Module 6
Taxation of Flow-Through Entities
A. Partnership Formations and Acquisitions of Partnership Interests
Income earned by flow-through entities is usually not taxed at the entity level.
Instead, the owners of flow-through entities are taxed on the share of entity-level income
allocated to them. Thus, unlike income earned by C corporations, income from flow-
through entities is taxed only once—when it “flows through” to owners of these entities.1
Flow-through entities with multiple owners are governed by two somewhat different sets
of rules in our tax system.2 Unincorporated business entities such as general partnerships,
limited partnerships, and limited liability companies (LLCs) are generally treated as
partnerships under the rules provided in Subchapter K of the Internal Revenue Code.3 In
contrast, corporations whose owners elect to treat them as flow-through entities are
classified as such under the rules in Subchapter S. These corporations are called
S-corporations. See the Entities Overview chapter for further detail regarding the tax
treatment of different entity types.
When Congress adopted Subchapter K in 1954, it had to decide whether to follow
an entity approach and treat tax partnerships as entities separate from their partners or to
apply an aggregate approach and treat partnerships simply as an aggregation of the
partners’ separate interests in the assets and liabilities of the partnership. In the end,
Congress decided to apply both concepts in formulating partnership tax law. For instance,
one of the most basic tenets of partnership tax law—that partnerships don’t pay taxes—
reflects the aggregate approach. However, Congress also adopted other partnership tax
rules that fall more squarely on the side of the entity approach. For example, the
requirement that partnerships, rather than partners, make most tax elections represents the
entity concept. Throughout this and the following chapter, we highlight examples where
one or the other basic approach underlies a specific partnership tax rule.
When a partnership is formed, and afterwards, partners may transfer cash, other
tangible or intangible property, and services to the partnership in exchange for an equity
interest called a partnership interest. Partnership interests represent the bundle of
economic rights granted to partners under the partnership agreement (or operating
agreement for an LLC).6 These rights include the right to receive a share of the
partnership net assets if the partnership is liquidated, called a capital interest, and the
right or obligation to receive a share of future profits or future losses, called a profits
interest.7 It is quite common for partners contributing property to receive both capital and
profits interests in the exchange. Partners who contribute services instead of property
frequently receive only profits interests. The distinction between capital and profits
interests is important because the tax rules for partnerships are sometimes applied to them
differently.
Partnership formations are similar to other tax-deferred transactions, such as like-
kind exchanges and corporate formations, because realized gains and losses from the
exchange of contributed property for partnership interests are either fully or partially
deferred for tax purposes, depending on the specifics of the transaction. The rationale for
permitting taxpayers to defer realized gains or losses on property contributed to
partnerships is identical to the rationale for permitting tax deferral when corporations are
formed.8 From a practical perspective, the tax rules in this area allow entrepreneurs to
organize their businesses without having to pay taxes. In addition, these rules follow the
aggregate theory of partnership taxation because they recognize that partners contributing
property to a partnership still own the contributed property, albeit a smaller percentage,
since other partners will also indirectly own the contributed property through their
partnership interests.
As a general rule, neither partnerships nor partners recognize gain or loss when
they contribute property to partnerships.9 This applies to property contributions when a
partnership is initially formed and to subsequent property contributions. In this context,
the term property is defined broadly to include a wide variety of both tangible and
intangible assets but not services. The general rule facilitates contributions of property
with built-in gains, meaning the fair market value is greater than the tax basis, but it
discourages contributions of property with built-in losses, meaning the fair market value
is less than the tax basis. In fact, partners holding property with built-in losses are usually
better off selling the property, recognizing the related tax loss, and contributing the cash
from the sale to the partnership so it can acquire property elsewhere.
Among other things, partners need to determine the tax basis in their partnership
interest to properly compute their taxable gains and losses when they sell their
partnership interest. A partner’s tax basis in her partnership interest is called her outside
basis. In contrast, the partnership’s basis in its assets is its inside basis. As we progress
through this and the next chapter, you’ll see other important reasons for calculating a
partner’s outside tax basis. Calculating a partner’s initial tax basis in a partnership interest
acquired by contributing property and/or cash is relatively straightforward if the
partnership doesn’t have any debt. The partner will simply have a basis in her partnership
interest equivalent to the tax basis of the property and cash she contributed.10 This rule
ensures that realized gains and losses on contributed property are merely deferred until
either the contributing partner sells her partnership interest or the partnership sells the
contributed property.
