightforward when a like-kind exchange involves just two properties and no boot. In general, the basis of the property acquired in the exchange will be the same as the adjusted basis of the property transferred, with some modifications (TRC SALES: 30,302). Adjustments to Basis The new basis for the acquired property is increased by gain recognized in the exchange and decreased by loss recognized or cash received (boot) in the exchange. The basis will be allocated: 1. To boot received to the extent of its fair market value; then 2. Among nonrecognition property based on proportionate fair market value. EXAMPLE Joe transfers property with an adjusted basis of $15,000 in exchange for two parcels of property (property one and property two) with fair market values of $30,000 and $60,000, respectively, and stock with a fair market value of $6,000. Joe s $15,000 basis in the old property is first allocated to the stock in the amount of $6,000. The remaining $9,000 is allocated proportionately to the other properties such that one third of the basis or $3,000 is allocated to property one and the two thirds remaining or $6,000 is allocated to property two. Additionally, assumptions of liability or the acquisition of property subject to a liability will be treated as money received by the transferor of that property and will thereby reduce that transferor s basis. Assumption of Liabilities The assumption of liability owed on the property by the transferor reduces the transferor s basis in an exchange because it is treated as money received. However, the basis reduction is cancelled by a reciprocal basis increase to the extent that the assumption of liability results in recognized gain. Top_Fed_07_book.indb /15/2006 2:41:18 PM

53 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.21 EXAMPLE Richard transfers property with a basis of $80,000 and a mortgage of $75,000 for like-kind property with a fair market value of $200,000. Richard s realized gain is $200,000 $80,000, or $120,000. Of that amount, Richard would have to recognize gain in the amount of $75,000 because the debt relief is boot. Richard s basis in the new property will be $80,000 ($80,000 basis of property transferred increased by $75,000 in recognized gain reduced by $75,000 of boot received). Multiple Properties If multiple assets are exchanged for a single asset, the basis of the acquired asset will be the aggregate basis of all the assets transferred. If multiple assets are received, the basis of the asset or assets transferred is allocated among the acquired assets. EXAMPLE Amanda transfers two parcels of property, Blackacre and Whiteacre. Blackacre has an adjusted basis of $10,000 and Whiteacre has an adjusted basis of $15,000. Amanda receives one parcel of property, Blueacre. Amanda s basis in Blueacre is $25,000. Recapture and Basis In general, property listed under Code Sec (depreciable personal property) and Code Sec (depreciable real property) is subject to recapture rules. This means that the gains from the sale or other disposition of that property is taxed as ordinary income to the extent of all depreciation or amortization deductions previously claimed on that property. There are special rules for recognizing recaptured income in like-kind exchanges. STUDY QUESTIONS 7. Under the right circumstances, a homeowner can claim the gain exclusion from the sale of a principal residence under Code Sec. 121 as well as nonrecognition from a like-kind exchange of the residence if it is kept for investment prior to sale. True or False? 8. Boot may consist of all of the following types of property except: a. Relief from indebtedness b. Cash c. Excluded property d. Like-kind property Top_Fed_07_book.indb /15/2006 2:41:18 PM

54 2.22 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 9. If a like-kind exchange involves the reciprocal assumption of mortgages on property by both parties, the taxpayer acquiring the property with the lower debt: a. Receives boot on the difference of debt relieved and incurred b. May not offset the debt relieved and incurred c. Recognizes no gain on the exchange d. None of the above RELATED-PARTY EXCHANGES Related-party transactions are generally scrutinized closely by the IRS because of the likelihood that they are not arm s length and may therefore lack economic substance. Related parties engaging in like-kind exchanges are no exception and there are special rules for these transactions. Unlike some other tax provisions, however, related parties are not prohibited from entering into like-kind exchanges and fully enjoying the tax benefits. However, they must abide by a restrictive set of holding rules. Related-Parties Limitation In general, taxpayers engaging in like-kind exchanges with related parties will not qualify for nonrecognition treatment if within two years of the date of the last transfer made under the like-kind exchange provisions either the taxpayer or the related person disposes of the like-kind property (IRC 1031(f)). In addition, transactions structured to avoid this rule will not qualify for nonrecognition treatment. One of the main purposes behind this rule is to prevent cashing out by related parties. Cashing out. The IRS has not been shy in announcing (and then following up with litigation) its concern over transactions in which related parties made like-kind exchanges of high-basis property for a low-basis property in anticipation of a sale of the low-basis property (Rev. Rul ). Exceptions. There are certain exceptions for dispositions made within two years that will not bar nonrecognition: The disposition is after the death of the taxpayer or the related person; There is a compulsory or involuntary conversion if the exchange occurred before the imminence of such event; or Neither the exchange nor the disposition had as one of its principal purposes the avoidance of taxes. Top_Fed_07_book.indb /15/2006 2:41:18 PM

55 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.23 Related Parties Reporting Requirements Generally, taxpayers engaging in like-kind exchanges with related persons must report the exchange to the IRS by attaching Form 8824 to their return and specifying that the other party in the exchange was a person considered to be related under the rules. Related Parties and Qualified Intermediaries Related persons may not act as qualified intermediaries (QIs) or otherwise facilitate a like-kind exchange. See Qualified Intermediaries in this chapter for a discussion of QIs. In addition, several transactions where related parties used QIs to try to circumvent the related party rules have been barred from receiving nonrecognition treatment. The IRS will look to the result of these transactions to ascertain whether the transactions are structured to avoid taxes. Three cutting edge recent developments are pertinent: Disallowance of nonrecognition for related parties using QIs; Disallowance of nonrecognition for high-/low-basis strategy when a taxpayer relinquishes property to an unrelated person but who acquires property from a related person; and Allowance of nonrecognition treatment between related parties when there is no cashing out. The critical final result. In Teruya, the Tax Court did not allow nonrecognition treatment for an exchange involving related parties and a QI (Teruya Brothers, Ltd. & Subsidiaries v Commr, 124 TC 45 (2005)). In that case, a corporation in the business of purchasing and developing real estate, decided to dispose of some of its property through several like-kind exchanges. It transferred the properties to a QI who sold the properties to third parties. With the proceeds from the sales, the QI acquired replacement property for the corporation. Unfortunately, the replacement property acquired by the QI and transferred to the corporation was owned by a subsidiary of the corporation, a related party under the rules. The IRS held that the transactions did not qualify for nonrecognition treatment. The IRS stripped the transactions to its essence and determined the transactions were really an exchange between related parties the corporation and its subsidiary that would not be shielded by imposing a QI between them. Failed high-/low-basis strategy. In Rev. Rul , the IRS denied nonrecognition to a taxpayer who relinquished property through a QI to an unrelated person and acquired property through the QI from a related person. Here is how the taxpayer s plan worked: Individuals A and B were related persons under the rules. Individual A (the taxpayer) owned real property (Property 1) with a low basis and individual B owned real property (Property Top_Fed_07_book.indb /15/2006 2:41:19 PM

56 2.24 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 2) with a high basis. Individual C offered to purchase A s property. A then transferred Property 1 to the QI who sold Property 1 to C. The QI then acquired Property 2 from B with the proceeds from the sale to C. The QI then transferred Property 2 to A. The result? The IRS held this transaction did not qualify for nonrecognition treatment because the transaction was structured to avoid the purpose behind the related-party rules. Relying on legislative history, the IRS stated that the related party rules were designed in part to deal with cases where related taxpayers used like-kind exchanges to exchange low basis property for high basis property before the sale of the low-basis property. In essence, the related parties were attempting to sell the low-basis property to an unrelated party without recognizing any gain, and would therefore not be afforded nonrecognition treatment. Again, looking at the final result was the IRS s trump card. Successful cash-out. In a 2006 letter ruling, a transaction achieved likekind treatment despite its involvement of related parties. The key was that they were involved sufficiently in the taxpayer s side of the transaction (Ltr ). In the ruling, a trust and an S corp were related persons. The trust planned to transfer Building 1 to a buyer and to acquire Building 2, owned by the S corp, as replacement property in a like-kind exchange transaction. The S corp would also exchange Building 2 for other like-kind property. The S corp and the trust would use a QI to facilitate their exchanges. The QI would be treated as the seller of Building 1 to the buyer and as acquiring Building 2 from the S corp and transferring it to the trust in exchange for Building 1. The QI would then acquire additional replacement property and transfer that property to the S corp in exchange for Building 2. The IRS held the transactions would qualify for nonrecognition treatment. The exchanges would be valid if neither party disposed of the exchanged property for two years. The result of the transactions was that both parties would own like-kind property to the one exchanged and there would be no cashing out by either party, so the transaction would qualify for like-kind treatment. In general, the IRS will disallow transactions in which related parties use the like-kind exchange provisions to cash out of their investments without gain recognition. DEFERRED EXCHANGES A deferred exchange is an exchange in which a taxpayer transfers property held for productive use in a trade or business or for investment and subsequently receives property held for productive use in a trade a business or for investment. Special rules govern the identification and receipt of property for deferred exchange transactions to qualify for nonrecognition treatment. Top_Fed_07_book.indb /15/2006 2:41:19 PM

57 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.25 The law is not static in this area. Deferred exchanges remain the hot corner in like-kind exchange practice. Taxpayers are regularly pushing the envelope on how transactions can be structured to stay within the rules yet provide maximum flexibility. At times, the IRS and the courts resist. However, on many recent occasions, they have been approving new techniques under the original legislative purpose behind Code Sec. 1031: to encourage capital reinvestment. Gain, Loss, and Basis Rules The amount of gain or loss recognized in a deferred exchange is determined under the same like-kind exchange rules for exchanges that are not deferred. Identification Rules The identification rules (TRC SALES: 30,602; 30,602.5; 30,602.10, 20, ) allow the taxpayer 45 days starting on the date the taxpayer transfers relinquished property to identify replacement property. If multiple properties are relinquished as part of the same exchange, the identification period starts rolling on the earliest date on which a relinquished property is transferred. Other rules related to identification of property also apply: The identified property must be described unambiguously in a signed document that is delivered to a qualified party to the exchange. Real property is unambiguously described if the document provides a legal description, street address, or distinguishable name; Incidental property may be included in the identified property but cannot compose more than 15 percent of the aggregate value of the main property. Property is incidental to a larger property if it is typically transferred together in standard commercial transactions and the aggregate fair market value of the property does not exceed 15 percent of the aggregate fair market value of the larger item of property; Multiple replacement properties can be identified, even as alternative properties, but there may be no more than three properties identified or 200 percent of the fair market value of all relinquished properties; and The identification of replacement property can be revoked before the end of the replacement period in a properly signed and delivered document. EXAMPLE Multiple Replacement Properties: Monica transfers Yardley House, which has a fair market value of $100,000. She identifies Yardley Green, Yardley Park, Yardley Terrace and Yardley Towers with fair market values of $30,000, $40,000, $50,000 and $60,000, respectively as replacement properties. Because the aggregate fair market values of these properties ($180,000) does not exceed 200 percent of the fair market value of Yardley House ($100,000 2 = $200,000), the properties are properly identified. Top_Fed_07_book.indb /15/2006 2:41:19 PM

58 2.26 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE EXAMPLE Incidental Property: James receives in an exchange a truck with a fair market value of $10,000 and a spare tire and tool kit with a fair market value of $1,400. The three items are treated as one property because the fair market value of the spare tire and tool kit does not exceed 15 percent of the fair market value of the truck ($10, = $1,500). Receipt of Property Rules The deadline for receipt of qualified property is the earlier of 180 days after the date of transfer of the taxpayer s relinquished property or the due date of the transferor s tax return for the year in which the transfer occurred (including extensions). EXAMPLE ABC Corporation files its corporate tax return on a calendar-year basis. ABC transfers property in a deferred exchange on November 17, Year 1. The exchange period ends on March 15, Year 2, the due date for ABC s tax return for the tax year in which ABC transferred the property. If ABC is allowed an automatic six-month extension to file its tax return, the exchange period ends on May 16, Year 2, the date that occurs 180 days after the transfer of the property. If, as part of the same exchange, the taxpayer transfers more than one relinquished property and the properties are transferred on different dates, the period starts running on the earliest date on which any of the properties is transferred. In addition, for replacement property to be deemed received before the end of the exchange period, the replacement property received must be substantially identical to the replacement property identified. The Receipt-of-Other-Property-First Trap Taxpayers in a deferred exchange may fall into a big trap (TRC SALES: 30,608) if certain cash or other backstop guarantees are made part of the deal. Gain in an otherwise qualifying deferred exchange will be recognized if the taxpayer actually or constructively receives money or other property before the taxpayer receives the replacement property. These transactions will be treated as sales, even if the taxpayer does later receive the replacement property. Top_Fed_07_book.indb /15/2006 2:41:20 PM

