Stock Basis Calculation for Pass-Through Entities: Challenges for Tax Professionals

Transcription

1 Stock Basis Calculation for Pass-Through Entities: Challenges for Tax Professionals Tackling Complex Issues for S Corporations, LLCs and Partnerships TUESDAY, AUGUST 6, 2013, 1:00-2:50 pm Eastern IMPORTANT INFORMATION This program is approved for 2 CPE credit hours. To earn credit you must: Respond to verification codes presented throughout the seminar. If you have not printed out the Official Record of Attendance, please print it now. (see Handouts tab in Conference Materials box on left-hand side of your computer screen). To earn Continuing Education credits, you must write down the verification codes in the corresponding spaces found on the Official Record of Attendance form. Complete and submit the Official Record of Attendance for Continuing Education Credits, which is available on the program page along with the presentation materials. Instructions on how to return it are included on the form. To earn full credit, you must remain on the line for the entire program. For this program, attendees must listen to the audio over the telephone. WHOM TO CONTACT For Additional Registrations: -Call Strafford Customer Service x10 (or x10) For Assistance During the Program: - On the web, use the chat box at the bottom left of the screen - On the phone, press *0 ( star zero)

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4 Stock Basis Calculation for Pass- Through Entities: Challenges for Tax Professionals Seminar Aug. 6, 2013 Frank Gariepy, Eide Bailly Shauna Shafer, Eide Bailly

5 Today s Program S Corporation Basis Calculations [Frank Gariepy] Partnership Basis Calculations [Shauna Shafer] Partnership And LLC At-Risk Basis [Frank Gariepy] Slide 7 Slide 35 Slide 36 Slide 50 Slide 51 Slide 75

6 Notice ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY THE SPEAKERS FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

7 Frank Gariepy, Eide Bailly S CORPORATION BASIS CALCULATIONS

8 IRS Circular 230 Notice Any tax advice expressed in this communication is not intended to be used, and cannot be used, for the purpose of avoiding penalties imposed on the taxpayer by any governmental taxing authority or agency. In addition, if any such tax advice is made available to any person or party other than the party to whom the advice was originally directed, then such advice, under IRS Circular 230, is to be considered as being delivered to support the promotion or marketing (by a person other than Eide Bailly LLP) of the transaction or matter discussed or referenced. Thus, each taxpayer should seek specific tax advice based on the taxpayer s particular circumstances from an independent tax advisor. 8

9 Background S corporation basis is simple. Increases Amounts earned Amounts contributed Decreases Amounts deducted Amounts distributed Cannot go negative 9

10 From The Beginning Initial stock basis Cash paid for shares Net value of property contributed to the corporation (FMV or NTV, depending on transaction) Taxable value of shares received for services provided Carried over from shares received as gift Stepped-up for shares inherited Any combination of the above 10

11 Increases To Stock Basis Capital contributions (property or cash) Ordinary income Investment income Gains Excess of deductions for depletion 11

12 Decreases To Stock Basis Distributions (property or cash) Business deductions Non-deductible expenses Contributions 179 deduction Losses 12

13 Who Cares? Why and when basis does matter The company had losses. The company made distributions. There was an ownership change in the company. Basis is a piggybank. Excess distributions are taxable. 13

14 Order Of Basis Adjustments: IRC Sect. 1367(a) Order is very important First: Stock basis is increased for income items Second: It is decreased for distributions Third: It is decreased for nondeductible, noncapital expenses Fourth: It is decreased for items of loss and deduction Note: If basis is positive before distributions but would be zeroed out by deduction items, the excess loss is suspended rather than the excess distributions made taxable. Election to reduce basis by loss or deduction items before non-deductible expenses [Reg (g)] 14

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16 Example: [Reg (g)] Sophia owns all of the shares of Princess Inc., an S corporation that incorporated and elected S status on Jan. 1, 2012.The corporation uses a Sept. 30 year-end. Sophia s stock basis on Jan. 1 is $500,000. The corporation passes through a non-separately stated loss from business activities of $550,000 and $10,000 of non-deductible meals and entertainment. 16

17 Example 1: [Reg (g)] Under the ordering rules, the $10,000 non-deductible amount reduces basis before it is reduced by items of loss and deduction. Beginning basis $500,000 Less: Non-deductible M&E ($10,000) Basis before loss $490,000 Less: Loss (limited) ($490,000) Ending basis $0 Loss carried forward ($60,000) Loss utilized on 1040 ($490,000) 17