Partnerships may have either recourse debt or nonrecourse debt or both, and the
specific approach to allocating partnership debt to individual partners differs for each.
The fundamental difference between the two types of debt lies in the legal responsibility
partners assume for ultimately paying the debt. Recourse debts are those for which at
least one partner has economic risk of loss—that is, they may have to legally satisfy the
debt with their own funds. For example, the unsecured debts of general partnerships, such
as payables, are recourse debt because general partners are legally responsible for the
debts of the partnership. Recourse debt is usually allocated to the partners who will
ultimately be responsible for paying it.12 The partners must consider their partner
guarantees, other agreements, and state partnership or LLC statutes in making this
determination.
Because a partnership interest is a capital asset, its holding period determines
whether gains or losses from the disposition of the partnership interest are short-term or
long-term capital gains or losses. The length of a partner’s holding period for a
partnership interest acquired by contributing property depends on the nature of the assets
the partner contributed. When partners contribute capital assets or §1231 assets (assets
used in a trade or business and held for more than one year), the holding period of the
contributed property “tacks on” to the holding period of the partnership interest.20
Otherwise, it begins on the day the partnership interest is acquired.
Unlike corporations, entities taxed as partnerships track the equity of their owners
using a capital account for each owner. The methodology for maintaining owners’ capital
accounts depends on the approach these entities use to prepare their financial statements.
For example, an entity preparing GAAP financial statements would track each owner’s
share of the equity using GAAP capital accounts maintained using generally accepted
accounting principles. In addition to tracking the inside basis of its assets for tax
purposes, partnerships not required to produce GAAP financial statements may decide to
use inside tax basis, as well as tax income and expense recognition rules, to maintain
their books. Under this approach, a new partnership would prepare its initial balance
sheet using the tax basis for its assets. In addition, it would create a tax capital account
for each new partner, reflecting the tax basis of any property contributed (net of any debt
securing the property) and cash contributions. Because each new partner’s tax capital
account measures that partner’s equity in the partnership using tax accounting rules, it
will later be adjusted to include the partner’s share of earnings and losses, contributions,
and distributions.
So far we’ve assumed partners receive their partnership interests in exchange for
contributed property. They may also receive partnership interests in exchange for services
they provide to the partnership. For example, an attorney or other service provider might
accept a partnership interest in lieu of cash payment for services provided as part of a
partnership formation. Similarly, ongoing partnerships may compensate their employees
with partnership interests to reduce compensation-related cash payments and motivate
employees to behave more like owners. Unlike property contributions, services
contributed in exchange for partnership interests may create immediate tax consequences
to both the contributing partner and the partnership, depending on the nature of the
partnership interest received.
It’s fairly common for partnerships to compensate service partners with profits
rather than capital interests. Profits interests are fundamentally different from capital
interests, because the only economic benefit they provide is the right to share in the future
profits of the partnership. Unlike capital interests, profits interests have no liquidation
value at the time they are received. Nonservice partners generally prefer to compensate
service partners with profits interests because they don’t have to forgo their current share
of capital in the partnership and may not ever have to give up anything if the partnership
is ultimately unprofitable. Thus, a profits interest is more risky than a capital interest
from the perspective of the service partner.
B. Tax Elections, Accounting Periods, and Accounting Methods
A newly formed partnership must adopt its required tax year-end and decide
whether it intends to use either the cash or accrual method as its overall method of
accounting. As discussed in the Business Income, Deductions, and Accounting Methods
chapter, an entity’s tax year-end determines the cutoff date for including income and
deductions in a particular return, and its overall accounting method determines when
income and deductions are recognized for tax purposes. Partnerships must frequently
make other tax-related elections as well.
New partnerships determine their accounting periods and make tax elections,
including the election of overall accounting method, the election to expense a portion of
organizational expenses and start-up costs, and the election to expense tangible personal
property. Who formally makes all these elections? In theory, either the partnership or the
partners themselves could do so. With just a few exceptions, the partnership tax rules rely
on the entity theory of partnership taxation and make the partnership responsible for tax
elections.35 In many instances, the partnership does so in conjunction with filing its
annual tax return. For example, it selects an accounting method and determines whether
to elect to amortize organizational expenses or start-up costs by simply applying its
elections in calculating ordinary business income on its first return. The partnership
makes other tax elections by filing a separate document with the IRS, such as Form 3115
when it elects to change an accounting method.