59 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.27 EXAMPLE Bob and Lisa enter into an agreement on May 17, for a deferred exchange and Bob immediately transfers real property worth $100,000 to Lisa. By July 1, Bob is to identify replacement property and by November 13, Lisa is to purchase and transfer it to Bob. At any time on or after May 17, and before Lisa has purchased replacement property, Bob has the right to demand that Lisa pay $100,000 in lieu of purchasing the replacement property. As it turned out, however, Bob identified the replacement property and Lisa purchases and transfers it to him. Because Bob had the unrestricted right to demand payment of $100,000 as of May 17, he was in constructive receipt of that amount on that date. The exchange of properties will be treated as two cash sales. If the exchange qualifies under one of three safe harbors, however, a taxpayer will not be deemed to be in actual or constructive receipt of money or property. In addition, receipt of prorated rents or other items a seller may receive as a result of disposition of a property and transaction items such as commissions and taxes will also not result in gain if they are received by a taxpayer before the taxpayer receives the replacement property. Security or guarantee arrangements safe harbor. A taxpayer is not in receipt of other property before receiving replacement property just because the obligation of the other party is or may be secured by a mortgage, deed of trust, or other security interest in property, a standby letter of credit that does not allow the taxpayer to draw on the credit except in the case of the transferee s default, or a guarantee of a third party. Qualified trusts and escrow accounts safe harbor. The obligation of the other party to the transaction may be secured by cash or a cash equivalent held in an escrow account or in a qualified trust and the taxpayer will not be deemed to be in receipt of other property before he or she receives replacement property. However, receipt of escrow funds by the seller before transferring to the escrow agent will result in gain recognition when the escrow agreement does not impose restrictions on the seller. Interest and growth factors safe harbor. A taxpayer is not in receipt of other property before receiving replacement property just because the taxpayer may be entitled to receive interest or another growth factor with regard to the deferred exchange as long as the taxpayer s rights to receive the interest or other growth factor are limited. Top_Fed_07_book.indb /15/2006 2:41:20 PM

60 2.28 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE STUDY QUESTIONS 10. Exceptions to the two-year minimum period for dispositions of likekind property exchanged by related parties include all of the following except: a. Exchanges and dispositions in which the parties principal purpose was not tax avoidance b. The property is disposed of following the death of the taxpayer or the related person c. There is a compulsory or involuntary conversion where the exchange occurred before the imminence of such event d. All of the above are exceptions 11. In a, a taxpayer transfers property held for productive trade or business use or investment and subsequently receives property held for production use in a trade or business use or investment. a. Eventual exchange b. Deferred exchange c. Cash-out exchange d. Guaranteed exchange 12. Which of the following is not one of the safe harbors for deferred exchanges? a. Qualified trusts and escrow accounts b. Interest and growth factors c. Proof of receipt of the other property first d. All of the above are safe harbors QUALIFIED INTERMEDIARIES A business or investor does not always have the time or talent to find likekind property whose owner is willing to exchange. To solve this problem, and with the approval of the IRS, qualified intermediaries (QIs) were born. For a fee, these go-betweens in effect play matchmaker in finding a suitable property to exchange. They can actually find the owner and the property to make a direct exchange; or, more frequently, they can find the property to exchange but through trading several properties and cash in deals in which the owner of that property does not necessarily receive like-kind property from the taxpayer. Top_Fed_07_book.indb /15/2006 2:41:20 PM

61 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.29 EXAMPLE Business X has asset M-1 that it wants to exchange for like-kind property to avoid tax on the gain otherwise due from a cash sale. X transfers the property to QI. QI finds property M-2 owned by T who wants a cash sale. QI sells Asset M-1 to Z for cash, uses the cash to buy M-2 from T, then transfers M-2 to X. Exchanges structured through a QI will be treated as if the QI were not the agent of the taxpayer. Therefore, money or other property received by the QI before the QI receives replacement property will not be treated as money or other property received by the taxpayer. Instead, the taxpayer s transfer of relinquished property and subsequent receipt of replacement property will be treated as an exchange, and the determination of whether the taxpayer is in actual or constructive receipt of money or other property is made as if the QI were not the agent of the taxpayer. Requirements for Exchanges Structured Through QIs Transactions structured through QIs must meet several requirements in order to qualify for this safe harbor treatment: The QI must not be the taxpayer or a disqualified person; The QI must enter into a written agreement with the taxpayer under which the taxpayer s right to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the QI are expressly limited; and The QI must acquire relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer as required by the agreement. Disqualified Persons for QI Qualified Trustees and Escrow Agents Not just anybody can serve as a QI trustee or escrow agent. Specifically, taxpayers employees, attorneys, accountants, investment bankers or brokers, and real estate agents or brokers are disqualified if they have worked for the taxpayer within two years prior to the exchange. Not disqualified are bankowned exchange companies from which the taxpayer has received banking services from the parent bank and financial institutions, title insurance companies, and escrow companies that have provided routine financial, title, escrow, or trust services for the taxpayer. Potential bad news on QI escrow accounts. The QI usually holds the funds from the exchange in an escrow or a similar account. The IRS has issued proposed regulations on the tax consequences for these accounts (REG , REG ). The reaction from taxpayers has not Top_Fed_07_book.indb /15/2006 2:41:20 PM

62 2.30 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE been favorable for the most part; the IRS has promised to consider these viewpoints before finalizing the rules, probably sometime in late Under the prior regulations, the taxpayer who transferred property was the owner of the assets in a qualified escrow or qualified trust account, and the taxpayer had to take into account all items of income, deductions, and credits of these accounts. However, if under all facts and circumstances, the QI had the beneficial use and enjoyment of the assets, the QI was deemed to be the owner. Impact. Practitioners have commented that the proposed regulations will increase the overall cost of engaging in like-kind exchanges because QIs will have to pay taxes on the earnings from the amount of interest deemed loaned to the QI, increasing their costs in a business with a tight profit margin to begin with. Some practitioners and senators further believe this will have a negative effect, especially on small businesses. REVERSE EXCHANGES A reverse exchange is a qualifying like-kind exchange in which the qualifying property acquired in the exchange is obtained before the taxpayer relinquishes its own property. These transactions, also called reverse Starker exchanges after the case that first approved them, are spared the need to follow all the deferred exchange rules if they themselves follow separate reverse exchange safe harbor rules. In 2000, the IRS created a safe harbor for these reverse exchange transactions. The safe harbor is not the only way reverse exchanges can be accomplished, but it provides for a sure way to accomplish a reverse exchange that the IRS will allow. Reverse Exchange Safe Harbor In 2000, the IRS created a parking safe harbor for reverse exchanges (Rev. Proc ). It allows taxpayers to park the acquired asset with a third party through a qualified exchange accommodation agreement (QEAA). In essence, the taxpayer gives a third party called an exchange accommodation titleholder (EAT) beneficial ownership of the property while the taxpayer finds a company willing to purchase the asset and make an exchange. The taxpayer transfers its property by exchanging assets tax-free with the EAT within 180 days of the parking transaction, and the EAT transfers the relinquished property to the second company. Sometimes, the taxpayer and the EAT exchange property before the taxpayer has found a new company to take the relinquished property. Rules for Reverse Exchange Safe Harbor. In order for a reverse exchange to qualify for safe harbor treatment, the following requirements must be met: Top_Fed_07_book.indb /15/2006 2:41:20 PM

63 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.31 Indicia of ownership qualified indicia of ownership must be held by an EAT from the date of acquisition until the property is transferred; Bona fide intent the taxpayer s bona fide intent at the time the property is transferred to the EAT must be that the property be used as either replacement or relinquished property in a nonrecognition exchange; Written agreement there must be a concluded written agreement within five days of the transfer to the EAT. The agreement, which is the QEAA, must provide that: The EAT holds the property on behalf of the taxpayer, The transfer is intended to be a like-kind exchange, The EAT will report the acquisition, holding, and disposition of property, The EAT will be the beneficial owner for tax purposes, and Both parties will report the tax attributes of the property in a manner consistent with the QEAA; Identification the relinquished property must be identified within 45 days after the transfer of the qualified indicia of ownership; Transfer a transfer of property to the taxpayer as replacement person or to a person as relinquished property must be made within 180 days after transfer of the qualified indicia of ownership is transferred to the EAT; and Timing property can only be held in a QEAA for 180 days, measured by the combined period that the replacement and relinquished property are held in a QEAA (TRC SALES: 30,614, Richard Lipton, The State of the Art in Like-Kind Exchanges, Journal of Taxation, p.15 (Mar 2006)). Narrowing the Safe Harbor The IRS found some taxpayers were abusing the reverse exchange safe harbor. The IRS was mostly concerned with the scenario in which a taxpayer transfers its own property to the EAT and lends money to the EAT to improve the property. Then, the taxpayer exchanges a like-kind asset for the improved property. The EAT then sells the property and use the proceeds to pay back the taxpayer s loan. To curtail this kind of abuse, the IRS narrowed the safe harbor with Rev. Proc , which states that the safe harbor does not apply to taxpayers who use property they owned before the exchange as replacement property. PARTNERSHIPS The use of the like-kind rules within the context of partnerships has become another hot corner in the like-kind exchange area, both for uncovering new opportunities and for spawning IRS resistance. Drop and swap, special allocations, step transactions, and cash outs have all become part of the highly specialized vocabulary adopted to work through the issues created in this area. Top_Fed_07_book.indb /15/2006 2:41:20 PM

64 2.32 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Drop and Swap Transactions Drop and swap transactions are common in dissolving partnerships. Because partnership interests are ineligible property for nonrecognition treatment in a like-kind exchange, partnerships may want to engage in drop and swap transactions in order to get rid of their assets in a like-kind exchange. In these transactions, the partnership typically distributes property to the partners, who then want to use the property they receive in a like-kind exchange. Held for problem. The main issue with drop and swap transactions is that they may not meet the held for productive use or investment requirement because the immediate exchange of the received dropped property highlights an intent not to hold the property for a required purpose. Step transaction problem. Another problem that may arise with exchanging property immediately after or before the property is held by a partnership is use by the IRS of the step transaction doctrine to invalidate the transaction. This would most likely happen in a drop/swap and return transaction, i.e., the case of an individual who receives property from a partnership, exchanges the property for similar property, and then contributes the new property back to the partnership. The step transaction doctrine views the separate steps of a transaction as interdependent parts of an overall plan and treats them as a single transaction. In a drop/swap and return transaction, the IRS may argue that the taxpayer started and ended with an interest in a partnership, thus disallowing the exchange. PRACTICE POINTER As an alternative to distributing property to the partners and immediately exchanging the distributed property, former partners may want to hold the acquired property in a tenancy in common for a time period before exchanging it in order to qualify for nonrecognition treatment. There is no bar to like-kind exchanges of co-tenancy interests, but the tenancy in common must not be structured as a partnership. Cash-out Transactions A common problem shared by many real estate partnerships occurs during a partnership dissolution, when some partners want to cash out while others want to use part of the assets in a like-kind exchange. One solution is to sell the real estate owned by the partnership and use some of the proceeds to engage in a like-kind exchange and the other portion to pay the partners that want to cash out. However, these transactions may result in all the partners recognizing gain. Top_Fed_07_book.indb /15/2006 2:41:21 PM

65 MODULE 1 CHAPTER 2 Like-Kind Exchanges 2.33 EXAMPLE Anna, Barbara, Christopher, and David are equal partners in ABCD partnership. ABCD partnership owns one asset, Blackacre, a commercial building. A buyer has offered to purchase Blackacre and although all the partners want to sell the building, Anna and Barbara want to cash out while Christopher and David want to exchange their portions for like-kind property. If the property is sold to the buyer and half of the proceeds are placed with a QI who will facilitate a deferred exchange and the rest is given to Anna and Barbara, the partnership will have to recognize gain to the extent of the amount given to Anna and Barbara as boot. Special allocations. Partnerships may choose to perform special allocations in order to allocate the gain to the partners that want to cash out and none to the ones who want to continue their investment. A big problem with special allocations, however, is that they may fail the substantial economic effect test. In other words, rules related to partnerships may frustrate what may otherwise be allowed under the like-kind exchange rules. Allocations that are not in proportion to a partner s interest in a partnership must have a substantial economic effect to be respected. Because the special allocation of gain to the cashed out partners will be reflected in those partners capital accounts, the transaction may not be respected by the IRS, and the result will be that the gain will be allocated among all the partners. Redemptions. As an alternative, the partnership can redeem the interests of the partners that want to cash out and, after the redemption, engage in a like-kind exchange. The partnership will then consist only of the partners that want to reinvest and the held for requirement will be met because the partnership will have held the property before and after the redemption. Installment notes. Another option for partial cash-out transactions is for the partnership to exchange the relinquished property for replacement property and an installment note that extends for several years. The installment note would constitute boot, which is recognized under the like-kind exchange rules. However, the installment notes rule allows for gain recognized in a like-kind exchange to be postponed because, under the installment rules, payments are taxed in the year of receipt. Therefore, if at least one payment is due after the year in which the exchange occurs, the taxpayer can defer the gain under the installment rules. Top_Fed_07_book.indb /15/2006 2:41:21 PM

