Cpa Regulation Notes - Chapter 4

Chapter 4 – Partnership Taxation FORMATION General Rule
No gain or loss is on a contribution of property to a partnership in return for a partnership interest. Exceptions to non-recognition of gain (taxable events): • Capital interest acquired for services rendered (FMV)
Value of partnership interest acquired for services is ordinary income to the partner • Property subject to a (excess) liability
Property contributed subject to excess liability, the excess amount is taxable boot as a gain to the partner Basis: • • • • •

Cash – Amount contributed Property – Adjusted basis (NBV) - Put in by partner and is assumed by other partners is a reduction Services – FMV and taxable to incoming partner Liabilities – Other partners’ put in liabilities, and is assumed by incoming partner

Income Taxable
FMV
Non-taxable
None


Basis FMV NBV

Property subject to a excess liability = taxable boot
Property is contributed which has liability where the decrease in the partner’s individual liability exceeds his partnership basis, the excess amount is taxable boot = taxable gain to the partner Partnerships
Subtract only the liabilities assumed by the other partners and not the entire liability Corporations
Subtract 100% of liability Partner’s capital account in a partnership can never begin with a negative balance (when liabilities assumed by partnership are greater than the basis (NBV) of assets contributed). The excess liability is treated like taxable boot, not a negative capital account. The partner’s original holding period (before the partnership) remains as the partnership’s holding period if it is a capital asset or Section 1231 asset. (Partner bought asset in 1981, gave to partnership in 2007. Holding period = 1981). If ordinary income asset (i.e. inventory), the holding period restarts when the partnership acquires it (in 2007). Contributions = increase basis Withdrawals = decrease basis When a partner contributes property (which has a FMV that is higher or lower than basis), the “built-in” gain or loss with respect to the contributed property (when sold) must be allocated to the contributing partner. Partnership’s basis for contributed property = NBV Partnership takes the contributor’s basis for any contributed property (plus any gain recognized by the incoming partner).

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BASIS B–

Beginning Capital Account

Cash FMV services NBV assets

A–

+ % All Income

S–

<% All Losses>

Ordinary Capital Tax-free Partner may take a partnership loss as a tax deduction up to his/her basis

<Withdrawals>

E–

=

Property distribution reduce by adjusted basis (NBV) of distributed property; up to -0- in capital account

Ending Capital Account + % Recourse Liabilities Year-End Basis

***Difference between capital account and partnership basis: Basis = Capital Account + Partner’s Share of Liabilities Partnership tax returns
Not subject to income taxes, but files a partnership tax return for only the information (Schedule K and K-1) Tax year – Calendar year required. Otherwise 3 month deferral is permitted (ends on Sept.30, Oct.31, Nov.30, Dec. 31) Partnership terminates when: 1. Operations cease 2. 50% or more of the total partnership interest in both capital and profits is sold or exchanged within any 12-month period
Close old account and open new account!! 3. There are less than two partners Termination = 1. Distribution to remaining partners and purchaser, 2. Re-contribution of assets to a new partnership Related party = transactions between partnership and a controlling partner (over 50%): • Related party loss (WRaP) is Disallowed • Related party gain is ordinary income Determination of partner’s share of income, credits, and deductions  A partner must include his distributive share of partnership income – even if not received – in his tax return for his taxable year within which the taxable year of the partnership ends  Income
Taxable
Increase basis  Withdrawals
Non-taxable
Decrease basis Partnership loss deduction is limited to the partner’s adjusted basis, which is increased by partnership liabilities that he is personally liable for. Any unused loss can be carried forward and used in a future year when basis is available.

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Guaranteed payments = salary to partners • Deductible to the partnership • Taxable income to the partner: included on Schedule K-1 as ordinary income, and may be included as part of net earnings from self-employment Not-guaranteed payments = not deductible to partnerships b/c it is another way to distribute profits Payments received by retired partners = 1. Deductible to partnership, 2. Ordinary income to recipient Most elections that affect the calculation of taxable income are made by the partnership (i.e. depreciation and accounting methods)

Organizational expenditures and start-up costs: o Same as before – deduct up to $5,000 each for organizational expenditures and start-up costs, reduced if either types of cost exceed $50,000. Excess costs are amortized over 180 months (GAAP rule: expense immediately)

