Chapter 3 of 410–20% of exam

Area III: Entity Tax Planning

This area asks candidates to compare entity types and project the tax result of a proposed transaction before it happens. Typical questions compare formation and liquidation across entity types, time the use of losses, plan state tax exposure, and manage S corporation and partnership rules that depend on timing.

Choosing, forming and liquidating an entity

Legal features such as liability and management, together with the default tax classification, narrow the choice of entity. Forming a corporation and forming a partnership can give different results when the contributed property carries debt. Liquidation is where the difference is sharpest: a C corporation is taxed at two levels, an S corporation generally at one, and a partnership usually has no gain until the distributed property is later sold.

Default classification

A domestic eligible entity with two or more members is a partnership, and one with a single owner is disregarded, unless it elects otherwise.

Treas. Reg. §301.7701-3(b)(1)

Corporate liquidation

The corporation recognizes gain or loss as if it sold its property at fair market value. The shareholder treats what it receives as payment for the stock.

IRC §336(a), §331(a)

Partnership distributions

Neither the partnership nor the partner recognizes gain on a distribution of property other than money in excess of basis.

IRC §731(a)-(b)

C corporation planning

Planning for a C corporation includes timing income so that loss carryovers are used before they expire, choosing locations with state apportionment in mind, and meeting the estimated tax rules. Related-party rules can delay deductions that would otherwise be accrued. Distributing depreciated property wastes the loss, so selling first is usually better.

Large corporation estimated tax

A corporation with taxable income of $1,000,000 or more in any of the three preceding years may use the prior-year tax only for its first installment.

IRC §6655(d)(2), (g)(2)

Prior-year safe harbor

The prior-year exception is available only if that year was 12 months long and the return showed a tax liability.

IRC §6655(d)(1)(B)

Accruals to related parties

An accrual-method payer deducts an amount owed to a related cash-method payee only when the payee includes it in income.

IRC §267(a)(2)

P.L. 86-272

A state may not impose net income tax when the only in-state activity is soliciting orders for tangible goods, with the orders approved and filled from outside the state.

15 U.S.C. §381(a)

S corporation and partnership planning

A corporation that converts from C to S status carries a built-in gains tax on assets it held at conversion until its recognition period ends. S status can be lost when the corporation takes on an ineligible shareholder or keeps too much passive income while it has old E&P. In partnerships, contributed property keeps its built-in gain or loss with the contributing partner.

Built-in gains recognition period

The tax applies to built-in gain recognized in the five years beginning on the first day of the first S corporation year, at the highest corporate rate.

IRC §1374(b)(1), (d)(7)

Termination by ineligibility

The election ends on the day the corporation ceases to qualify, which splits the year into S and C short years. A new election generally must wait five years.

IRC §1362(d)(2), (e), (g)

Electing to distribute E&P first

With the consent of all affected shareholders, an S corporation may treat distributions as coming from accumulated E&P before AAA.

IRC §1368(e)(3)

Contributed property

Built-in gain is allocated to the contributing partner. Built-in loss is taken into account only for that partner, and distributing the property to another partner within seven years triggers the contributor's gain.

IRC §704(c)(1)(A)-(C)

Guaranteed payments

Payments for services or capital that do not depend on partnership income are included by the partner and deducted by the partnership.

IRC §707(c)

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