66 2.34 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE STUDY QUESTIONS 13. Parking transactions allow exchange accommodation titleholders beneficial ownership of property in reverse exchanges if the taxpayer has: a. Not owned the property for longer than 180 days b. Not received the acquired property yet c. Has signed a written QEAA with the EAT and given the EAT qualified indicia of ownership d. Not made the EAT the beneficial property owner for tax purposes 14. Which of the following is not a requirement for an exchange accommodation titleholder that must be specified in writing in the QEAA? a. The EAT will be the beneficial property owner for tax purposes b. The EAT will report the acquisition, holding, and disposition of the property c. The property owner will continue to hold the property during the term of the QEAA d. Both parties will report the tax attributes of the property consistently with the terms of the QEAA 15. In drop and swap like-kind exchanges of partnerships, installment notes constitute: a. Capital gains b. No taxable transaction c. A disqualifier for nonrecognition of the transaction under likekind regulations d. Boot CONCLUSION Like-kind exchanges have become common transactions for investors and businesses as a way to continue their investments without recognizing gain. However, as the popularity of like-kind exchanges has increased and taxpayers have experimented with different ways to fit transactions into the likekind exchange mold, the rules have become more specific and detailed. Taxpayers should follow the rules closely and comply with the IRS s specifications as rigorously as possible to ensure that their transactions will not ultimately be taxed. The price for making a mistake is a hefty one immediate and total recognition of gain. The benefits of success, however, are equally of high stakes deferral of a significant amount of tax that can instead be reinvested into a taxpayer s business or portfolio. Top_Fed_07_book.indb /15/2006 2:41:21 PM

67 3.1 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction This chapter explores the small business expensing deduction for business or trade property under Code Sec The chapter outlines which taxpayers and what types of property qualify to claim this deduction, the maximum deduction available, and the special requirements for enterprise zone and renewal community business property. Descriptions of how taxpayers may elect or revoke the deduction, as well as how and why the deduction amount may be subject to recapture, round out the discussion of how small and many midsized organizations can use this tax break opportunity to write off the costs of business assets. LEARNING OBJECTIVES Upon completion of this chapter, you will be able to: Distinguish qualifying from ineligible property for claiming the Code Sec. 179 deduction; Understand the deduction phaseout amounts and inflation adjustments for 2006 and beyond; Apply exceptions to the general limitations for enterprise zone, GO Zone, and renewal community businesses; Calculate the basis adjustments for partnership interests affected by the Code Sec. 179 cost allocations; Understand how to elect and revoke the deduction; and Calculate the recapture amount for property used less than the minimum percentage required for business use. INTRODUCTION Taxpayers can elect to recover all or part of the cost of certain qualifying property, up to a limit, by deducting it in the year it is placed into service. The Code Sec. 179 small business expensing deduction enables many businesses to deduct the entire cost of their depreciable property during the tax year in which it is purchased and placed in service. The purpose behind this tax break is two-fold: simplification and to act as an incentive. It avoids the complicated process of computing regular depreciation deductions using the MACRS system. It also encourages capital investment by small businesses through accelerating their depreciation deductions all into the initial year of purchase. An ancillary benefit is that the expense deduction is fully allowed for alternative minimum tax (AMT) purposes. Top_Fed_07_book.indb /15/2006 2:41:21 PM

68 3.2 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Normally, a taxpayer cannot take a current business deduction for the entire cost of a capital asset in the year it is purchased because the asset s usefulness to the business will extend beyond that initial year. Generally, expenditures for capital assets must be capitalized and not immediately deducted. Code Sec. 179 is an important exception to this rule. Since the deduction s introduction in 1997, Congress has repeatedly enhanced and extended it to encourage businesses to invest in new equipment and grow the economy. Special treatment applies to property placed in service in the New York City Liberty Zone, the Gulf Opportunity (GO) Zone, and other areas. These enhancements have helped to make the Code Sec. 179 expensing deduction more valuable than ever. At the same time, however, a word of caution for business taxpayers is necessary. The enhancements are complex and require careful and strategic tax planning. REMINDER The Code Sec. 179 small business expensing deduction is an election that taxpayers must choose to take. Sometimes, as explained later in this chapter, it may be more beneficial not to elect to take the deduction. WHO CAN CLAIM THE DEDUCTION? Anyone in business other than trusts, estates, and certain noncorporate lessors can claim the deduction. Lessors of qualifying depreciable property that are treated as the owners of the property for federal income tax purposes are eligible for the Code Sec. 179 deduction provided they hold the property as part of an active trade or business and not merely for investment purposes. COMMENT Although the Section 179 deduction is also known as the Section 179 small business deduction, it is not technically limited to be claimed by small businesses. However, because the deduction begins to be phased out if qualifying purchases exceed $430,000 for the year (inflation-adjusted as of 2006), usually only small businesses qualify. A noncorporate lessor is only eligible for the Code Sec. 179 deduction if: The lessor manufactured or produced the property that is subject to the lease; or The lease term was less than 50 percent of the useful life of the property and the trade or business expenses generated by the property in its first 12 months of use exceeds 15 percent of the rental income produced by the property. Top_Fed_07_book.indb /15/2006 2:41:21 PM

69 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction 3.3 QUALIFYING PROPERTY For a taxpayer to take the Code Sec. 179 deduction, the property must meet the following requirements: It must be eligible property (described next); It must be acquired for business use (see Property Acquired Partially for Business Use ); and It must have been acquired by purchase (see Property Acquired by Purchase ). Eligible Property Only certain assets are eligible for the Code Sec. 179 expensing deduction. The property may be purchased new or used. However, the property must be one of the following types of depreciable property. Tangible personal property. Code Sec tangible personal property is any tangible property but not real property. This includes: Machinery and equipment; Property contained in or attached to a building (refrigerators, grocery store counters, office equipment, printing presses, testing equipment, and signs); Gasoline storage tanks and pumps at retail service stations; Livestock, including horses, cattle, hogs, sheep, goats, and mink and other furbearing animals; Off-the-shelf computer software, but is required to be: Readily available for purchase by general public; Subject to nonexclusivity license; and Not substantially modified. Software includes programs designed to cause a computer to perform a desired function. The software must be placed in service in tax years beginning in 2003 through CAUTION Databases or similar products are not included, unless they are in the public domain and incidental to the operation of otherwise qualifying software. Other tangible property. Other tangible property included in Code Sec tangible property is property that is used as: An integral part of manufacturing, production, or extraction of furnishing transportation, communication, electricity, gas, water, or sewage disposal services; Top_Fed_07_book.indb /15/2006 2:41:21 PM

70 3.4 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE A research facility used in connection with any of the activities listed above; or A facility used in connection with any of the activities listed above for the bulk storage of fungible commodities. Farm structures. Single-purpose agricultural or horticultural structures are considered Code Sec property. Storage facilities. Code Sec property includes storage facilities used in connection with distributing petroleum or any primary product petroleum. COMMENT Software includes programs designed to cause a computer to perform a desired function. The software must be placed in service in tax years beginning in 2003 through COMMENT An item determined to be real or tangible property is not controlled by local law, such as fixture laws. Property Acquired Partially for Business Use Property may be acquired for partial use in trade or business. However, the property must be used a minimum of more than 50 percent for business in the year placed in service. If used for more than 50 percent, the deduction is prorated by multiplying the cost of property by the percentage of use. EXAMPLE Sarah bought and placed into service Code Sec. 179 property that cost $11,000. She used the property 80 percent of the time for business and 20 percent of the time for personal uses. Her cost for the business use of the property is $8,800 (80 percent $11,000). COMMENT Property that is acquired for personal use and then converted to business use by a client does not qualify for Code Sec. 179 treatment. Top_Fed_07_book.indb /15/2006 2:41:22 PM

71 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction 3.5 CAUTION Property that is only used for production of income through investments or rental property and property that produces royalties do not qualify for the Code Sec. 179 small business expense deduction. Property Acquired by Purchase The property must be acquired by purchase. The rules define purchase broadly to include all acquisitions except if: Property is acquired by a related party, including one member of a controlled group from another member of the same group; or The property s basis is determined: In whole or in part by its adjusted basis in the hands of the person from whom it was acquired (a gift), or Under the stepped-up basis rules for property acquired from a decedent (inheritance). EXAMPLE Lori is a fashion designer and bought two industrial sewing machines from her father. She placed both of the sewing machines into service the same year she purchased them. Lori is unable to take a Code Sec. 179 deduction because she and her father are related persons. COMMENT Property that is acquired in a deemed asset acquisition under Code Sec. 338 is eligible for expensing. STUDY QUESTIONS 1. Property acquired for personal use and then converted to business use by a client: a. Qualifies for the full Code Sec. 179 deduction b. Qualifies for the deduction prorated from the year of acquisition until the year of conversion c. Qualifies for deducting half of the fair market value of the property d. Does not qualify for the Code Sec. 179 deduction Top_Fed_07_book.indb /15/2006 2:41:22 PM

72 3.6 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 2. All of the following are types of property qualified for the Code Sec. 179 deduction except: a. Code Sec. 338 deemed asset acquisitions b. Code Sec tangible personal property c. Tangible property leased to the taxpayer d. Partial-use property NOTE Answers to Study Questions, with feedback to both the correct and incorrect responses, are provided in a special section beginning on page SPECIFIC PROPERTY THAT DOES NOT QUALIFY Some types of property will not qualify under any circumstance. The most important property within this disqualified group includes land and land improvements. Land and Land Improvements Generally, land and land improvements do not qualify for expensing because the improvements are usually considered Code Sec real property. Examples are buildings; permanent structures and their components; swimming pools; paved parking areas; wharves; docks; bridges; and fences. Excepted Property Even if all other requirements are met, taxpayers are still unable to take a Code Sec. 179 deduction for: Certain property leased to others (if a noncorporate lessor); Certain property used predominately to furnish lodging or in connection with the furnishing of lodging; Air conditioning or heating units; Property used predominately outside of United States; Property used by certain tax-exempt organizations, unless the tax on unrelated business income applies; and Property used by government units or foreign persons or entities (unless subject to a short-term lease). Leased property. Taxpayers generally cannot claim a deduction for the cost of property that is leased to someone else. Taxpayers are exempted from this rule, however, if the: Top_Fed_07_book.indb /15/2006 2:41:22 PM

73 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction 3.7 Taxpayer manufactured or produced the property and then leased it to others; or The property was purchased and leased to others: With a lease term that is less than 50 percent of the class life; and For the first 12 months after the property is transferred to the lessee, the total business deductions allowed on the property (other than rents and reimbursed amounts) are more than 15 percent of the rental income from the property. Property used for lodging. Taxpayers usually cannot claim a Code Sec. 179 deduction for property that is used predominately to furnish lodging except for: Nonlodging commercial facilities that are available to those not using the lodging facilities on the same basis as it is available to those using the lodging facilities; Property used by a hotel or motel in connection with the trade or business of furnishing lodging where the predominant portion of the accommodations is used by transients (living quarters of which more than half are rented for periods of 30 days or less are not considered lodging facilities); Any certified historic structure to the extent its basis is due to qualified rehabilitation expenditures; or Any energy property. Energy property for purposes of being allowed a 179 deduction even though connected with use for lodging is defined as: Equipment that: (a) uses solar energy to generate electricity, to heat or cool a structure, to provide hot water for use in a structure, or to provide solar process heat; (b) is acquired after December 31, 2005, that uses solar energy to illuminate the inside of a structure using fiber optic distributed sunlight; (c) is used to produce, distribute, or use energy derived from a geothermal deposit; or (d) is qualified fuel cell property or qualified microturbine property acquired after December 31, 2005; Property, the construction, reconstruction, or erection of which must be completed by the taxpayer; Property, the original use for which must begin with the taxpayer; and Property meeting the performance and quality standards, if any, prescribed by regs in effect at the time the property is acquired. CAUTION If the purchase also qualifies for an energy credit, the amount of that credit reduces the basis of the qualifying property for purposes of claiming a Code Sec. 179 deduction on the remainder of the cost basis. Top_Fed_07_book.indb /15/2006 2:41:22 PM

74 3.8 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE STUDY QUESTIONS 3. Property that is not excepted from being eligible for the Code Sec. 179 deduction includes: a. Property that the taxpayer manufactured, then leased to another party b. Property used under long-term leases by government units c. Property used primarily outside of the United States d. Air conditioning units 4. To qualify as energy property for the Code Sec. 179 deduction, property must: a. Have been acquired prior to December 31, 2005, if it is a fiber optic sunlight indoor illumination system b. Be equipment used for the electrical transmission stage of geothermal power c. Be put to its original use beginning with the taxpayer claiming the deduction d. None of the above qualifies as energy property HOW MUCH CAN TAXPAYERS DEDUCT? The cost of the qualifying property is generally the amount of the deduction. However, the total amount a taxpayer can deduct is subject to dollar limits, investment limits, and a business income limit. The Code Sec. 179 deduction applies to each taxpayer and not to each business. Therefore, taxpayers with multiple businesses or sources of income must evaluate which qualifying property they will elect to expense for that year. CAUTION Special rules apply to married couples, partnerships, S corporations, and opportunity zones, as explained later in this chapter. REMINDER If a taxpayer is only able to deduct a portion of the property s cost, the taxpayer can depreciate the remainder under normal depreciation rules to recover the cost of the property. When a business acquires property through a trade-in of other property, the cost of the purchase will only be the cash that is paid. In other words, Top_Fed_07_book.indb /15/2006 2:41:22 PM