18 Example 2: [Reg (g)] If an election is made to reverse the ordering rules, the $10,000 non-deductible amount reduces basis AFTER it is reduced by items of loss and deduction. Beginning basis $500,000 Less: Loss (limited) ($500,000) Basis before n/d items $0 Carryforward non-deductible M&E ($10,000) Loss carried forward ($50,000) Loss utilized on 1040 ($500,000) 18

19 [Reg (g)] The election to reduce basis by loss or deduction items before nondeductible expenses results in a higher deductible loss. The non-deductible item, however, carries over to future years and will reduce basis when there is sufficient basis to absorb it. If the election is not made, the non-deductible items do not carry over, even if basis is reduced to zero in the current year. 19

20 When To Calculate Basis? Normally calculated at the end of the corporation s taxable year [Reg (d)] Exceptions: Disposal of entire shareholder interest Disposal of substantial interest 20

21 Per-Share, Per-Day Pass-through items are generally allocated per-share, per-day [IRC Sect. 1377(a)(1)]. Each item is divided by the number of days in the tax year, then that amount is allocated equally among the shareholders who held shares on each day [IRC Sect. 1377(a)(1)]. Simplified method: The percentage of stock owned is multiplied by the percentage of the year that it is owned [1120S instructions]. 21

22 Cut-Off Method Shareholder s entire interest is disposed. Requires specific accounting election under [Reg (b)(1)] Pass-through items are allocated through cut-off date and then again from cut-off date until the end of the year. Basis is adjusted at cut-off date. Distributions adjust basis. 22

23 Cut-Off Method: Example Same facts as previous examples The corporation had net income for the year of $400,000, made up of a loss of $100,000 through March 31 and income of $500,000 for the remainder of the year. Leo has other income that brings him into the 35% tax bracket. 23

24 Cut-Off Method: Example (Cont.) Income Jan. 1 March 31 Income Apr. 1 Dec, 31 Total Leo ($50,000) $0 ($50,000) Juliet ($50,000) $500,000 $450,000 Total ($100,000) $500,000 $400,000 Per-Share, Per- Day Specific Accounting Leo $50,000 ($50,000) Juliet $350,000 $450,000 24

25 Cut-Off Method: Example (Cont.) Leo s ending basis is $150,000 $50,000 = $100,000. Gain on sale is $350,000 - $100,000 = $250,000 capital gain. Overall income: Ordinary loss: ($50,000) = ($17,500) Capital gain: $250,000 = $37,500 Total: $200,000 = $20,000 tax Leo s tax as compared to per-share per day is $20,000 less. Juliet s tax is $35,000 more. 25

26 Cut-Off Method (Cont.) All affected shareholders must consent (actual consent kept in taxpayer records). If corporate redemption, all shareholders are affected. Election affects pass-through items only. One tax return is filed. May require supplemental schedules for basis calculations Attach election statement to return (means decision can be deferred until tax return is filed) The stock sale agreement should address decision process. 26

27 Cut-Off Method: Other Options Qualifying disposition of stock [Reg (g)(2)] Shareholder disposes of 20% or more of the corporation s issued stock in one or more transactions within any 30-day period during the corporation s tax year (sale or redemption). Stock equal to or greater than 25% of the previously outstanding stock is issued to one or more new shareholders within any 30-day period during the corporation s tax year. All shareholders who held stock must consent. The first tax year is deemed to end on the date the threshold is met. 27

28 Other Stock Basis Issues Corporate-owned life insurance Basis reduced by premiums to extent attributable to pure life insurance coverage Portion attributable to increase in CSV is a capital expenditure, not a reduction in basis. Increased by proceeds (tax-exempt income) Proceeds do not increase AAA. Items increasing basis MUST be reported on shareholder s income tax return. Contributions of appreciated property reduce stock by adjusted property basis, not by FMV. 28

29 Debt Basis Shareholder loans provide debt basis. Losses can reduce debt basis. Basis reduction is applied at year-end. Debt basis is restored before stock basis by corporate income. Repayment of reduced-basis loan is taxable. Capital gain if debt is evidenced by note. Ordinary income if no written note Investment income 29

30 Debt Basis: Issues Partial payments Gain is recognized. Computed pro-rata based on the relationship of the reduction in basis to face value of the loan Example Corporation makes payment of $75,000 on reduced basis debt. Income is calculated as follows: $125,000 (face amount) - $100,000 (basis) $125,000 (face amount) X $75,000 (repayment) = $15,000 Income 30

31 Debt Basis: Requirements Must incur a true economic outlay Owed by corporation to shareholder Loan made directly by shareholder Note not required but recommended Over $25,000 debt at year-end is treated as if evidenced by written note Guarantee does not create basis (payments made by shareholder do create basis) 31

