Chapter 5 of 523–33% of exam

Area V: Federal Taxation of Entities

Area V covers C corporations, S corporations, partnerships, LLC classification and tax-exempt organizations, with an emphasis on preparing and reviewing returns. Expect reconciliations from book to taxable income, basis roll-forwards and classification of items as ordinary or separately stated.

C corporations and book-tax differences

A C corporation pays a flat 21 percent tax on taxable income, which starts from book income and is reconciled on Schedule M-1 or, for larger corporations, Schedule M-3. Permanent differences never reverse; temporary ones do. Several deductions have corporate-only rules, and state taxation turns on nexus and apportionment.

Book-tax reconciliation

Federal income tax expense, fines paid to a government and the nondeductible half of meals are added back; tax-exempt interest is subtracted. Corporations with $10 million or more of total assets file Schedule M-3.

IRC 275; IRC 162(f); IRC 274(n); Instructions for Schedule M-3

Dividends received deduction

50 percent (less than 20 percent owned) or 65 percent (20 percent or more owned), limited to that percentage of taxable income unless the full deduction creates or increases an NOL.

IRC 243(a), (c); IRC 246(b)

Losses

Net capital losses offset only capital gains and carry back 3 and forward 5 years; NOLs from years after 2017 carry forward indefinitely, deductible up to 80 percent of taxable income.

IRC 1211(a); IRC 1212(a); IRC 172(a)

Estimated tax

A large corporation (taxable income of $1 million or more in any of the prior 3 years) must base installments after the first on current-year tax.

IRC 6655(d)(2), (g)(2)

State nexus and apportionment

Public Law 86-272 bars a state net income tax when in-state activity is limited to soliciting orders for tangible goods approved and shipped from outside; business income is apportioned by formula and nonbusiness income allocated, such as dividends to the commercial domicile.

15 U.S.C. 381; UDITPA

S corporations

S status requires a small business corporation and a timely election, and it ends by revocation, by ceasing to qualify, or by excess passive income with old C earnings. Income and loss pass through, separately stated where their character matters, and shareholder basis controls both loss deductions and the taxation of distributions.

Eligibility

A domestic corporation with no more than 100 shareholders (a family counts as one), only individuals, estates, certain trusts and exempt organizations as shareholders, no nonresident aliens, and one class of stock (voting differences are ignored).

IRC 1361(b)-(c)

Election and termination

An election made by the 15th day of the third month applies to the current year; otherwise the next year. Revocation needs holders of more than half the shares. Ceasing to qualify terminates the election that day; re-election generally waits five years.

IRC 1362(b), (d), (g)

Passive income test

The election terminates after three consecutive years with accumulated C earnings and profits and passive investment income over 25 percent of gross receipts.

IRC 1362(d)(3)

Basis ordering

Stock basis is increased for income, then reduced for distributions, nondeductible expenses and losses, in that order; losses beyond stock and debt basis carry forward, and income first restores reduced debt basis.

IRC 1366(d); IRC 1367; Treas. Reg. 1.1367-1(f)

Distributions and AAA

With no accumulated earnings and profits, distributions are tax-free up to stock basis and gain beyond it; the AAA tracks income and deductions like basis but ignores tax-exempt items.

IRC 1368(b), (e)

Partnerships

Partnerships file Form 1065 and pass items through on Schedule K-1. Ordinary business income is reduced by guaranteed payments, while capital gains, section 1231 items and charitable contributions are separately stated. A partner's outside basis starts with contributions and moves with income, losses, distributions and shares of partnership liabilities.

Contributions

No gain or loss on contributing property for an interest; the partner's basis and the partnership's basis in the property both equal the contributed property's adjusted basis.

IRC 721; IRC 722; IRC 723

Guaranteed payments

Payments for services or capital determined without regard to partnership income are deductible by the partnership and ordinary income to the partner.

IRC 707(c)

Basis and liabilities

Basis increases for income (including tax-exempt income) and for increases in the partner's share of liabilities, and decreases for distributions, losses and decreases in liability shares.

IRC 705; IRC 752

Distributions

Gain is recognized only when money exceeds basis; distributed property takes the partnership's basis, limited in a current distribution to the partner's remaining basis.

IRC 731(a); IRC 732(a)

Tax year

A partnership generally uses the tax year of partners owning more than 50 percent of profits and capital.

IRC 706(b)

LLC classification and tax-exempt organizations

An LLC's federal tax status follows the check-the-box regulations rather than state law. Exempt organizations are classified by the Code section describing their purpose, and even exempt organizations pay tax on unrelated business income.

Default classification

A domestic eligible entity with one owner is disregarded; with two or more members it is a partnership; either may elect corporate status, and a change generally cannot be repeated for 60 months.

Treas. Reg. 301.7701-3

Types of exempt organizations

Section 501(c)(3) covers charitable and educational organizations, 501(c)(4) social welfare organizations, 501(c)(6) business leagues and trade associations, and 501(c)(7) social clubs.

IRC 501(c)

Unrelated business income

Income from a regularly carried on business not substantially related to the exempt purpose is taxed; dividends, interest and royalties are excluded, as is a business run substantially by volunteers.

IRC 511-513

General business credit

Unused credit carries back one year and forward 20 years.

IRC 39(a)(1)

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