75 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction 3.9 if the taxpayer buys qualifying property with cash and trades in other property, its qualifying cost, for purposes of the Code Sec. 179 deduction, is only the cash paid. EXAMPLE Jamie traded in his old drafting table worth $800, plus $520 in cash, for a new drafting table valued at $1,320. He also traded a used truck, with a basis of $4,500, for a new truck that cost $9,000 based on a $4,800 trade-in allowance and $4,200 cash. Because only cash qualifies when determining cost under Code Sec. 179, Jamie was only able to deduct a total cost of $4,720 ($520 + $4,200) for the qualifying property. Dollar Limits For each tax year, the Internal Revenue Code sets, by way of an inflation formula, the total dollar amount of Code Sec. 179 property placed in service during that particular tax year that can qualify for the Section 179 deduction. For 2006, that amount is $108,000. In addition, a taxpayer that purchases too much Section 179-type property within the course of one year (i.e., more than a certain dollar maximum) must reduce the otherwise allowable Section 179 deduction under phaseout rules, which could reduce the deduction to zero. Table 1 shows the maximum dollar amount that can be taken as a Section 179 deduction. Table 1. Maximum Deduction by Tax Year Tax Year Deduction Allowed 1997 $18, $18, $19, $20, $24, $24, $100, $102, $105, $108, $100,000 + inflation adjustment $25,000 (no inflation adjustment) For 2007, the inflation-adjusted deduction limit is projected to rise to $112,000. Top_Fed_07_book.indb /15/2006 2:41:22 PM

76 3.10 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE NOTE The Section 179 deduction has been extended several times in its short history. The latest extension took place in the Tax Increase Prevention and Relief Act (TIPRA), passed in Without that extension, the expensing limit would have dropped to $25,000 on a $200,000 cap after Before passage of that tax bill, the American Jobs Creation Act of 2004 (AJCA) had extended for 2006 and 2007 an increase in the deduction introduced by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). Taxpayers can acquire and place into service more than one item of qualifying property during a tax year, but the maximum deduction applies to the total of all qualifying property purchased. Taxpayers have the opportunity to allocate the Code Sec. 179 deduction in any way among qualifying property in reducing basis, but the deduction cannot exceed the limit. Additionally, taxpayers are not required to claim a deduction valued at the entire limit. COMMENT The amount that is elected to be deducted is not affected if the taxpayer places the qualifying property into service in a short tax year or if the taxpayer places the qualifying property in service for only a part of a 12-month tax year. In this instance, the full dollar limitation may be expensed (subject to investment limitation and taxable income limitation) in a short tax year. CAUTION Although the dollar limit is used to determine the tentative deduction, the taxpayer must also apply the investment limitation and the business income limit to determine the actual Code Sec. 179 deduction. EXAMPLE In 2006, Albert bought and placed into service a tractor that cost $110,000 and a circular saw that cost $2,000. He elected to deduct $106,000 of his tractor s cost and $2,000 of the circular saw s cost for the maximum dollar limit for 2006, equaling $108,000. Because Albert elected to deduct $2,000 for the circular saw, he was able to completely recover its cost, making its basis for depreciation zero. However, he was unable to deduct the entire cost for the tractor, so he had a remaining basis of $4,000 ($110,000 $106,000) that he will then be able to depreciate under normal depreciation rules. Top_Fed_07_book.indb /15/2006 2:41:23 PM

77 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction 3.11 PLANNING POINTER Taxpayers should consider allocating the Code Sec. 179 expense to property with the longest recovery period. For example, if an item of qualifying 10-year MACRS-type depreciable property and qualifying 5-year MACRS property is placed in service, the Code Sec. 179 deduction should be allocated to the 10-year property. This will allow for the cost of property to be recovered in the shortest period of time. Investment Limitation Taxpayers can have too much of a good thing as far as Code Sec. 179 property is concerned. Phaseout. The Code Sec. 179 deduction phases out as the cost of the Section 179 property purchased and placed in service for the year increase over a certain maximum dollar amount. The deduction in excess of this overall threshold is reduced on a dollar-for-dollar basis. The limitation amount was $400,000 in 2003, after which it is increased each year by an inflation amount. In 2006, that amount is $430,000. It sets the maximum for the Section 179 deduction regardless of whether the taxpayer chooses to take the full deduction. For example, if the cost of six items of qualifying property in 2006 totals more than $430,000, the taxpayer s maximum $108,000 Section 179 deduction must be reduced dollar-for-dollar for the total dollar amount of Section 179 qualifying property that exceeds $430,000. The taxpayer must reduce the dollar limit (but not below zero) by the amount of the cost exceeding $430,000. As a result, the taxpayer s available $108,000 Section 179 deduction is reduced to zero if the total amount of Section 179 purchased and placed in service for 2006 exceeds $538,000. Note, further, that if the taxpayer exceeds the limit because of the acquisition of several items of qualifying property during the course of the year, the taxpayer may choose how to divide among the property the total reduction of the Section 179 deduction. Generally, taxpayers chose to take the maximum deduction on the property with the shortest depreciable class life in order to accelerate overall deductions as much as possible. Table 2 lists the investment limits for tax years 2000 and beyond. Top_Fed_07_book.indb /15/2006 2:41:23 PM

78 3.12 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Table 2. Investment Limits for Claiming Full Code Sec. 179 Deduction by Year Tax Year Investment Limit 2000 $200, $200, $200, $400, $410, $420, $430, $400,000 + inflation adjustment $200,000 (no inflation adjustment) For 2007, the inflation-adjusted investment limit is projected to rise to $450,000. EXAMPLE In 2005, Karen placed into service a printer costing $495,000. Because the cost of the printer was more than $430,000, she had to compute the excess amount, which is $495,000 $420,000 = $75,000. She then had to take the 2005 dollar limit of $105,000 and reduce it by the excess amount of $75,000, which reduced her total dollar limit for taking the Code Sec. 179 deduction in 2005 to $30,000 ($105,000 $75,000). The rest of her otherwise qualifying costs had to be depreciated over the life of the printer (generally, five years). The purpose of the investment limit used to reduce the dollar limit is to keep the benefits of the deduction focused primarily on the small business. The investment limitation is also adjusted for inflation. Any unused portion of the dollar limit may not be carried forward. Therefore, tax planning helps in delaying certain Section 179 property purchases into a subsequent year when the taxpayer s expenses exceed the $400,000-plus-inflation limit for the current year. Inflation adjustments. Both the dollar limit and the investment limit for tax years beginning after 2003 and before 2010 are adjusted for inflation. Remember, also, that the Section 179 deduction itself is all about inflation in the sense of accelerated deductions. If the Section 179 deduction is taken, depreciation deductions for that Section 179 amount that would have otherwise been taken over the asset s remaining useful life are lost. Based on the assumption that it is better to take a deduction sooner, the Section 179 deduction is better. As with most generalizations, this is not always the case. An immediate deduction is useless (or not as useful) if the business has overall losses, if the Top_Fed_07_book.indb /15/2006 2:41:23 PM

79 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction 3.13 business will be in a higher tax rate in future years, if a cashout through an sale of the business is anticipated or other similar circumstances are expected. In such circumstances, going against the norm might be advisable. Special Situations Congress has allowed for special situations that affect the dollar limits for certain taxpayers. Two of the situations relate to disasters: Liberty Zone expensing put in place after 9/11 and GO Zone expensing created after Hurricane Katrina devastated the Gulf Coast. Liberty Zone. Legislation has increased the Code Sec. 179 deduction dollar limit for property that is placed in the New York Liberty Zone (Liberty Zone). The dollar limit is the lesser of: $35,000; or The cost of the qualified Liberty Zone property. COMMENT The Liberty Zone is the area proximate to the former World Trade Center, located on or south of Canal Street, East Broadway (east of its intersection with Canal Street), or Grand Street (east of its intersection with East Broadway) in the Borough of Manhattan in New York City. The property must be qualified Liberty Zone property. Property placed in service in the Liberty Zone before January 1, 2007, is available for this deduction. Taxpayers calculating this deduction should only include 50 percent of the cost of Liberty Zone property when calculating the investment limit ($430,000 for 2006). Enterprise zone and renewal community businesses. Congress has also allowed for the annual dollar limit to be increased for property placed in enterprise zone businesses and for renewal community businesses. To qualify, the property must be placed within these zones. Therefore, the dollar limit on Code Sec. 179 deduction will be increased if the business qualifies. It will be the lesser of: $35,000; or Cost of 179 property that is also qualified zone property. In addition, only 50 percent of the cost of the qualified property placed in service by the enterprise zone or community renewal business during the tax year is taken into account for purposes of applying the inflation-adjusted investment limitation ($430,000 for 2006). In 2002, the annual dollar limitation for Code Sec. 179 property that is enterprise or renewal zone property was $59,000 ($24,000 + $35,000). This Top_Fed_07_book.indb /15/2006 2:41:23 PM

80 3.14 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE amount rose in 2003 to $135,000; in 2004 to $137,000; and in 2005 to $140,000. In 2006, it is $143,000. Gulf Opportunity (GO) Zone property. In areas that the Federal Emergency Management Agency (FEMA) has declared to be a disaster area after Hurricane Katrina, Congress has designated an increased Code Sec. 179 dollar limit for property placed into service. This applies to all qualified Code Sec. 179 property that is acquired after August 27, COMMENT IRS Publication 4492, Information for Taxpayers Affected by Hurricanes Katrina, Rita and Wilma, contains a complete list of the areas that have been designated for assistance by FEMA. The GO Zone increased dollar limit is the smaller of: $100,000; or The cost of qualified Code Sec. 179 GO Zone property placed in service during the year (including such property placed in service by your spouse, even with a separate return). In addition to an increased dollar limit, Congress has provided for an increased investment limit for GO Zone property. As under the regular Section 179 deduction rules, the amount a taxpayer can take under an election that includes GO Zone property is reduced if the cost of all Code Sec. 179 property placed in service exceeds that year s investment limit. The limit will be increased by the smaller of $600,000 (adjusted for inflation) or the cost of qualified Code Sec. 179 GO Zone property placed in service during the year. Code Sec. 1400N requires that substantially all of the property must be used in the GO Zone. The IRS clarified this requirement to mean that the property must be used at least 80 percent during each tax year in the GO Zone. The property also must be used in the active conduct of a trade or business by the taxpayer. Notice elaborates that active conduct can be determined by applying a facts and circumstances test. Active conduct requires the meaningful participation in the management or operations by the taxpayer. Property generally restricted from the enhanced GO Zone deduction includes that used in connection with a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, liquor store, or gambling or animal racing property, with certain de minimis exceptions. Sport utility and other vehicles. Taxpayers cannot elect to expense more than $25,000 of the cost of a sport utility vehicle (SUV) placed in service during the tax year. This limit applies to any four-wheel drive vehicle that is designed to carry passengers over public streets, roads, or highways that Top_Fed_07_book.indb /15/2006 2:41:23 PM

81 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction 3.15 weighs more than 6,000 pounds but less than 14,000 pounds. The $25,000 limit does not apply to: Vehicles designed to hold more than nine passengers behind the driver; Vehicles that are equipped with a cargo area that is open or enclosed by a cap, of at least six feet in interior length that is not readily accessible from passenger compartment; or Vehicles that have an integral enclosure fully enclosing the driver compartment and load-carrying device, do not have seating behind the driver s seat, and contains no body section more than 30 inches ahead of the leading edge of the windshield. Married taxpayers. How a married individual can claim the Code Sec. 179 deduction depends on whether he or she files a joint or separate tax return. When taxpayers file jointly, the taxpayer and spouse are treated as one taxpayer for determining any reduction to the dollar limit, regardless of who purchased the property. If the married couple files separate returns, for purposes of the small business expense, the couple will still be treated as one for the dollar limit, including the investment limitation ($430,000 for 2006). The couple must allocate the dollar limit, after the reduction for the investment limitation. Without an affirmative allocation, married taxpayers are each allocated 50 percent of the cost that can be taken into account for the Code Sec. 179 deduction. This allocation occurs regardless of which taxpayer actually paid for and acquired the property. The default allocation will also happen if the sum of the percentages that had been elected by the spouses does not equal 100 percent. EXAMPLE Lisa and Doug are married and file separate returns. Doug bought and placed into service $430,000 of qualified farm machinery in Lisa has her own business, and she bought and placed into service $10,000 of qualified equipment. Doug and Lisa s total cost of qualified property is $440,000 to be placed into service. To calculate their dollar limit, they first need to reduce the cost of property by the amount it exceeds the investment limit ($440,000 of qualified property $430,000 investment limitation = $10,000). Doug and Lisa will then reduce the $108,000 dollar limit by that $10,000 excess over the investment limit. Between the two of them, they can elect to expense $98,000. If they do not choose how to allocate the $98,000, it will be split evenly; however, they have the option to allocate the $98,000 between them any way they see fit. Married couples who file an amended joint return after filing separate returns for the same tax year are limited by the separate annual dollar limitation stated on their separate returns and are subject to the annual dollar limit on the joint return rather than the aggregate amount deducted on the Top_Fed_07_book.indb /15/2006 2:41:24 PM