The first potential required tax year is the majority interest taxable year, the
taxable year of one or more partners who together own more than 50 percent of the
capital and profits interests in the partnership.38 However, there may not be a majority
interest taxable year when several partners have different year-ends. For example, if a
partnership has two partners with 50 percent capital and profits interests and each has a
different tax year, there will be no majority interest taxable year. In that case, the
partnership next applies the principal partners test to determine its year-end. Under the
principal partners test, the required tax year is the taxable year the principal partners all
have in common. For this purpose, principal partners are those who have 5 percent or
more interest in the partnership profits and capital.39 Consider a partnership with two
calendar-year partners, each with a 20 percent capital and profits interest, and 30
additional fiscal year-end partners, each with less than a 5 percent capital and profits
interest. In this scenario, the required taxable year of the partnership is a calendar year
corresponding with the taxable year of the partnership’s only two principal partners. If, as
in the earlier example, the partnership had two 50 percent capital and profits partners
with different tax years, it would then use the tax year providing the “least aggregate
deferral” to the partners, unless it is eligible to elect an alternative year-end.
Although partnerships may use the accrual method freely, they may not use the
cash method under certain conditions because it facilitates the deferral of income and
acceleration of deductions. For example, partnerships with C corporation partners are
generally not eligible to use the cash method41 unless their average annual gross receipts
for the three prior taxable years do not exceed $25 million and they otherwise
qualify.42-Entities generally eligible to use the overall cash method of accounting must
nevertheless use the accrual method to account for the purchase and sale of inventory
unless they unless they have average annual gross receipts over the prior three years of
$25 million or less.
C. Reporting the Results of Partnership Operations
The first section in the Internal Revenue Code dealing with partnerships states
emphatically that partnerships are flow-through entities: “A partnership as such shall not
be subject to the income tax imposed by this chapter. Persons carrying on business as
partners shall be liable for income tax only in their separate or individual capacities.”
This feature of partnership taxation explains why partnerships are sometimes favored
over corporations, whose shareholders are subject to a double tax—once when the
income is earned and again when it is distributed to shareholders as a dividend or when
the shares are sold.
Although partnerships are not taxpaying entities, they are required to file
information returns annually. They also distribute information to each partner detailing
the amount and character of items of income and loss flowing through the partnership.45
Partners must report these income and loss items on their tax returns even if they don’t
receive cash distributions from the partnership during the year. When gathering this
information for their partners, partnerships must determine each partner’s share of
ordinary business income (loss) and separately stated items. Partnership ordinary
business income (loss) is all partnership income (loss) exclusive of any separately stated
items of income (loss). Separately stated items share one common characteristic—they
are treated differently from a partner’s share of ordinary business income (loss) for tax
purposes. To better understand why certain items must be separately disclosed to
partners, consider how two particular separately stated items, dividend income and
capital losses, might affect an individual partner’s tax liability. Qualified dividend
income allocated to individual partners is taxed at either a 0 percent, 15 percent, or
20-percent rate, depending on individual partners’ tax brackets.
In addition to dividends, capital gains, and other routine separately stated items,
guaranteed payments are also a very common separately stated item for partners who
receive them. As their name suggests, guaranteed payments are fixed amounts paid to
partners regardless of whether the partnership shows a profit or loss for the year.52 We
can think of them—and some partnerships treat them—as economically equivalent to
cash salary payments made to partners for services provided.53 Specifically, they are
typically deducted in computing a partnership’s ordinary income or loss for the year.
Though included in a partnership’s ordinary business income (loss) computation,
guaranteed payments must, nevertheless, be separately stated to the partners who receive
them. This separate reporting serves the same purpose as providing W-2 forms to
employees. Because guaranteed payments are similar to salary payments, partners treat
them as ordinary income.
Individual partners, like sole proprietors, may be responsible for paying self-
employment taxes in addition to income taxes on their share of earned income from
partnerships.55 The degree to which partners are responsible for self-employment taxes
depends on their legal status as general partners, limited partners, or LLC members and
their business activities. General partners report guaranteed payments for services they
provide and their share of ordinary business income (loss) as self-employment income
(loss) because they are actively involved in managing the partnership. Limited partners,
on the other hand, are generally not allowed under state law to participate in the
management of limited partnerships. Therefore, their share of ordinary business income
(loss) is conceptually more like investment income than trade or business income. As a
result, ordinary business income (loss) allocated to limited partners is not subject to self-
employment tax. However, if limited partners receive guaranteed payments for services
provided to the partnership, they treat those payments as self-employment income.