Syndication costs (i.e. offering materials, raising money) are not deductible

When partnership transfers a capital or profits interest in the partnership to a creditor in satisfaction of partnership debt, the partnership recognized “cancellation of debt” income. Partnership does not pay taxes
It reports partnership income and losses on K-1 Partnership files an information return Form 1065 by April 15 (extension to July 15) Items pass through each individual partner as separate line items to be treated by each partner according to their portion The items are reflected on K-1 and each partner gets their own K-1

Individual partners report net income or loss on Schedule E o Partner must include on his personal income tax return his distributive share of each separate “pass-thru” item o Guaranteed payments are distributive deductions to the partners via the partnership K-1 and also taxable income to individual partner receiving the payments Partner’s share of loss is limited to the basis. A partner cannot have a negative loss. The excess of basis is a carry-forward indefinitely. DISTRIBUTION - Treat like bank withdrawals! - Generally, it is non-taxable to partner - Distribution of cash or property received is the same basis as with the partnership - Property = Non-taxable = NBV (but limited to basis) o The basis may not exceed basis in partnership o Stop at zero! - Gain is only recognized to the extent of cash excess the basis LIQUIDATION 3 ways: 1. Complete withdrawal 2. Sale of partnership interest 3. Retirement or death Complete withdrawal (liquidation) Partner’s basis = same as basis in partnership, but reduced by any monies actually received

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Non-taxable Liquidation Beginning Capital Account % Income Up to Withdrawal Partner’s Capital Account % of Liabilities Adjusted Basis @ Date of Withdrawal Remaining Basis to Be Allocated to Assets Withdrawn Rule: Zero out to get out! Partner recognizes gain only to the extent that money received exceeds the partner’s basis. Partner recognizes loss if only money, unrealized receivables, or inventory are received and if the basis of assets received is less that his basis – see example on page: R4-18 Withdrawal
Non-liquidating
Liquidating


Basis Used
Stopping Point NBV Asset Taken
Stop at Zero Partnership interest
Must “Zero-out” Account

Sale of Partnership Interest (Liquidation) Generally, partner has capital gain or loss when transferring partnership because partnership is a capital asset Gain or Loss on Transfer (General Rule – Capital Gain/Loss) Gain = difference between realized amount of sale and basis in partnership Partnership liabilities transferred to buyer are part of realized amount

Beginning Capital Account % Income Up to Withdrawal

Net effect is ZERO!!!

Capital Account @ Sale Date % of Liabilities Adjusted Basis

Amount Received = Cash, Cancellation of debt (COD), FMV Property

Gain or Loss

NOTE: % of Liabilities and the Cancellation of Debt (COD) = Net effect is ZERO!!! Exception (Ordinary Income, not Capital Gain): Any gain representing partner’s share of “hot assets” is treated as “ordinary income” as if cash were taken. “Hot Assets” = - Unrealized receivables (as if exchanged for cash) - Appreciated inventory (as if exchanged for cash) Retirement or Death of Partner Payments to retiring partner or successor of deceased partner to liquidate his partnership are allocated between payment for interest in partnership assets and other payments.

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Payment for partnership interest assets is a capital gain or loss. Other payments are partnership income. This “other payments” are taxable as ordinary income to retired partner.

Estate, Trust, and Gift Taxation Distributions are deductible by the trusts and estates, but taxable to recipient. Estates and trusts are conduits. Gifts may be taxed, and gift tax is payable by the donor. Fiduciary: Trustee of a trust and Executor of an estate Estate taxation: • Income tax: o Income earned while the estate is in existence • Estate tax: o Transfer tax based on value of estate (taxed to estate before transfer of property) Unified estate and gift tax (transfer tax): • Cumulative lifetime gifts: gifts under $12,000 per person per year are tax-free • Death time transfers: credit for lifetime gifts $345,800 exempts the first $1,000,000 of lifetime transfers. Credit for combined lifetime gifts and death time transfers $780,800 exempts the first $2,000,000 in life/death transfers Corpus = principal (vs. Income) Distributable Net Income (DNI): Estate/Trust Gross Income [includes capital gains] - Estate/Trust Deductions = Adjusted Total Income [Form 1041, line 17] + Tax Exempt Income - Capital Gains [attributable to corpus] = Distributable net Income (DNI) Gross income = includes capital gains, and determined in the same manner as for individuals Deductions = allowed for • Carrying on a trade or business • Production of income • Management or conservation of income-producing property (incl. Trustee’s or executor’s fees) • Determination, collection, or refund of any tax • Contributions to a charity (unlimited charitable deduction allowed if in the will) Tax credits = usually the same for individuals and for fiduciaries Income distributed to the beneficiaries = income distributed to beneficiaries is same character as at the fiduciary level (this is similar to partnership) Income distribution deduction = LESSER of: • Actual distribution to beneficiary, OR • Distributable net income (DNI) less any tax-exempt income Annual ESTATE Income Tax (Form 1041): • Required when income exceeds $600 (exemption for estate = $600, no standard deduction) • Tax year – may elect either calendar year or fiscal year – You can die anytime! • Is exempted from making estimated tax payments for the first two years!