82 3.16 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE original separate returns. Additionally, taxpayers who file separate returns and choose to deduct less than the maximum amount may not subsequently increase the aggregate deduction on a joint return filed for the same tax year, above the total amount originally expensed on their returns. Therefore, when married taxpayers are amending their returns after the due date, the dollar limit on the joint return is lesser of the following: Dollar limit (after the investment deduction); or The total cost of the Code Sec. 179 property the taxpayer and spouse elected to expense on separate returns. EXAMPLE Joan and Greg, who are both calendar year taxpayers, purchase and place into service $10,000 worth of Code Sec. 179 qualifying property for the direct expense deduction. Joan and Greg file separate income tax returns for Joan decided to expense $3,000 of the property on her return and Greg decided to expense $2,000 on his return and depreciate the balance. After the due date of their separate returns passes, both Joan and Greg decide to file an amended return using the joint filing status. Joan and Greg, on their joint return, can only elect to expense $5,000. COMMENT A special rule allows a taxpayer to revoke or change an election made with respect to property placed in service in a tax year beginning in 2003 through 2009 if the limitations period for filing an amended return has not expired. PLANNING POINTER Presumably, Joan and Greg in the above example taxpayers could avoid the limitation result by amending their returns to claim a combined deduction of $10,000. Married taxpayers who file separate returns are treated as separate taxpayers for purposes of determining the taxable income limitation. However, married taxpayers who file joint returns, including those who elect to file a joint return after filing separate returns, must aggregate the taxable income of both spouses when applying the taxable income limitation. Business Income Limit The total cost a taxpayer can deduct each year after the dollar limit is taken into account is limited to the taxable income from the active conduct of Top_Fed_07_book.indb /15/2006 2:41:24 PM

83 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction 3.17 any trade or business during the year. This must be from a meaningful participation in the management or operations of the trade or business. COMMENT Any cost not deductible in one year under Code Sec. 179 because of the business income limitation can be carried forward to the next year. Taxable income. Taxpayers calculate their taxable income for this purpose by totaling their net income and losses from all trades and businesses the taxpayer actively conducted during the year. This total includes: Code Sec gains or losses (for more information see IRS Publication 544); Interest from working capital of the trade or business; Wages, salaries, tips, or other pay earned as an employee; Net profits from active conduct of a sole proprietorship; Net profits from active conduct of real estate rental activity; and Net distribution profit received from passthrough entities in which the client is an active participant. Also, taxpayers should not include any of the following when calculating their taxable income: Code Sec. 179 deduction; Deduction for one-half of self-employment taxes; Any net operating loss carryback or carryforward; Any unreimbursed employee business expenses; and Deductions suspended under any code provision. Corporate taxable income. The aggregate amount of taxable income that is derived from the active conduct of any trade or business by a corporation, not including S corporation income, is the amount of the corporation s taxable income before deducting its net operating loss deduction and special deductions (as they are reported on the corporation s income tax return) adjusted to reflect those items of income or deduction included in that amount that were not derived from any actively conducted businesses. Two different taxable income limits. In case the taxpayer has other taxable income limits for another type of deduction, the taxpayer should follow these steps: 1. Calculate taxable income without the Code Sec. 179 deduction or the other deduction; 2. Calculate a hypothetical Code Sec. 179 deduction using the taxable income figured in Step 1; Top_Fed_07_book.indb /15/2006 2:41:24 PM

84 3.18 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 3. Subtract the hypothetical Code Sec. 179 deduction figured in Step 2 from the taxable income figured in Step 1; 4. Calculate a hypothetical amount for the other deduction using the amount figured in Step 3 as taxable income; 5. Subtract the hypothetical other deduction figured in Step 4 from the taxable income figured in Step 1; 6. Calculate the actual Code Sec. 179 deduction using the taxable income figured in Step 5; 7. Subtract the actual Code Sec. 179 deduction figured in Step 6 from the taxable income figured in Step 1; 8. Calculate the actual other deduction using the taxable income figured in Step 7. EXAMPLE On February 1, 2006, ABC Corporation purchased and placed into service qualifying Code Sec. 179 property that cost $108,000. It elects to expense the entire $108,000 cost under Code Sec In June, the corporation gave a charitable contribution of $10,000. ABC Corporation s limit on charitable contributions is calculated after subtracting the Code Sec. 179 deduction. The business income limit for Code Sec. 179 deduction is figured after subtracting any allowable charitable contributions. Assume ABC Corporation s taxable income calculated without the Code Sec. 179 deduction or the deduction for charitable contributions is $125,000. ABC Corporation figures its Code Sec. 179 and charitable deduction by following these steps: 1. ABC Corporation s taxable income without either deduction: $125,000; 2. Using this $125,000 as taxable income, ABC Corporation s hypothetical Code Sec. 179 deduction is $108,000; 3. Subtract the hypothetical deduction from taxable income: $125,000 $108,000 = $17,000; 4. Using $17,000 from Step 3 as taxable income. The hypothetical charitable contribution (which is limited to 10 percent of taxable income) is $1,700; 5. Subtract hypothetical charitable deduction from taxable income: $125,000 $1,700 = $123,300; 6. Using $123,300 (from Step 5) as taxable income, ABC Corporation figures the actual Code Sec. 179 deduction. ABC Corporation s taxable income is at least $108,000, the 2006 maximum dollar limit, so ABC Corporation can take a $108,000 Code Sec. 179 deduction; 7. Subtract the actual Code Sec. 179 deduction from Step 6 from the taxable income in Step 1: $125,000 $108,000 = $17,000; and 8. Using $17,000 from Step 7 as taxable income, ABC s actual charitable contribution (limited to 10 percent of taxable income) is $1,700. Top_Fed_07_book.indb /15/2006 2:41:24 PM

85 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction 3.19 EXAMPLE X Corporation, a calendar year taxpayer, elects to expense $10,000 of the cost of qualifying property placed in service in the current year. X also makes a charitable contribution of $5,000. X s taxable income is $11,000. In determining the taxable income under Code Sec. 179, X must first compute its charitable contribution deduction. X s charitable deduction is limited to 10 percent of its taxable income, which is determined by taking into account the Code Sec. 179 deduction. In accordance with the charitable deduction provision, X first computes it hypothetical contribution deduction by assuming its Code Sec. 179 deduction is not affected. Therefore, in computing the hypothetical contribution deduction, X s taxable income under Code Sec. 179 is $11,000 and the Code Sec. 179 deduction is $10,000. The hypothetical charitable contribution deduction is $100 (10 percent ($11,000 $10,000 Code Sec. 179 deduction)). The taxable income limitation for purposes of the Code Sec. 179 deduction is $10,900 ($11,000 $100 hypothetical contribution deduction). X s actual Code Sec. 179 deduction is $10,000 for all purposes of the code, including computation of the actual contribution deduction. Carryover of disallowed deduction. If the amount the taxpayer chooses to expense exceeds the taxable income and consequently is not allowed, the taxpayer can carry over for an unlimited amount of years the cost of the Code Sec. 179 deduction. If the taxpayer places more than one piece of qualifying property in service in that year, the taxpayer can select the property for which the cost will be carried forward, but this selection must be reflected in the businesses books and records. COMMENT Partnerships and S corporations should treat the costs here as one item of Code Sec. 179 property. If a selection is not made, the total carryover will be allocated equally among the properties elected to expense for the year. If costs from more than one year are carried forward to a subsequent year, in which only part of the total carryover can be deducted, the taxpayer must deduct the costs being carried from the earliest year first. COMMENT If the property is sold or otherwise disposed of before the full amount has been used of the carryover, neither the taxpayer nor the new owner can deduct any of the unused amount. The unused amount must be added back into the property s basis. Top_Fed_07_book.indb /15/2006 2:41:24 PM

86 3.20 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE PLANNING POINTER Taxpayers should elect the Code Sec. 179 deduction in a tax year even if there will be no immediate tax benefits resulting in that year, such as a lack of income, to preserve the option to carry forward the deduction. If it is not preserved in this way, the deduction cannot be taken in the future and the taxpayer will be limited to recovering the cost of the property by depreciation only. EXAMPLE In 2005, Good Company places Code Sec. 179 property that has a cost of $100,000 in service. Good Company has a trade or business income in 2005 of $150,000 and has a Code Sec. 179 carryforward of $50,000 from A $100,000 deduction for the property that is placed into service in 2005 is applied first against Good Company s 2005 income, leaving $50,000 in taxable income for The $50,000 carryforward may also be applied against 2005 income, but only to the extent of the $105,000 annual dollar limit the $100,000 deduction taken for the 2005 property, leaving $5000. Remaining carryover of $45,000 ($50,000 $5,000) will be carried forward to 2006 until it is finally used. STUDY QUESTIONS 5. The actual Code Sec. 179 deduction is determined by applying each of the following except: a. Dollar limit of property placed in service during the tax year b. Investment limitation and phaseout c. Business income limitation d. All of the above are applied 6. Most taxpayers will claim the Code Sec. 179 deduction except when: a. They plan to sell their business b. The business will gradually be subject to a higher tax bracket in subsequent tax years c. They are married filing separate returns and one spouse is in a higher tax bracket d. All of the above are circumstances in which taxpayers probably will not make the election Top_Fed_07_book.indb /15/2006 2:41:24 PM

87 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction 3.21 PARTNERSHIPS, S CORPORATIONS, AND OTHER PASSTHROUGH ENTITIES Each taxpayer is entitled to one annual Section 179 deduction limit. Complications arise in figuring the deduction when a business is owned by several individuals, especially if the business is operated as a passthrough entity such as a partnership or S corporation in which profits, losses, and certain tax characteristics are passed through to the owner partners or shareholders. Partnerships and Partners The Code Sec. 179 deduction limits apply both to the partnership and the partners. First, the partnership determines its deduction subject to the limits, then allocates the deduction among the partners. The partnership will first apply the dollar limit, investment limit, and the taxable income limit at the entity level to determine the total deduction that may be allocated among the partners. Each partner will add the amount allocated from partnerships (Schedule K-1, Form 1065, Partner s Share of Income, Deductions, Credits, etc.) to his or her nonpartnership Code Sec. 179 costs and then will apply the dollar limit to the total. When partners are calculating the investment limitation (anything more than $430,000 in 2006), they do not include any cost of Code Sec. 179 property that is placed into service by the partnership. After the dollar limit (for any nonpartnership property) is applied, any remaining cost of partnership and nonpartnership Code Sec. 179 property is subject to business income limit. Partnership s taxable income. A partnership s business income limit is computed by calculating the net income of the aggregate amount of partnership items. The partnership s taxable income is calculated by adding the net income and losses from all of the trade and/or business activity that is conducted by the partnership during the year. Not included are: Credits; Tax-exempt income; Code Sec. 179 deduction; and Guaranteed payments under Code Sec. 707(c). CAUTION Any limitation on the amount of a partnership item that may be taken into account for purposes of computing the taxable income of a partner is disregarded in computing the taxable income of the partnership. Top_Fed_07_book.indb /15/2006 2:41:25 PM

88 3.22 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Carryover of disallowed deductions. Partnerships may carry over Code Sec. 179 deductions disallowed at the partnership level as a result of the taxable income limitation. The basis of qualifying property must be reduced by the Code Sec. 179 amount even if all or a portion of it must be carried forward. COMMENT The general rules for carrying over deductions when the property is disposed of or transferred also apply to partnerships. Partner s share of partnership s taxable income. The taxable income of a partner engaged in the active conduct of one or more of a partnership s trades or businesses includes his or her allocable share of taxable income derived from the partnership s active conduct of any trade or business. EXAMPLE In 2006, AAA partnership placed in service Code Sec. 179 property equaling $455,000. The partnership must reduce its dollar limit because the property is over the $430,000 investment limit ($455,000 $430,000 = $25,000). So the maximum Code Sec. 179 deduction AAA partnership can take is $83,000 ($108,000 $25,000). The partnership elects to expense that amount. Assume that the partnership s taxable income from the active conduct of all its trades or businesses for the year was $100,000, so it can deduct the full $83,000. It allocates $40,000 of its Code Sec. 179 deduction and $50,000 of taxable income to Dan, one of the partners. Dan is also a partner at BBB partnership, which allocated $30,000 of its Code Sec. 179 deduction and $35,000 taxable income from its active conduct of its business. Dan is also a sole proprietor and placed Code Sec. 179 property into service that costs $55,000. For that business he had a $5,000 loss for the year. When calculating his dollar limit, Dan does not have to include Code Sec. 179 partnership costs, so his total Code Sec. 179 costs are not more than $430,000. His maximum Code Sec. 179 deduction is $108,000. Dan chooses to expense all of the $70,000 ($40,000 from AAA and $30,000 from BBB) deduction from partnerships, plus $35,000 from his sole proprietorship. He enters this information into the books. His business income limit however only allows him to take $80,000. He received $50,000 from AAA, $35,000 from BBB, and a loss of $5,000 from his sole proprietorship. Therefore, he can carry over $28,000 of the costs to the next year ($108,000 $80,000). Dan has to note which property deduction will be carried over to the next year in his books and he chooses the property from the proprietorship. Top_Fed_07_book.indb /15/2006 2:41:25 PM