Because LLC members may be either managing or nonmanaging members, the
approach to taxing their share of ordinary business income (loss) for self-employment tax
purposes does depend to some degree on their level of involvement in the LLC.56 Tax
rules in this area were developed before LLCs became popular, however, so the IRS has
not issued any authoritative rules to help LLCs decide whether to characterize their
members’ shares of ordinary business income (loss) as self-employment income (loss).
However, a proposed regulation issued by the IRS and later withdrawn can assist
partnerships in drawing the line between aggressive and conservative positions in this
area.57 It provides that LLC members who have personal liability for the debts of the
LLC by reason of being an LLC member, who have authority to contract on behalf of the
LLC, or who participate more than 500 hours in the LLC’s trade or business during the
taxable year should be classified as general partners when applying the self-employment
tax rules.
As explained in the Business Income, Deductions, and Accounting Methods
chapter, the deduction for business interest expense is limited to the sum of (1) business
interest income and (2) 30 percent of the adjusted taxable income of the taxpayer for the
taxable year.60 For entities taxed as partnerships, this limitation is applied at the
partnership level first. Under this approach, any business interest expense of a partnership
that is not disallowed due to the limitation is taken into account in determining the
partnership’s ordinary business income or loss for the year. In contrast, disallowed
business interest expense is allocated and separately stated to partners, reducing the basis
in their partnership interests.61 Subsequently, the disallowed business interest expense is
carried forward indefinitely at the partner level until the partnership has excess business
interest expense limitation to allocate to the partners. This will occur whenever the
partnership’s business interest expense limitation (partnership business interest income
plus 30 percent of adjusted taxable income) exceeds the partnership’s business interest
expense in a given year. Partners may deduct their carried forward disallowed interest
expense from a given partnership in any future year to the extent they are allocated
excess business interest expense limitation (the adjusted taxable income equivalent is
separately stated to partners62) from the same partnership.
Partnership tax rules provide partners with tremendous flexibility in allocating
overall profit and loss as well as specific items of profit and loss to partners, as long as
partners agree to the allocations and they have “substantial economic effect.” Partnership
allocations designed to accomplish business objectives other than reducing taxes will
generally have substantial economic effect.67 If they are not defined in the partnership
agreement or do not have substantial economic effect, allocations to partners must be
made in accordance with the “partners’ interests in the partnership.”68 According to tax
regulations, the partners’ interests in the partnership are a measure of the partners’
economic arrangement and should be determined by considering factors such as their
capital contributions, distribution rights, and interests in economic profits and losses (if
different from their interests in taxable income and loss). Partnership allocations
inconsistent with partners’ capital interests or overall profit-and-loss-sharing ratios are
called special allocations.
D. Partner’s Adjusted Tax Basis in Partnership Interest
Earlier in this chapter, we discussed how partners measure their initial tax basis in
their partnership interests when they contribute property or services to partnerships in
exchange for their partnership interests, or when they purchase partnership interests from
an existing partner. Unlike the basis in a stock or other similar investment, which is
usually fixed, the basis in a partnership interest is dynamic and must be adjusted as the
partnership generates income and losses, changes its debt levels, and makes distributions
to partners. These annual adjustments to a partner’s tax basis are required to ensure
partners don’t double-count taxable income/gains and deductible expenses/ losses, either
when they sell their partnership interests or when they receive partnership distributions.
They also ensure tax-exempt income and nondeductible expenses are not ultimately taxed
or deducted.
While partners generally prefer not to invest in partnerships with operating losses,
these losses generate current tax benefits when partners can deduct them against other
sources of taxable income. Unlike capital losses, which are of limited usefulness if
taxpayers don’t also have capital gains, ordinary losses from partnerships are deductible
against any-type of taxable income. However, they are deductible on the partner’s tax
return only when they clear three separate hurdles: (1) tax-basis, (2) at-risk, (3) passive
activity, and (4) excess business loss limitations.
The at-risk hurdle or limitation is more restrictive than the tax-basis limitation,
because it excludes a type of debt normally included in a partner’s tax basis. We have
already highlighted the distinction between recourse and nonrecourse debt and noted that
partners allocated recourse debt have economic risk of loss, while partners allocated
nonrecourse debt have no risk of loss. Instead, the risk of loss on nonrecourse debt is
borne by lenders. The at-risk rules in §465 were adopted to limit the ability of partners to
use nonrecourse debt as a means of creating tax basis to use losses from tax shelter
partnerships expressly designed to generate losses for the partners. The at-risk rules limit
partners’ losses to their amount “at risk” in the partnership—their at-risk amount.