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Annual TRUST Income Tax (Form 1041): • • •

•

All trusts, except tax-exempt trusts, must use a calendar year May deduct amounts distributed to beneficiaries up to the DNI Simple trusts o Makes distributions out of current income, cannot make distributions from trust corpus o Required to distribute all of its income o Cannot take a deduction for a charitable contribution o Entitled to a $300 exemption in arriving at its taxable income Complex trusts o Trust may be simple one year and complex the next o May accumulate current income o May distribute principal o May deduct charitable contributions o Permitted an exemption of $100 in arriving at its taxable income

Income tax years: Trusts = year-end = I “trust” you will remember Dec. 31 is year-end Estates = anytime = the government lets you die “anytime” Estate Tax (Form 706) = transfer tax • Filing requirements – gross estate exceeds $2,000,000 for 2006-2008 • Must be filed within 9 months after the decedent’s death –9 months from conception to birth, 9 months after death

Gross Estate

FMV Property Insurance Proceeds Incomplete Gifts Revocable Transfers Income in respect of decedent

FMV Assets

< Nondiscretionary Deductions >

Medical Expenses Administrative Expenses Outstanding Debts Claims Against the Estate Funeral Expenses Indebtedness of Property Certain Taxes (i.e. taxes before death and state death taxes)

< Liabilities >

= Adjusted Gross Estate < Discretionary Deductions >

= Net Worth Charitable Bequests Marital Deductions

= Taxable Estate Adjusted Taxable Gifts

< Transfers >

= Remainder Post 1976 gifts that were taxed No double tax because subtracted later in this computation

= Tentative Tax Base at Death

x Tax Rate

= Estate Tax

x Uniform Tax Rates

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= Tentative Estate Tax < Gift Taxes Paid >

< Credits >

= Gross Estate Tax < Unified Credit >

< State Taxes >

= Estate Tax Due

= Federal Estate Tax

Gross Estate = value at date of death (or alternate valuation date 6 months after date of death • FMV of Property Owned (spouse joint = 50/50 or non-spouse = 100% less other owner’s contribution) • Insurance proceeds (if estate is beneficiary) • Incomplete gifts (joint accounts) [Gift = Drawn upon] • Revocable transfers • All property entitled to be received (income in respect of a decedent) -

Individual dies 6 months (maximum) to value the property 9 months to file tax form

Taxpayer
Estate
Beneficiary


Event
Taxed
Taxable
FMV
Non-taxable
None


Basis FMV NBV (FMV from estate)

Estate Deductions = Reduced by non-discretionary expenses and discretionary expenses. Non-discretionary expenses: • Medical expenses = it is an expense on income tax return or liability on estate tax return, but not both • Administrative expenses = it is an expense on income tax return or liability on estate tax return, but not both • Outstanding debts of decedent • Claims against the estate • Funeral costs • Certain taxes (including State Death Taxes) Discretionary expenses: • Unlimited Charitable Deduction • Unlimited Marital Deduction Credits that reduce the gross estate tax include: • Unified credit: federal estate law provides for unified credit instead of exemptions for gift and estate taxes paid • Foreign death taxes • Prior death taxes: technically not a credit, but subtracted from tentative estate tax to arrive at gross estate tax The Gift Tax Annual exclusion: gifts under $12,000 per person per year are tax free Unlimited Exclusion: • Payments made directly to an educational institution • Payments made directly to a health care provider for medical care • Charitable gifts • Marital deduction (must be a terminable interest)