89 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction 3.23 Different tax years. If the partner s tax year and the partnership or other partners tax years are different, the partner s share of the partnership s taxable income for a tax year is generally the partner s distributive share for the partnership tax year that ends with or within the partner s tax year. EXAMPLE Andrew and Barbara are equal partners in AB Company. AB Company uses a tax year that ends January 31. However, A and B use a tax year that ends on December 31. For the tax year that ends January 31, 2006, the partnership s taxable income from active trade or business is $80,000, $70,000 of which was earned in Andrew and Barbara can include $40,000 each (entire share) of taxable income in computing their business income limit for the 2006 tax year. PLANNING POINTER Partnerships (and this could apply as well to S corporations) should take some time to determine the effects of the deduction on the partners before they elect to expense the property. This will avoid wasting the deduction. However, considering the effects on the individual partners can be challenging if there are a lot of partners. If that is the case, the organization should consider not electing to expense any of the property. PLANNING POINTER Partnerships (this reasoning can also apply to S corporations) that will place into service property that will be greater than the applicable phaseout limit should consider having the partners purchase the property themselves and place it into service and then contribute the property to the entity. Adjustments to partners distributable shares and capital accounts could compensate for disproportionate contributions made in this manner. These contributions may be particularly beneficial during the formation or early years of a partnership when it is being formed from a previously existing business or businesses. Adjustment of a partner s basis in partnership. Partners must reduce the basis of their partnership interest by the total amount of Code Sec. 179 costs allocated from the partnership, even if the partner cannot currently deduct the entire amount. A partner may have carryover of a disallowed deduction with respect to expense amounts allocated from the partnership. A partner who is allocated Code Sec. 179 amounts of the partnership must reduce the basis of its partnership interest by the amount allocated, even if all or a portion must be carried forward. However, the carryover is not available to a transferee if the partners dispose of their interest or transfer the partner- Top_Fed_07_book.indb /15/2006 2:41:25 PM

90 3.24 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE ship interest in a nonrecognition transaction (including transfers at death). The basis for determining loss or gain will be increased by any outstanding carryover of disallowed Code Sec. 179 expenses from the partnership. Adjustment of partnership s basis in Code Sec. 179 property. The basis of a partnership s Code Sec. 179 property must be reduced by the Code Sec. 179 deduction elected by the partnership. The reduction of basis must be made even if the partner cannot take all or part of the Code Sec. 179 deduction allocated to that partner by the partnership because of limits. S Corporations For the most part, the rules that apply to partnerships are similar to the rules that apply to S corporations and their shareholders. The deduction limits apply to the S corporation and to each shareholder. The S corporation allocates the Code Sec. 179 deduction to the shareholders, who then take it subject to their own limits. Calculating taxable income for an S corporation. To calculate taxable income (or loss) from the active conduct by an S corporation, shareholders total the net income and loss from all trades or business during the year. The shareholders take into account items from that trade or business that are passed through and used in determining each shareholder s tax liability. The shareholders should not take into account any: Credits; Tax-exempt income; 179 deduction; and Deduction for compensation paid to shareholder-employees. To determine the total amount of S corporation items, one treats deductions and losses as negative income. For calculating taxable income of an S corporation, one disregards any limits on the amount of an S corporation item that must be taken into account when figuring a shareholder s taxable income. Different tax years. The rule that applies to partners regarding different tax years also applies to shareholders. The share of taxable income is generally the share from the S corporation s tax year that ends with or within the shareholder s tax year. STUDY QUESTIONS 7. Partnerships may not carry over Code Sec. 179 deductions that are disallowed at the partnership level because of the taxable income limitation. True or False? Top_Fed_07_book.indb /15/2006 2:41:25 PM

91 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction Which of the following is included in calculating an S corporation s taxable income for purposes of the Code Sec. 179 deduction s business income limit? a. Deduction for shareholder-employee compensation b. Net losses c. Tax-exempt income d. Credits ELECTING THE DEDUCTION Taxpayers must elect to take the Code Sec. 179 expensing deduction. This is done by completing Part I of Form CAUTION If a taxpayer elects a deduction for listed property (for example, a computer), the taxpayer first needs to complete Part V of Form 4562 before Part I is filled out. Listed property includes: Any passenger automobile; Any other property used as a means of transportation; Any property of a type generally used for purposes of entertainment, recreation, or amusement; Any computer or peripheral equipment; and Any other property of a type specified by the IRS. For property that is placed into service in 2006, the taxpayer needs to file Form 4562 with either of the following: Original 2006 tax return (whether or not filed timely); or An amended return 2006 filed within the time prescribed by law. An election made on an amended return must specify the item of Code Sec. 179 property to which the election applies and the part of the cost each such item to be taken into account. The election must also include resulting adjustments to taxable income. REMINDER When taking the Code Sec. 179 deduction, taxpayers must keep records to show the specific identification of each property; how it was acquired; the person from whom the property was acquired; and when it was placed into service. Top_Fed_07_book.indb /15/2006 2:41:25 PM

92 3.26 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE COMMENT Because an election to expense reduces adjusted gross income and taxable income, it may also reduce exemptions and deductions, social security coverage of the self-employed, and certain tax credits in the case of those taxpayers who would have the Section 179 deduction pass through to their personal Form 1040 returns. Revoking an Election For tax years that begin in 2003 through 2009, a taxpayer may fully or partially revoke an election on an amended return. A taxpayer may also elect to expense an asset on an amended return and revoke that election on a later-filed amended return. CAUTION All amended returns must be filed before the expiration of the applicable statute of limitations period for filing an amended return for the tax year that the Code Sec. 179 property was placed in service. Generally, a threeyear statute of limitations period applies, so it would be three years from the due date of the original return. Generally, the revocation is irrevocable. However, for tax years before 2003 and after 2009, an election to expense is revocable only with the consent of the IRS. It must be made by filing Form 4562 with the taxpayer s return (regardless of whether the return was timely) for the tax year that the property was placed into service, or with an amended return that is filed prior to the due date (including extensions) for filing the taxpayer s return. TIMING RECAPTURE OF THE DEDUCTION Taxpayers must recapture the deduction if at any point in the year within its designated depreciable life the use of the property drops to 50 percent or less. Taxpayers should include the recapture amount as ordinary income in Part IV of Form 4797 and increase the basis of the property by the recapture amount. Recapture is only required if the decline in business use occurs during the MACRS recovery period used to depreciate the property or that would have been used to depreciate the property if it had not been fully expensed. Top_Fed_07_book.indb /15/2006 2:41:25 PM

93 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction 3.27 EXAMPLE Laundromat Inc. had a business use of a fully expensed machine that was placed in service in The machine has a seven-year MACRS recovery period. If the business use drops to 40 percent in 2008, which would be after the recovery period would have expired, Laundromat Inc. is not required to recapture any portion of the Code Sec. 179 deduction. COMMENT If property is sold, exchanged, or disposed of, rules for the recapture of depreciation under Code Sec property generally apply. The Code Sec. 179 deduction is treated like a depreciation deduction for purposes of the recapture rules when a depreciable property is sold or otherwise disposed of. The amount of the Code Sec. 179 allowance and any regular MACRS depreciation deductions claimed on that expensed property will be treated under the recapture rules as ordinary income to the extent of gain recognized. The recapture amount is equal to the difference between the amount expensed and the MACRS depreciation that could have been claimed on the expensed amount through the year of recapture. The recaptured amount is added to the basis of the property so that it may be recovered through depreciation deductions during the remaining years in the recovery period. To calculate the recapture amount, taxpayers need to: 1. Compute the depreciation that would have been allowed on the Code Sec. 179 deduction claimed. (Begin with the year the property was placed in service and include the year of recapture); 2. Subtract the depreciation from (1) from the Code Sec. 179 deduction claimed; and 3. The result is the amount that must be recaptured. EXAMPLE In January 2004 Harry, who is a calendar year taxpayer, bought and placed into service Code Sec. 179 property which cost $10,000. The property is not listed property. Harry elected $5,000 for the Code Sec. 179 deduction for the property and also elected not to claim a special depreciation allowance. Harry only used the property for business use in 2004 and In 2006 he used the property 40 percent for business use and 60 percent for personal use. The Code Sec. 179 deduction in 2004 was $5,000. Subtracting the allowable depreciation, 2004: $1,666.50; 2005: $2,222.50; 2006: $ ($ percent business use) gives a total of $4, The 2006 recapture amount is $814.80, which must be included in Harry s income. Top_Fed_07_book.indb /15/2006 2:41:26 PM

94 3.28 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Listed property. If the property is listed property, taxpayers should not calculate the recapture amount under the rules given above when the business use drops to 50 percent or less. Special rules apply when the business use of listed property, like a passenger car or a cell phone, drops to 50 percent or less. The listed property recapture rules require recapturing as ordinary income the difference between (1) the amount expensed and any depreciation deductions claimed prior to the tax year of recapture and (2) the amount of depreciation that could have been claimed using the MACRS alternative depreciation system (ADS) through the tax year prior to the tax year of recapture. Beginning in the tax year of recapture and through the remaining ADS recovery period, depreciation is computed using the ADS method. Recapture does not apply if the business use has dropped to 50 percent or less in a tax year after the applicable ADS recovery period has expired. Liberty Zone, GO Zone, and other special property. If any of the qualified zone property including renewal property, Liberty Zone property, or GO Zone property ceases to be used within its respective zones in a later year, the benefit of the increased Code Sec. 179 deduction must be reported as other income on the taxpayer s return for that year. STUDY QUESTIONS 9. The recapture amount for a previously claimed deduction on Code Sec. 179 property is: a. The difference between the amount expensed with the deduction and MACRS depreciation that could have been claimed b. Equal to the MACRS depreciation amount c. The basis of the property plus the total deduction d. None of the above 10. The listed property recapture rules require recapturing a prior Code Sec. 179 deduction as: a. Ordinary income b. Long-term capital gain c. Depreciation d. None of the above Top_Fed_07_book.indb /15/2006 2:41:26 PM

95 MODULE 1 CHAPTER 3 Electing the Section 179 Expensing Deduction 3.29 CONCLUSION Despite generous long-term benefits from accelerated methods for depreciating assets, many small- and medium-sized businesses find it difficult to come up with the cash necessary to purchase new assets to improve their operations. Fortunately, many of these businesses have a significant window of opportunity. From 2003 through 2009, they have the option of taking an immediate write-off of up to $100,000 (plus an inflation adjustment) each year. After 2009, the amount of the immediate write-off goes down to a $25,000 cap (unless extended again by Congress). To take full advantage of this tax break, a business needs to think strategically. Coordinating purchases of qualifying Section 179 property with business income and annual deduction limitations can make a significant difference to a small business s after-tax bottom line. Keeping an eye on whether Congress will again extend the enhanced deduction after 2009 is also important in determining whether accelerated purchasing plans should be set in motion. Finally, a business may need to effectively coordinate the enhanced Section 179 expensing tax break with other federal tax incentives. Despite its sometimes complicated rules, however, the Section 179 election is well worth the effort to maximize for most small businesses. Planning is essential. The right to a Section 179 deduction does not accumulate each year. Once each tax year ends, the opportunity to retrieve a missed Section 179 deduction because of a foregone purchase is lost forever. CPE NOTE: When you have completed your study and review of chapters 1, 2 and 3 which comprise this Module, you may wish to take the Quizzer for this Module. CPE instructions can be found on page The Module 1 Quizzer Questions begin on page The Module 1 Answer Sheet can be found on pages and For your convenience, you can also take this Quizzer online at Top_Fed_07_book.indb /15/2006 2:41:26 PM

96 10.1 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Answers to Study Questions MODULE 1 CHAPTER 1 1. b. Correct. Schedule D, Capital Gains and Losses, is used to claim a deduction for the loss realized from the sale of a business asset. a. Incorrect. Schedule C is used to report profits and losses from the business generally, not capital loss deductions. c. Incorrect. Schedule SE, Self-Employment Tax, is filed with Form 1040 to report self-employment earnings. d. Incorrect. Capital loss deductions are not claimed directly on Form 1040 without a supporting schedule. 2. c. Correct. A sole proprietor does not need an employer identification number just to file a return for the sole proprietorship. No separate declaration of the choice of entity is required for a sole proprietorship. a. Incorrect. An employer identification number is required to report employee wages and manage tax withholding for employees. b. Incorrect. An employer identification number is required for qualified retirement plan filings. d. Incorrect. An employer identification number is required if the sole proprietor files returns for excise taxes. 3. a. Correct. A C corporation is not a passthrough entity for which prorata shares of profits and losses, as well as deductions, flow through to individual shareholders to claim on their tax returns. b. Incorrect. Ease of transferability is an advantage of the C corporation entity. c. Incorrect. C corporations have a flexible capital structure; companies can issue or buy back their stock shares depending on their financial situations. d. Incorrect. Personal assets of C corporation owners are protected from creditor claims. 4. d. Correct. The corporation is allowed to deduct ordinary and necessary salary expenses paid or incurred during a taxable year; however, the compensation must be reasonable. a. Incorrect. Issuing Section 1244 stock allows losses to be deducted as more favorable ordinary losses, as opposed to capital gains. It does nothing in situations in which there are net profits rather than net losses; in that case, the potential double taxation of those profits remains unaffected by the issuance of Section 1244 stock. Top_Fed_07_book.indb /15/2006 2:42:01 PM