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33 Debt Basis: Requirements (Cont.) Back-to-back loans - background A third-party makes a loan to shareholder(s), then the Shareholders re-loan to S corporation What if not third party but a related company? IRS argues no economic outlay Hitchins, 103 TC 711 (1994) supports IRS position 33

34 Debt Basis: Requirements (Cont.) Prop. Reg (a)(2) Preference for any bona fide indebtedness to run directly from the shareholder to the S corporation. Back-to-back loan between a shareholder and two related S corporations is bona fide indebtedness. Depends upon all the facts and circumstances 34

35 Summary Keep careful basis records from Day One Basis is the responsibility of the shareholder. Tax preparers should be prepared. Save K-1s in permanent file, in case of basis questions in the future Carefully plan debt transactions and follow the plan 35

36 Shauna Shafer, Eide Bailly PARTNERSHIP BASIS CALCULATIONS

37 IRS Circular 230 Notice Any tax advice expressed in this communication is not intended to be used, and cannot be used, for the purpose of avoiding penalties imposed on the taxpayer by any governmental taxing authority or agency. In addition, if any such tax advice is made available to any person or party other than the party to whom the advice was originally directed, then such advice, under IRS Circular 230, is to be considered as being delivered to support the promotion or marketing (by a person other than Eide Bailly LLP) of the transaction or matter discussed or referenced. Thus, each taxpayer should seek specific tax advice based on the taxpayer s particular circumstances from an independent tax advisor. 37

38 Partnership Basis Comparisons 38

39 Who Cares? Why and when basis does matter The partnership had losses. The partnership made distributions. There was an ownership change in the partnership. Rules of economic effect under Sect. 704(b) 39

40 Inside And Outside Basis Often are the same Three common exceptions Acquisition of partnership interest other than by contribution. Gain or loss recognized on a distribution. Increase and decrease in basis of partnership assets on distribution. Sect. 754 election 40

41 Calculation Of Tax Basis: Sect. 705(a) Increased by: Contributions to the partnership and transfers of partnership interests (Sect. 722 and Sect. 742) Taxable partnership income Partnership income exempt from tax Excess of deductions for depletion over the basis of the property subject to depletion Decreased by (but, not to below zero): Distributions by the partnership (Sect. 733) Losses of the partnership, including items not deducted for tax purposes Depletion 41

42 Initial Tax Basis Contributions: Sect. 722 Cash Adjusted basis of property Taxable income recognized from services Gain recognized because of investment company rule of Sect. 721(b) 42

43 Tax Basis Of Transferred Interest: Sect. 742 Purchase price paid Gift donor s basis Inherited fair market value 43

44 Alternative Rule: Sect. 705(b) Partner s basis is equal to proportionate share of partnership property. Used when partnership cannot apply the general rule, or In the view of the IRS, results will not vary substantially from the general rule. 44

45 General Rule Contributions of property Partner receives basis equal to adjusted basis in partnership property. Distribution of property Partner basis is decreased (not below zero) by adjusted basis in partnership property. Exceptions Disguised sales Shifting of liabilities Liquidating distributions 45

46 Liabilities Increase in share of liabilities - deemed cash contribution (sections 722 and 752(a)) Decrease in share of liabilities deemed cash distribution (sections 733 and 752(b)) May include: Amounts owed to a partner Amounts connected to the purchase of property, even if the partnership has not legally assumed the liability 46

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48 Allocation Of Liabilities Non-recourse Minimum gain Sect. 704(c) gain Excess non-recourse liabilities Recourse Economic risk of loss rules 48

49 Beware Of Changing Liabilities Contributions and distributions of encumbered property Changes of profit and loss ratios Payment of partnership liabilities Changes in partnership minimum gain Changes in general and limited partnership interests 49

50 Summary Maintain careful tax (outside) basis records Apply basis ordering rules correctly Be aware and plan for changes in liabilities Review debt and partnership agreements in order to properly allocate debt 50

51 Frank Gariepy, Eide Bailly PARTNERSHIP AND LLC AT- RISK BASIS

52 IRS Circular 230 Notice Any tax advice expressed in this communication is not intended to be used, and cannot be used, for the purpose of avoiding penalties imposed on the taxpayer by any governmental taxing authority or agency. In addition, if any such tax advice is made available to any person or party other than the party to whom the advice was originally directed, then such advice, under IRS Circular 230, is to be considered as being delivered to support the promotion or marketing (by a person other than Eide Bailly LLP) of the transaction or matter discussed or referenced. Thus, each taxpayer should seek specific tax advice based on the taxpayer s particular circumstances from an independent tax advisor. 52

