Stock Basis Calculation for Pass-Through Entities: Challenges for - - PowerPoint PPT Presentation

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Stock Basis Calculation for Pass-Through Entities: Challenges for - - PowerPoint PPT Presentation

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


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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

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

Shauna Shafer, Eide Bailly sshafer@eidebailly.com

  • Aug. 6, 2013

Frank Gariepy, Eide Bailly fgariepy@eidebailly.com

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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 51 – Slide 75 Slide 36 – Slide 50

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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.

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S CORPORATION BASIS CALCULATIONS

Frank Gariepy, Eide Bailly

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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

  • riginally 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.

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Background

  • S corporation basis is “simple.”
  • Increases
  • Amounts earned
  • Amounts contributed
  • Decreases
  • Amounts deducted
  • Amounts distributed
  • Cannot go negative

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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

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Increases To Stock Basis

  • Capital contributions (property or cash)
  • Ordinary income
  • Investment income
  • Gains
  • Excess of deductions for depletion

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Decreases To Stock Basis

  • Distributions (property or cash)
  • Business deductions
  • Non-deductible expenses
  • Contributions
  • 179 deduction
  • Losses

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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.

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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
  • ut 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. 1.1367-1(g)]

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Example: [Reg. 1.1367-1(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.

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Example 1: [Reg. 1.1367-1(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)

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Example 2: [Reg. 1.1367-1(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

  • f 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)

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[Reg. 1.1367-1(g)]

  • The election to reduce basis by loss or deduction items before non-

deductible 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
  • ver, even if basis is reduced to zero in the current year.

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When To Calculate Basis?

  • Normally calculated at the end of the corporation’s taxable year

[Reg. 1.1367-1(d)]

  • Exceptions:
  • Disposal of entire shareholder interest
  • Disposal of substantial interest

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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].

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Cut-Off Method

  • Shareholder’s entire interest is disposed.
  • Requires “specific accounting election” under [Reg. 1.1377-1(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.

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Cut-Off Method: Example

  • Same facts as previous examples
  • The corporation had net income for the year of $400,000, made up
  • f 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.

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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

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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.

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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.

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Cut-Off Method: Other Options

  • Qualifying disposition of stock [Reg. 1.1368-1(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.

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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.

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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

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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

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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)

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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

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Debt Basis: Requirements (Cont.)

  • Prop. Reg. 1.1366-2(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

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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

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PARTNERSHIP BASIS CALCULATIONS

Shauna Shafer, Eide Bailly

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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.

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Partnership Basis Comparisons

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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)

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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

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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

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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)

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Tax Basis Of Transferred Interest: Sect. 742

  • Purchase – price paid
  • Gift – donor’s basis
  • Inherited – fair market value

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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.

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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

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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

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Allocation Of Liabilities

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

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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

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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

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PARTNERSHIP AND LLC AT- RISK BASIS

Frank Gariepy, Eide Bailly

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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

  • riginally 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.

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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

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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.

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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 non-

recourse debt allocated by profit ratio

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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.

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At-Risk Basis (Cont.)

Partnership basis comparisons

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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))

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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.

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At-Risk Basis: Debt Allocation

  • Allocation of recourse debt Reg. 1.752-2
  • 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.

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At-Risk Basis: Debt Allocation (Cont.)

  • Allocation of non-recourse debt Reg 1.752-3
  • Partnership minimum gain, the excess of a non-recourse liability
  • ver 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

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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. 1.465-27(b)(4)).

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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

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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 at-

risk basis for loss deduction

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Example: Tax Basis And At-Risk

  • Basis comparisons with debt allocations

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Example: Tax Basis And At-Risk (Cont.)

  • Basis comparisons with disproportional debt allocations

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Debt Allocation Issues

  • Multi-tiered partnerships
  • Reg. 1.752-4(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

  • f 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. 1.752-2(k), rather than look-through to the owner of the DE.

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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)

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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. 1.752-2(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.

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Proposed Reg And Tax Cases

Proposed regulations

  • Proposed Reg. 1.465-6(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. 1.465-6(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. 9607 12/21/2012: IRS has retroactively removed the de

minimis rule in the partnership regs of 1.704-1 (those owning less than 10%).

  • CCA 201308028, 2/22/2013: Office of Chief Counsel of IRS

provides opinion contrary to proposed Reg. 1.465-6(d).

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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

  • bligations 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 2008-46, supplementing, 125 T.C. 72 (2005).

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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. 1.752- 2, in which all of the assets are worthless and the payment of the liabilities is determined by who bears the economic risk.

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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).

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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 un-

intended allocations

  • Check with tax attorneys on your state law for LLC members

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