97 10.2 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE b. Incorrect. Issuing more shares will not reduce double taxation unless the stock incurs a loss, and the taxpayers must have been original investors in the corporation in order for the stock to qualify as Section 1244 stock. c. Incorrect. Withdrawing capital just causes shareholders to be taxed more at the individual level. 5. b. Correct. No small business corporation shareholders may be a nonresident alien. a. Incorrect. Qualifying tax-exempt entities may be small business corporation shareholders. c. Incorrect. Estates may shareholders of small business corporations under Subchapter S. d. Incorrect. One of the choices is a type of shareholder not allowed for Subchapter S small business corporations. 6. False. Correct. An S corporation may be challenged if it pays a shareholder unreasonably low wages, which the corporation owners may attempt to do to minimize employment tax. True. Incorrect. S corporation wages to shareholders are not subject to self-employment tax, so the corporation may pay unreasonably low wages to shareholder-owners to minimize its share of employment taxes on the wages. The IRS may challenge these unreasonably low wages. 7. d. Correct. All three choices should be spelled out in the partnership agreement. a. Incorrect. Special allocations should be addressed in the partnership agreement. b. Incorrect. The agreement should describe how the entity proceeds if a partner withdraws from the partnership or dies. c. Incorrect. Any restrictions on the sale of partnership interests is covered in the partnership agreement. 8. a. Correct. The contributing partner does not recognize a gain if appreciated property is contributed, but his or her basis in the partnership is reduced if the contributed property is subject to a liability, such as a loan or lien. b. Incorrect. The basis of the property as contributed does affect basis, and all partners do not necessarily contribute property of equal value nor receive the same percentage of partnership interest. c. Incorrect. Liabilities and gains related to the contributed property do affect the partner s basis. d. Incorrect. Cash is considered a property contribution exchanged for an interest in the partnership. The basis is the same as the basis of the property (money) contributed. Top_Fed_07_book.indb /15/2006 2:42:02 PM

98 ANSWERS TO STUDY QUESTIONS CHAPTER True. Correct. General partnerships use the partnership agreement for governance, but limited partnerships are governed by both the state and their partnership agreements, but the state law usually serves as a fallback for any areas not specified in the agreement. False. Incorrect. The limited partnership entity form is subject to state statute as well as its partnership agreement. 10. d. Correct. The general partner is responsible for the partnership s debts and obligations, whereas limited partners are not liable unless they activity participate in control of the business. a. Incorrect. The designation of the general partner is not necessarily tied to the percentage of property contributed to the partnership. b. Incorrect. Seniority is not a factor in general versus limited partners. c. Incorrect. The general partner may be an individual, corporation, or other domestic or foreign legal entity. The general partner may also be a limited partner, so the two are not necessarily distinct in entity. 11. d. Correct. Generally, domestic business entities that are not corporations will be automatically treated as partnerships for tax purposes if they have two or more owners, or will be disregarded as entities separate from their owner if they have only one owner. a. Incorrect. Domestic business entities that are not corporations must elect to be taxed as an association (C corporation) or must make an election to be an S corporation for federal tax purposes. b. Incorrect. Federal tax law does not recognize the classification of limited liability companies. Limited liabilities are automatically treated as partnerships or disregarded entities, depending on the number of members, unless the entity elects otherwise. Classification as an S corporation requires an affirmative election to be taxed as such and, therefore, cannot be a default classification. c. Incorrect. Entities must elect treatment as an association on Form 8832 under the check-the-box regulations. Limited liability companies are not recognized as a distinct tax entity under federal law. 12. b. Correct. LLCs are a relatively new form of entity and there is not a lot of case law involving this topic. a. Incorrect. LLCs may have an unlimited number of members. S corporations can have no more than 100 members. c. Incorrect. LLCs may have multiple classes of membership interests. S corporations can have no more than one class of stock. d. Incorrect. S corporations must elect to be taxed as an S corporation under federal law. Top_Fed_07_book.indb /15/2006 2:42:02 PM

99 10.4 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 13. b. Correct. Accountants must now squeeze all return preparations into the months between December and April, but the legislation would allow partnerships and S corps to elect any of several taxable year-ends. a. Incorrect. Sole proprietors follow the calendar tax year applicable to individuals, which would not change under the proposed legislation. c. Incorrect. There is no provision in the legislation that calls for combining filing for multiple tax types together. d. Incorrect. Only one of the choices is a feature of the legislation that would benefit accountants. 14. a. Correct. By 2013 more than 52 million personal tax forms will report business activity for small businesses and self-employed taxpayers. b. Incorrect. Although S corporations will remain the most popular corporate entity choice and S corporation filings increase annually by almost 9 percent, it nevertheless has fewer returns filed annually than another entity type. c. Incorrect. Another entity type has more returns filed annually than any type of partnership. d. Incorrect. One of the choices is the entity type for which the most returns are expected to be filed in b. Correct. LLCs were the most common type of partnership, but limited partnerships reported the largest share of overall partnership profits. a. Incorrect. LLCs were the most prevalent variety of partnership, but another variety reported the largest share of profits. c. Incorrect. General partnerships were neither the most common variety of partnership nor the one with the largest share of profits in d. Incorrect. LLLPs have only recently been recognized as entities and are not yet permitted in all states, so they are less prevalent and their percentage of profits is lower than some other varieties of partnership. MODULE 1 CHAPTER 2 1. c. Correct. Nonrecognition treatment applies because no gain or loss is realized on the exchange. However, an adjustment must be made for any cash or non-like-kind property paid or received. a. Incorrect. The transaction must involve only the exchange of business or investment property in order for the transaction to be disregarded for tax purposes. b. Incorrect. Like-kind exchanges are distinct from bartering, in which property exchanges are taxable. Like-kind exchanges are limited to business or investment property exchanged for like-kind property and put to business or investment use following the transaction. Barter systems may involve non-like-kind exchanges and personal-use property. Top_Fed_07_book.indb /15/2006 2:42:02 PM

100 ANSWERS TO STUDY QUESTIONS CHAPTER d. Incorrect. Like-kind exchanges do not require multiple parties to facilitate transactions, although more than two parties may be involved in facilitating the exchanges. 2. d. Correct. Because like-kind exchanges defer gain or loss on transactions, the recognition of a loss upon the sale of property would be delayed were the transaction classified as a like-kind exchange. a. Incorrect. Because the basis of property acquired and relinquished is generally the same, there are no general tax consequences of like-kind exchanges. b. Incorrect. The tax rate is no different for gains and the deduction no different for losses generated by like-kind exchanges. c. Incorrect. Losses from the exchanges are not nondeductible. 3. d. Correct. The property must have been exchanged by the due date of the tax return for that tax year or by the end of 180 days of the date of transfer. a. Incorrect. Taxpayers have a longer period than one month to complete the transaction. b. Incorrect. The period during which the transaction must be completed is not 60 days. c. Incorrect. The deadline for completing the transaction is not 120 days. 4. d. Correct. Real property and personal property are not the same class or kind of property and may not be used in like-kind exchanges even if both properties are of similar grade. a. Incorrect. Such tangibles are like kind if they are of like class or kind. b. Incorrect. Personal property is permitted if the property involved is nearly identical. c. Incorrect. Fractional interests may be exchanged for entire interests in other real property. 5. False. Correct. Partnership interests do not qualify for nonrecognition, regardless of whether the partnership interest is a general or limited one. Liquidation is irrelevant to the nonrecognition. However, if partnerships elected not to be treated as partnerships for tax purposes, their interests are treated as interests in each asset involved in an exchange. True. Incorrect. If partnerships are taxed as partnerships, exchanges of interests are not qualified for nonrecognition. 6. b. Correct. A residual group must be created when the aggregate FMV of the properties relinquished differs from the aggregate FMV of the properties received, including liabilities. Top_Fed_07_book.indb /15/2006 2:42:02 PM

101 10.6 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE a. Incorrect. Exchange groups consist of all properties relinquished or acquired in multiple property exchanges that are of like kind or like class. The FMV of the properties is not a factor in forming exchange groups. c. Incorrect. A chose in action is a personal right not reduced to possession but recoverable by bringing and maintaining a lawsuit. It is unrelated to multiple property exchanges. d. Incorrect. One of the choices describes what is required when the fair market values of multiple properties relinquished and acquired do not match. 7. True. Correct. According to Rev. Proc , the same residential property used for gain exclusion can be held for investment and qualify for nonrecognition in a like-kind exchange. False. Incorrect. If a homeowner meets the residency requirements for gain exclusion, the same property can be held as an investment and qualify for nonrecognition in a like-kind exchange. 8. d. Correct. Like-kind property is not considered boot but rather part of the like-kind exchange. a. Incorrect. Boot can include relief from indebtedness. b. Incorrect. Boot can be cash. c. Incorrect. Boot can be excluded property because it is not like kind and thus is not property considered as qualifying property for nonrecognition. 9. a. Correct. The taxpayer has boot from the relief of liability to the extent that the relief is greater than the debt incurred. b. Incorrect. The offset is permitted. c. Incorrect. The taxpayer acquiring the lower debt must recognize the gain. d. Incorrect. One of the choices reflects the taxpayer s result. 10. d. Correct. Related parties are allowed nonrecognition for dispositions of property made after the death of one of the taxpayer or the related person, if there is a compulsory or involuntary conversion in which the exchange occurred before the imminence of such event, and under circumstances in which the primary purpose of the exchange was not tax avoidance. a. Incorrect. Neither the original exchange nor the disposition may have tax avoidance as its principal purpose. b. Incorrect. The two-year minimum does not apply if the taxpayer or the related person dies and the exchange takes place after such event. c. Incorrect. A compulsory or involuntary conversion of the property is an exception to the two-year minimum if the exchange occurred before the imminence of such event. Top_Fed_07_book.indb /15/2006 2:42:03 PM

102 ANSWERS TO STUDY QUESTIONS CHAPTER b. Correct. Special rules govern the ways in which property is identified and received in deferred exchanges. a. Incorrect. This is not the name of exchanges in which the relinquished property and acquired property are not transferred at the same time. c. Incorrect. A cash-out exchange does not feature staggered relinquishment and acquisition of the properties. d. Incorrect. This is not the name of the type of like-kind exchange in which the properties have staggered transfers. However, backstop guarantees are a trap in disallowed deferred exchanges. 12. c. Correct. If a taxpayer actually or constructively receives cash or property before he or she receives the replacement property, the transactions will be treated as sales, not a deferred exchange. a. Incorrect. The obligation may be secured by cash or its equivalent held in an escrow account or trust. b. Incorrect. Entitlement to receive a growth factor does not mean that the taxpayer is in receipt of the property, as long as the taxpayer s right of receipt is limited. d. Incorrect. One of the choices is not a safe harbor for deferred exchanges. 13. c. Correct. The property owner must have a written qualified exchange accommodation agreement with the EAT and provide qualified indicia of ownership held by the EAT until the property is transferred to the final acquirer. a. Incorrect. 180 days is the maximum time a QEAA may hold the property, not the maximum time the relinquishing party has owned the property. b. Incorrect. In reverse exchanges the taxpayers receive property before their property is relinquished. d. Incorrect. For the reverse exchange safe harbor to apply, for tax purposes the EAT is the beneficial owner of the property being held. 14. c. Correct. QEAA terms must provide that the EAT, not the property owner, hold the property during the period of the QEAA. a. Incorrect. This tax issue must be addressed in the QEAA and is a responsibility of the EAT. b. Incorrect. Reporting requirements are the responsibility of the EAT and specified in the QEAA. d. Incorrect. Reporting requirements are terms that must be specified in the QEAA. Top_Fed_07_book.indb /15/2006 2:42:03 PM

103 10.8 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 15. d. Correct. The installment note is considered boot. a. Incorrect. The note is not capital gain because the gain has not been realized. b. Incorrect. The note is taxable as boot but the gain may be deferred under the installment rules. c. Incorrect. The transaction may still qualify for nonrecognition in general, but there are tax consequences for the installment note portion. MODULE 1 CHAPTER 3 1. d. Correct. Converted property is ineligible for the deduction. a. Incorrect. Converted property does not qualify for the full Code Sec. 179 deduction. b. Incorrect. The deduction is not prorated. c. Incorrect. The deduction is not divided. 2. c. Correct. The property must be acquired by purchase, so leased property is ineligible. a. Incorrect. Deemed asset acquisitions under Code Sec. 338 are eligible property for purposes of the expensing deduction. b. Incorrect. Code Sec tangible personal property consisting of items such as tanks, livestock, and machinery and equipment is eligible for the deduction. d. Incorrect. Partial-use property is eligible if used for more than 50 percent of the time in the trade or business. 3. a. Correct. Although property leased by a taxpayer to someone else generally is ineligible for the deduction, property manufactured or produced by the taxpayer and leased to someone else is exempted from the rule. b. Incorrect. Property used by government units is ineligible for the deduction unless it is subject to a short-term lease. c. Incorrect. Property used primarily outside of the country is ineligible for the deduction. d. Incorrect. Air conditioning and heating units are ineligible for the deduction. 4. c. Correct. The original use of energy property must begin with the taxpayer. a. Incorrect. Solar optic energy property must have been acquired after, not before, December 31, b. Incorrect. Electricity-generating geothermal equipment includes stages up to but not including the electrical transmission stage. d. Incorrect. One of the choices qualifies as energy property. Top_Fed_07_book.indb /15/2006 2:42:03 PM