53 Subjects To Be Covered In This Section At risk basis and tax basis At-risk basis Debt allocation issues Proposed regulatory and tax cases affecting at-risk 53

54 At-Risk And Tax Basis Book capital accounts for the relative economic rights of a partner Tax basis tracks the individual partner s after tax investment in the partnership. At-risk basis reflects the partner s economic risk of loss by use of the liabilities to finance tax basis losses. Partnership-level debt provides tax basis and at-risk basis for partners to deduct losses prior to repayment of the debt or contribution of capital. 54

55 At-Risk Basis At-risk basis IRC Sec. 465 Partners and LLC members allocated losses are limited to the capital contributed and amounts they may be obligated to personally repay or have pledged as security for debt. Recourse and non-recourse debt can provide basis for deduction of tax losses in excess of capital for tax purposes. At-risk amounts generally do not include non-recourse debts. Allocation of at risk debt amounts Complicated rules using a constructive liquidation approach Generally, recourse debts allocated by loss ratio and nonrecourse debt allocated by profit ratio 55

56 At-Risk Basis (Cont.) The role of debt in computing basis Debt reflects the economic at-risk amounts of a partner s interest in a partnership. Debt supports the allocations and deductions of operating losses, for tax and at-risk purposes. Deficit capital accounts are rare without debt. Entity level debt for tax and at-risk basis is a major difference between partnerships and S corporations in computing outside basis. 56

57 At-Risk Basis (Cont.) Partnership basis comparisons 57

58 At-Risk Basis (Cont.) Compliance: Form 6198 Required form if there are current amounts not at-risk Non-recourse loans used to finance the activity Exception for QNR financing Cash, property or borrowed amounts protected against losses with a guarantee or other type stop-loss arrangement Loans that would qualify as recourse or QNR except for the lender being another partner/llc member or 10% related member (IRC Sect. 465(b)(3)(C)) 58

59 At-Risk Basis (Cont.) Compliance: Form 6198 (Cont.) Increases and decreases to at-risk amounts Amounts similar to tax basis increases and decreases FMV of pledged property property not used in activity used to borrow amounts provided to activity Cash or adjusted basis of contributed property Increase in non-recourse debt, or a change from recourse debt to non-recourse debt, can cause a decrease. Change in QNR debt to recourse due to guarantee can be a significant decrease. Deficit basis amounts are subject to at-risk loss recapture. 59

60 At-Risk Basis: Debt Allocation Allocation of recourse debt Reg Follows a constructive liquidation computation, in which assets are valued at zero and sold for the amount of debt. The partner bears the economic risk of loss in this test to the extent he is obligated to pay the creditor or make a contribution to the partnership to satisfy the liability. In practice, this allocation most often follows the loss ratio of the partner. 60

61 At-Risk Basis: Debt Allocation (Cont.) Allocation of non-recourse debt Reg Partnership minimum gain, the excess of a non-recourse liability over the 704(b) book value Partner s 704(c) gain if property is disposed for the amount of the associated debt Remaining amounts allocated by profit ratio 61

62 At-Risk Basis: Debt Allocation (Cont.) Partner at-risk basis accounting affected by type of entity General partnership (GP) All partners have unlimited liability for all partnership debts and would be considered as recourse debts and at-risk. Limited partnership (LP) The general partner would have unlimited liability, but the limited partners do obtain at risk basis on QNR debt, as the associated real property is considered pledged for the debt (IRC Reg (b)(4)). 62

63 At-Risk Basis: Debt Allocation (Cont.) Partner at-risk basis accounting affected by type of partner (Cont.) Limited liability company (LLC) Generally, all debts are non-recourse, and members are not at risk with the exception of direct member loans to the LLC. Member-guaranteed loans and debt that qualifies as QNR Limited liability partnership (LLP) Partner is not liable for the debts of the LLP. Allocation rules will be similar to LLC. Limited liability limited partnership (LLLP) Similar debt allocations rules as with limited partnerships, with the general partner having unlimited liability 63

64 At-Risk Basis: Debt Allocation (Cont.) Contrast with S corporations Debt within S corps does not provide at-risk or tax basis for deducting losses by the shareholder. Shareholder direct loans provide basis. Very limited tax cases of shareholder guaranteed inter-company debt providing at risk basis for losses No QNR debt allocation within an S corporation will provide atrisk basis for loss deduction 64