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Gifts: Present vs. Future Interest • Future interest = Postponement of right to use, possess, or enjoy the property • Present interest = annual exclusion and in most instances would be removed from estate • Future interest (or present interest without ascertainable value) does not qualify for the annual exclusion Future interest gifts: - Reversions (gifting assets and later getting the property back) - Remainders (distributed at some future time) - Trust income interests where accumulation of income by a trustee is mandatory and distribution is in the future - Present interests without ascertainable value Present interest gifts: - Outright gifts of cash or property - Trust income interests where annual or more frequent distribution is mandatory - Life estates (ownership of right to use property presently, but not ownership of property itself) - Estates for a term certain - Bonds or notes (even though interest is not payable until maturity) - Unrestricted transfers of life insurance policies Gifts: Complete vs. Incomplete Gifts - Complete gifts qualify for annual exclusion and or not considered part of gross estate at death - Incomplete gifts are included in gross estate for computing estate tax o Conditional gifts (must graduate from college to get a car for a gift) o Revocable gifts (donor reserves the right to revoke the gift or change beneficiaries) Basis to the recipient equals donor’s basis plus gift tax paid due to the appreciation in value inherent in the gift. “Total amount of gifts” – aggregate value of all gifts made during calendar year less applicable annual exclusions In order to apply the annual exclusion to a gift, it must be: • A present interest • Complete • Under $12,000/$24,000 per donee (unless paid directly for medical expenses or educational expenses) Generation-Skipping Transfer Tax (GSTT) - Designed to prevent a rich individual from escaping an entire generation of gift and estate tax - Separate tax in addition to federal estate and gift tax - Applies when individuals transfer property to a person that is two or more generations younger than donor - Trustee or transferor pays GSTT Tax Return Preparer Issues Penalties:  Failure to file a tax return by due date  Failure to pay the tax due  Accuracy related penalty  Fraud penalty  Earned income credit penalties Preparer must provide a copy of the return to the taxpayer by or at the time the taxpayer signs the original Preparer must keep: o A list of those for whom returns were filed, OR o Copies of the returns for three years

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Preparer shall be subject to additional penalties for: o Disclosure to enable third party to solicit business, and o Knowing or reckless disclosure of information Acceptable circumstances for disclosure: o Computer processing o Peer review o Administrative order (court order) A tax preparer should make reasonable inquiries if the taxpayer’s information is incomplete Upon discovering an error, the CPA should promptly notify the client (either orally or in writing) of the error, and advise the client of the appropriate measure to be taken. If client does not rectify, CPA should consider withdrawing. The Sarbanes-Oxley Act of 2002 SOX provides for Public Company Accounting Oversight Board (PCAOB) which consists of 5 members: - 2 members must be CPAs - 3 members cannot be CPAs Board is subject to oversight by the SEC and has the duty to: • Register public accounting firms that prepare audit reports for issuers • Establish rules relating to the preparation of audit reports for issuers • Conduct inspections, investigations, and disciplinary proceedings concerning registered public accounting firms Only a registered public accounting firm with PCAOB may prepare audit reports for an SEC issuer Each registered firm must adhere to the following auditing standards: • Maintain audit work-papers and supporting documentation for seven years • Provide a concurring or second partner review of each audit report • Describe in audit reports the scope of the testing of the issuer’s internal control structure and procedures SOX prohibits a registered public account firm to offer “FIVE MEALS” for its auditing clients:         

F – Financial Information Systems Design/Implementation I – Internal Audit Outsourcing V – Valuation/Appraisal E – Examining Bookkeeping Functions M – Management/HR Function E – Expert Services A – Actuarial Services L – Legal Services S – Suggesting Investments

Tax service is permissible if pre-approved by audit committee. A partner must rotate off the audit every 5 years. 1 year cool-off period - Cannot audit public companies whose CEO, CFO, etc. if also a previous employee of the accounting firm who worked on the audit during the preceding year. Audit committee appointed by the board

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CEO and CFO must sign 10-K and 10-Q reports, whether or not they have a code of ethics for senior financial officers. If they do not have a code, they must state why. - The report is true, does not contain material deficiencies, and fairly represents the issuer’s financial position - Signing officer is responsible for establishing internal controls Auditors must retain work-papers related to issuer’s audit for 7 years. Statute of limitations from securities fraud
later of 2 years after discovery or 5 years after action occurred Whistleblower protection: employees discharged because they lawfully provided information about the firms conduct may sue their employer. Ethics and Professional Responsibilities

Consulting services may include one or more of the following: consultations, advisory services, implementation services, transaction services, staff and other support services, and product services.

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