104 ANSWERS TO STUDY QUESTIONS CHAPTER d. Correct. In addition to considering the dollar limit of property for the deduction, taxpayers must also apply the investment limitation and the business income limit to determine the actual deduction. a. Incorrect. The dollar limit, which is $108,000 in 2006, is applied in calculating the deduction. b. Incorrect. The investment limitation, which is $430,000 in 2006, is applied in calculating the deduction. c. Incorrect. The total deduction is limited to the taxable income from the active conduct of the taxpayer s trade or business for the year. That is, the deduction cannot exceed the taxpayer s income for that business. However, excess deductions are allowed to be carried over into subsequent years (during which the same business income limitation would apply). 6. d. Correct. All three choices are situations in which taxpayers may prefer not to elect the deduction. a. Incorrect. Taxpayers generally will not wish to claim the deduction if a cashout is planned by selling the business. b. Incorrect. Taxpayers may wish to time the purchase of Code Sec. 179 property in a later tax year to elect the deduction as an offset to higher taxes or may wish to take depreciation deductions in those later years. c. Incorrect. The deduction cannot exceed income of the business, so it is not usable when the business experiences losses. 7. False. Correct. Partnerships are allowed this carryover. True. Incorrect. Partnerships may carry forward the deduction disallowed because of the partnership s taxable income limitation but must reduced the basis of the qualifying property by the deduction amount. 8. b. Correct. Only the net losses, if any, of the S corp are included in calculating its taxable income. Compensation, tax-exempt income, and tax credits are not taken into account. a. Incorrect. Shareholder-employee income is not factored into the taxable income determination for the business income limit. c. Incorrect. Tax-exempt income is not part of taxable income of the S corp for the business income limit. d. Incorrect. Tax credits are not taken into account in calculating the income limit. 9. a. Correct. This difference is then added to the property s basis so it may be depreciated in remaining years b. Incorrect. The recapture amount is not equal to the depreciation amount. c. Incorrect. The basis is not added to the total deduction to determine the recapture amount. d. Incorrect. One of the choices is the recapture amount. Top_Fed_07_book.indb /15/2006 2:42:03 PM

105 10.10 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 10. a. Correct. The recaptured amount is reported as ordinary income. b. Incorrect. The recaptured deduction is treated differently than long-term capital gains for tax purposes. c. Incorrect. The recaptured deduction is not equivalent to depreciation. d. Incorrect. One of the choices is the result of recapturing the deduction for listed property. MODULE 2 CHAPTER 4 1. a. Correct. By the year 2030 one out of five Americans will be at least 65 years old. b. Incorrect. One in eight is not the correct ratio of Americans who will be age 65 or older by the year c. Incorrect. More than one out of ten Americans will be at least age 65 by the year d. Incorrect. One of the choices is the correct ratio of Americans who will be at least 65 years old by the year c. Correct. Unlike previous generations that were quite conservative in investment vehicles for retirement, many boomers are concerned about missing out on upswings in the equities market yielding revenues needed for their lengthy retirement. a. Incorrect. Boomers are concerned about the bite inflation will take out of retirement assets. b. Incorrect. Excessive lifetime transfers leaving retirees low on funds are concerning boomers planning retirement. d. Incorrect. Because boomers may anticipate much longer retirement periods than did previous generations, they are especially concerned about outliving their assets. 3. c. Correct. Single taxpayers are allowed tax-free gains of only $250,000 from the sale of their principal residences, although married couples can exclude $500,000. a. Incorrect. Married couples may exclude up to $500,000 of gain. b. Incorrect. Whether homeowners itemize deductions or list their property tax as a deduction in the year of sale is irrelevant to the exclusion on gain. d. Incorrect. One of the choices is subject to capital gains tax on a portion of the gain. 4. False. Correct. The homeowner does not have to have lived in the residence continuously as long as the total time in residence is at least two years during the five years preceding the sale. True. Incorrect. A total of two years is the minimum time in residence to claim the home sale exclusion, but the period does not have to be continuous. Top_Fed_07_book.indb /15/2006 2:42:04 PM

106 12.3 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE Quizzer Questions: Module 1 Answer the True/False questions by marking a T or F on the Quizzer Answer Sheet. Answer Multiple Choice questions by indicating the appropriate letter on the Answer Sheet. 1. Most small businesses operate as: a. Limited partnerships b. C corporations c. Sole proprietorships d. Limited liability companies 2. To qualify as a small business corporation, money and property received for stock, contributions to capital, or paid in surplus cannot exceed. a. $1 million b. $2 million c. $5 million d. $10 million 3. A C corporation s stock is not Section 1244 stock if the corporation derives more than of its gross receipts from royalties, rents, dividends, interest, annuities, and stock or security sales. a. 10 percent b. 25 percent c. 50 percent d. 75 percent 4. Which of the following is not a requirement for an S corporation? a. A single class of stock b. No shareholders who are nonresident aliens c. 100 or fewer shareholders d. All of the above are requirements for S corporations Top_Fed_07_book.indb /15/2006 2:42:13 PM

107 12.4 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 5. A small business corporation elects S corporation status by filing and having the consent of. a. Form 8869; corporate officers b. Form 2553; all shareholders c. Form 8832; the corporation s founders d. Form 1065; the majority of shareholders 6. The limited liability limited partnership entity may be distinguished from other limited partnerships by: a. Their differing federal information returns filed b. The name of the former must include limited liability limited partnership or LLLP c. The type of professions permitted to choose each entity type d. Their creation process, which differs markedly between the two 7. A limited liability company having more than one member cannot elect which of the following entity tax treatments? a. An entity disregarded as an entity separate from its owner b. Partnership c. Corporation d. All of the above are tax treatments available for LLCs 8. Statistics show that LLCs with single members generally choose which type of entity treatment for tax purposes? a. Corporation b. Partnership c. An entity disregarded as an entity separate from its owner d. None of the above 9. Which of the following is not a major difference between LLCs and limited partnerships for federal tax purposes? a. In LLCs no member is liable for the entity s obligations as the general partner is in limited partnerships b. All LLC members generally can participate in the business management of the company, unlike the limited partners who are generally prohibited from active participation c. There are no distinctions in LLCs between general and limited partners, as are made in limited partnerships d. All of the above are major differences Top_Fed_07_book.indb /15/2006 2:42:13 PM

108 QUIZZER QUESTIONS Module Dual-chartered entities already in existence on August 12, 2004, must apply the final dual-chartered entity regulation as of: a. August 12, 2004 b. January 1, 2005 c. May 1, 2006 d. January 1, According to the IRS Fiscal Year Return Projections report for , which choice of entity will be most popular from now through 2013? a. Sole proprietorships b. C corporations c. Limited partnerships d. S corporations 12. The TIGTA report of the Treasury Inspector General concluded that partnerships became the fasting growing segment of all filers during the 1990s because: a. Favorable legal and regulatory changes, plus the check-the-box regulations, aided their popularity b. The trend toward increasing litigation drove business founders to seek limited liability in partnerships such as LLCs and LLPs c. The 1990s saw entrepreneurial businesses flourish that sought less restrictive entity types d. Start-up costs for businesses in the 1990s became prohibitively expensive for solo business leaders, frequently driving them into partnerships to share costs 13. The two components of the self-employment tax of sole proprietors are OASDI and FUTA. True or False? 14. Either a C or S corporation can qualify as a small business corporation. True or False? 15. Unless an LLC elects to be taxed as a sole proprietorship, the only two entity types in which the business owner directly pays self-employment tax are partnerships and sole proprietorships. True or False? Top_Fed_07_book.indb /15/2006 2:42:13 PM

109 12.6 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 16. All of the following are reasons taxpayers would avoid classifying transactions as like-kind exchanges except: a. To get a higher basis for the property received b. To gain the right to more future depreciation deductions c. To offset gain recognized on the sale of property with an operating loss carryover d. To avoid recognition of gains or losses 17. Property not transferred by both parties simultaneously in a like-kind exchange must be identified within after the sate of transfer of the relinquished property. a. 10 days b. 45 days c. 3 months d. 6 months 18. The businesses that search for and match property for like-kind exchanges are called: a. Exchange accommodators b. Form 8824 expediters c. Qualified intermediaries d. Exchange accommodation titleholders 19. All of the following types of property are excluded from nonrecognition in like-kind exchanges except: a. Choses in action b. Partnership interests c. Fractional interests in real property d. Property held in inventory for sale 20. The North American Industry Classification System (NAICS) applies to which type of assets? a. Intangible business assets b. Depreciable tangible personal property c. Depreciable real property d. Intangible personal property Top_Fed_07_book.indb /15/2006 2:42:13 PM

110 QUIZZER QUESTIONS Module When an exchange consists of multiple properties of a trade or business, taxpayers must use a method of allocation for property not treated as transferred for the like-kind assets. a. Residual b. Cash c. Deferred d. Partial 22. Adjustments to basis in like-kind exchanges involving cash and nonrecognition property are allocated first to: a. Nonrecognition property b. Boot received c. All assets equally based on fair market value d. None of the above 23. If gains arise from like-kind exchanges of Code Sec or Code Sec property on which the transferring owner claimed depreciation or amortization, the gains are: a. Offset only to the extent of losses on nondepreciable property b. Treated as boot c. Taxed as capital gains d. Taxed as ordinary income up to the total of previously claimed depreciation or amortization deductions on that property 24. To prevent cashing out by related parties, their like-kind exchanges will not qualify for nonrecognition treatment within years of the date of last transfer. a. Two b. Three c. Five d. Ten 25. Under the reverse exchange safe harbor, relinquished and replacement property may only be held by a QEAA for a combined total of days. a. 60 b. 90 c. 120 d. 180 Top_Fed_07_book.indb /15/2006 2:42:13 PM

111 12.8 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 26. The IRS objects to drop/swap and return transactions by partnerships contributing exchanged property back to their partnerships due to the: a. Step transaction doctrine b. Held for requirement c. Cash-out problem d. None of the above 27. Which of the following is not an alternative used by dissolving partnerships seeking to avoid gain recognition in selling partnership property? a. Installment notes for partial cash-outs b. Redemption of partnership interests prior to like-kind exchanges c. Special allocations of gains to partners cashing out d. All of the above are alternatives used by partnerships 28. A like-kind exchange may be taxable to one party but not the other. True or False? 29. The held for requirement for nonrecognition treatment does not require the property to actually be used in a trade or business. True or False? 30. Under proposed regulations (REG and REG ), QIs will be taxed on earnings from interest deemed loaned in escrow accounts to the QIs. True or False? 31. Partial-use property must be used at least more than percent for business in order to claim a prorated Code Sec. 179 deduction a. 50 b. 55 c. 65 d Which of the following types of property is qualified for the Code Sec. 179 deduction? a. Paved parking areas b. Fences c. Air-conditioning units d. Sewage disposal services Top_Fed_07_book.indb /15/2006 2:42:14 PM

112 QUIZZER QUESTIONS Module The maximum Code Sec. 179 deduction allowed for qualifying property placed in service during 2006 is: a. $100,000 b. $105,000 c. $108,000 d. $122, For Code Sec. 179 property placed in service during the year 2007, the investment limit before phaseout: a. Remains at $430,000 b. Is $400,000 plus an inflation adjustment c. Is $200,000 plus an inflation adjustment d. Is $200,000 with no inflation adjustment 35. Which of the following is included in calculating a partnership s taxable income for purposes of the Code Sec. 179 deduction s business income limit? a. Code Sec. 707(c) guaranteed payments b. Net losses c. Tax-exempt income d. Credits 36. To elect the Code Sec. 179 deduction, a taxpayer must complete Part I of: a. Form 1041 b. Form 1065B c. Form 4562 d. Form When business use of Code Sec. 179 property drops to 50 percent or less, taxpayers must recapture the deduction amount and the property. a. Increase the basis of b. Decrease the useful life of c. Decrease the basis of d. None of the above Top_Fed_07_book.indb /15/2006 2:42:14 PM

113 12.10 TOP FEDERAL TAX ISSUES FOR 2007 CPE COURSE 38. When qualified zone property ceases to be used within its zone, it must be: a. Depreciated as regular business property b. Reported as other income on that year s return c. Treated as deferred income d. None of the above 39. The Code Sec. 179 deduction applies to each business, not each taxpayer, so taxpayers owning multiple businesses may claim up to the maximum allowable deduction annually for each small business. True or False? 40. Partners reduce the basis of their partnership interests by the total amount of Code Sec. 179 deduction allocated from the partnership. True or False? Top_Fed_07_book.indb /15/2006 2:42:14 PM