65 Example: Tax Basis And At-Risk Basis comparisons with debt allocations 65

66 Example: Tax Basis And At-Risk (Cont.) Basis comparisons with disproportional debt allocations 66

67 Debt Allocation Issues Multi-tiered partnerships Reg (a): An upper-tier partnership's share of the liabilities of a lower-tier partnership (other than any liability of the lower-tier partnership that is owed to the upper-tier partnership) is treated as a liability of the upper-tier partnership for purposes of applying section 752 and the regulations thereunder to the partners of the upper-tier partnership. Pass-through recourse debt can change to non-recourse debt on second-tier LLC. Debt guaranteed by an upper-tier LLC does not become recourse debt to the member. Debt allocable to a DE is allocable to the extent of the DE value, per Reg (k), rather than look-through to the owner of the DE. 67

68 Debt Allocation Issues (Cont.) Shifting of at-risk amounts Non-recourse debt and QNR can become recourse debt to the guarantor partner/member and shift the related allocations of expenses to the guarantor. Debt refinancing in which a new guarantor executes a guarantee can cause a debt shift and recapture of prior at risk losses. Drafting guarantees by the appropriate members can insure allocations do not shift to a single guarantor Aggregation of activities IRC Sect. 465(c)(2)(B) 68

69 Debt Allocation Issues (Cont.) Debt guarantees Recourse debt Minimal effect on at-risk amounts for a partner, since he steps into the shoes of the creditor upon payment and has a right to collect from the partnership or other partners. Non-recourse debt Risk of loss can substantially shift to the guarantor, especially if when there is a waiver of subrogation or recourse against the partnership. De minimis exceptions Reg (d) states a guarantor with a 10% or less interest in the partnership is not considered to bear the economic risk when they guarantee debt. 69

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71 Proposed Reg And Tax Cases Proposed regulations Proposed Reg (d) states a guarantor does not receive at-risk basis until the taxpayer/guarantor pays on the guarantee and has no right to reimbursement. Proposed Reg (d) is the Service s position, per the IRS Audit Guide on Partnerships. This is similar to what an S corp. shareholder would face with a debt guaranteed by a shareholder. T.D /21/2012: IRS has retroactively removed the de minimis rule in the partnership regs of (those owning less than 10%). CCA , 2/22/2013: Office of Chief Counsel of IRS provides opinion contrary to proposed Reg (d). 71

72 Proposed Reg And Tax Cases (Cont.) Tax cases government position 1983 Tax Court Decision, (Brand v. Commissioner 81 T.C. 821), held partners were not at risk for the partnership loans they guaranteed, since they were entitled to reimbursement from the primary obligor. Subsequent cases uphold the shift in at-risk amounts to the guarantor. Melvin v Commissioner 88 T.C. 63 (1987) looks at who will ultimately be obligated to pay the partnership debt obligations if the partnership is unable. A limited partner or LLC member is not considered at-risk for partnership recourse debt, and the existence of a DRO provision may not change this under Sect. 465, (Hubert Enterprises T.C. Memo , supplementing, 125 T.C. 72 (2005). 72

73 Proposed Reg And Tax Cases (Cont.) Tax cases guarantee increases at-risk basis Abramson, Edwin D.,et al, (1986) 86 TC 360 Gefen (1986) 87 TC 1471 Bennion, Sam H., (1987) 88 TC 684 Tax Court permitted increased basis when: Guarantee is absolute and unconditional. There is no right of subrogation or reimbursement from the entity or other owners. Guarantor bears the ultimate risk of responsibility for the debt similar to the hypothetical transaction in Reg , in which all of the assets are worthless and the payment of the liabilities is determined by who bears the economic risk. 73

74 Proposed Reg And Tax Cases (Cont.) Partnership law vs. LLCs State law applicable to partners may be different for LLC members in the way liabilities are allocated. LLC liability will generally be non-recourse, with the exception of QNR debt. S corp. owner or LLC member guaranteeing debt may have a legal right under state law for reimbursement upon paying the guaranteed debt. This takes away the absolute and unconditional nature of the guarantee. Check your state law with a knowledgeable attorney and/or consider changes to your operating agreement to take into consideration the effect of a guarantee and whether the allocations of income and losses resulting from the shift still represent substantial economic effect under IRC 704(d). 74

75 Summary Partnership basis follows four separate basis methods: 704(b) - >Tax ->At Risk ->Passive) Be aware of outside basis compared with inside basis Review debt obligations annually for guarantees Review operating agreements for possible changes to avoid unintended allocations Check with tax attorneys on your state law for LLC members 75