Chapter 2 of 430–40% of exam

Area II: Entity Tax Compliance

This area covers nonroutine compliance for C corporations, S corporations, partnerships, trusts and exempt organizations. The recurring task is to follow noncash property into and out of an entity and track the owner's basis. International items are limited to general sourcing and structure concepts; foreign law and treaties beyond the basic permanent establishment idea are not tested.

C corporations: losses, transfers, distributions and consolidation

Net operating losses from recent years carry forward only, subject to an 80% limit. Corporate capital losses offset only capital gains. A change in ownership caps the use of old losses. Section 351 governs transfers of property to a controlled corporation, and distributions of appreciated property trigger gain at the corporate level. Affiliated groups may file one consolidated return, which defers gains on sales between members.

NOL deduction limit

For losses arising after 2017, the deduction is limited to 80% of taxable income before the NOL deduction. Losses arising after 2020 carry forward indefinitely, with no carryback for most corporations.

IRC §172(a)(2), (b)(1)(A)

Corporate capital losses

Capital losses offset only capital gains. A net capital loss is carried back three years and forward five years as a short-term loss.

IRC §1211(a), §1212(a)(1)

Section 382 limitation

After a more-than-50-percentage-point ownership change within the testing period, pre-change losses may offset only the old loss corporation's value times the long-term tax-exempt rate each year.

IRC §382(b), (g)

Liabilities in excess of basis

In a §351 exchange, liabilities assumed that exceed the total basis of the property transferred are gain to the transferor.

IRC §357(c)

Distributions of appreciated property

The corporation recognizes gain as if it sold the property. The shareholder's distribution and basis are measured at fair market value.

IRC §311(b), §301(b), (d)

International concepts

Income is sourced by type: interest by the payor's residence, services where performed, royalties where the property is used, and purchased inventory where the sale occurs. A foreign corporation pays a 30% gross-basis tax on passive U.S.-source income, collected by withholding. Its effectively connected income is taxed on a net basis, and a U.S. branch also faces the branch profits tax. A controlled foreign corporation is defined by the stock held by its 10% U.S. shareholders.

Sourcing of services and royalties

Compensation for services is sourced where the services are performed, and royalties where the property is used.

IRC §861(a)(3)-(4), §862(a)(3)-(4)

FDAP income of foreign corporations

U.S.-source fixed or determinable income not effectively connected with a U.S. business is taxed at 30% of the gross amount and withheld at source.

IRC §881(a), §1442

Controlled foreign corporation

A foreign corporation is a CFC if U.S. shareholders, each owning at least 10% by vote or value, together own more than 50%.

IRC §951(b), §957(a)

Permanent establishment

A fixed place of business, or a dependent agent who habitually concludes contracts, creates a permanent establishment. Storage and delivery facilities, independent agents and short construction projects do not.

U.S. Model Income Tax Convention (2016), Art. 5

S corporations and partnerships

Both pass income through to their owners, but basis works differently. An S shareholder's basis comes from stock and direct loans to the corporation. A partner's basis also includes a share of the partnership's debts. Distributions of property are taxable events for an S corporation but generally not for a partnership. Ownership changes bring per-day allocations, closing of the tax year for a departing partner, and optional or mandatory basis adjustments.

S corporation basis ordering

Basis is increased for income first, then reduced for distributions, and only then reduced for losses and deductions.

Treas. Reg. §1.1367-1(f)

S corporation debt basis

Only a bona fide debt the corporation owes directly to the shareholder counts. A guarantee creates none until the shareholder pays. Later net increases restore reduced debt basis before stock basis.

Treas. Reg. §1.1366-2(a)(2); IRC §1367(b)(2)

Partnership liabilities

An increase in a partner's share of liabilities is treated as a contribution of money. A decrease is treated as a distribution of money, and it produces gain to the extent it exceeds basis.

IRC §752(a)-(b), §731(a)(1)

Basis of distributed property

In a nonliquidating distribution, property takes the partnership's basis, limited to outside basis less cash. In a liquidating distribution, it takes outside basis less cash.

IRC §732(a)-(b)

Transfers of an interest

With a §754 election, or with a substantial built-in loss over $250,000, inside basis is adjusted for the transferee alone.

IRC §743(a)-(b), (d)

Trusts and exempt organizations

A trust is a simple trust in a year it must distribute all income, makes no charitable gifts and distributes no corpus; otherwise it is complex. Distributable net income caps the distribution deduction and carries the character of trust income out to beneficiaries. A revocable trust is a grantor trust. Exempt organizations keep their status by staying within §501(c)(3) and filing annual returns, and they pay tax on unrelated business income.

Capital gains and DNI

Gains allocated to corpus and not distributed or set aside for charity are excluded from distributable net income.

IRC §643(a)(3)

Tax-exempt income carried out

No distribution deduction is allowed for the part of a distribution made up of tax-exempt income.

IRC §661(c)

Political campaign prohibition

A §501(c)(3) organization may not participate or intervene in any campaign for or against a candidate for public office.

IRC §501(c)(3)

Automatic revocation

Failing to file a required annual return or notice for three consecutive years revokes exempt status.

IRC §6033(j)(1)

Unrelated business income

Income from a regularly carried on trade or business not substantially related to the exempt purpose is taxed. Dividends, interest, royalties and most real property rents are excluded.

IRC §512(b), §513(a)

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