Generally, a partner’s at-risk amount is the same as her tax basis except that, with one
exception, the partner’s share of certain nonrecourse debts is not included in the at-risk
amount. Specifically, the only nonrecourse debts considered to be at risk are nonrecourse
real estate mortgages from commercial lenders that are unrelated to borrowers. This type
of debt is called qualified nonrecourse financing.82 In addition to qualified nonrecourse
financing, partners are considered to be at risk to the extent of cash and the tax basis of
property contributed to the partnership. Further, partners are at risk for any partnership
recourse debt allocated to them.
Prior to 1986, partners with sufficient tax basis and at-risk amounts were able to
utilize ordinary losses from their partnerships to offset portfolio income (i.e., interest,
dividends, and capital gains), salary income, and self-employment income from
partnerships and other trades or businesses. During this time, a partnership tax shelter
industry thrived by marketing to wealthy investors partnership interests designed
primarily to generate ordinary losses they could use to shield other income from tax. To
combat this practice, Congress introduced the passive activity loss (PAL) rules.83 These
rules were enacted as a backstop to the at-risk rules and are applied after the tax-basis and
at-risk limitations. Thus, depending on their situation, partners may have to overcome
three separate hurdles before finally reporting partnership ordinary losses on their returns.
In a nutshell, the passive activity loss rules limit the ability of partners in rental real estate
partnerships and other partnerships they don’t actively manage (passive activities) from
using their ordinary losses from these activities (remaining after the application of the
tax-basis and atrisk limitations) to reduce other sources of taxable income.
The passive activity rules define a passive activity as “any activity which involves
the conduct of a trade or business,84 and in which the taxpayer does not materially
participate.” According to the Code and Treasury regulations, participants in rental
activities, including rental real estate,85 and limited partners without management rights
are automatically deemed to be passive participants. In addition, participants in all other
activities are passive unless their involvement in an activity is “regular, continuous, and
substantial.” Clearly, these terms are quite subjective and difficult to apply. Fortunately,
regulations provide more certainty in this area by enumerating seven separate tests for
material participation.86 An individual, other than a limited partner, can be classified as a
material participant in activities, other than rental activities, by meeting any one of the
seven tests.
E. Basics of Sales of Partnership Interests
As we’ve seen in preceding chapters, owners of various business entities receive
returns on their investments, either when the business makes distributions or upon the
sale of their business interest. Corporate shareholders may sell their stock to other
investors or back to the corporation. Likewise, partners may dispose of their interest in
several ways: sell to a third party, sell to another partner, or transfer the interest back to
the partnership. The payments in a disposition (sale) can come from either another owner
of the partnership or a new investor; in either case, the sale proceeds come from outside
the partnership. Selling a partnership interest raises unique issues because of the flow-
through nature of the entity. For example, is the interest a separate asset, or does the
disposition represent the sale of the partner’s share of each of the partnership’s assets?
(See the-Forming and Operating Partnerships chapter for a discussion of the entity and
aggregate approaches to taxation of flow-through entities.) To the extent the tax rules
follow an entity approach, the interest is considered a separate asset and a sale of the
partnership interest is very similar to the sale of corporate stock. That is, the partner
simply recognizes capital gain or loss on the sale, based on the difference between the
sales price and the partner’s tax basis in the partnership interest.
A new investor in a partnership is of course concerned with determining how
much to pay for the partnership interest. However, his primary tax concerns are about his
outside basis and his share of the inside basis of the partnerships assets. In general, for a
sale transaction, the new investor’s outside basis will be equal to his cost of the
partnership interest.12 To the extent that the new investor shares in the partnership
liabilities, his share of partnership liabilities increases his outside basis.
If a partner’s interest in a partnership increases or decreases during the
partnership’s tax year, the partnership income or loss allocated to the partner for the year
must be adjusted to reflect her varying interest in the partnership.16 Partners’ interests
increase when they contribute property or cash to a partnership17 or purchase a
partnership interest. Conversely, partners’ interests decrease when they receive
partnership distributions18 or sell all or a portion of their partnership interests. Upon the
sale of a partnership interest, the partnership tax year closes for the selling partner only.
Regulations allow partners to choose between two possible methods for allocating
income or loss to partners when their interests change during the year.19 The first method
allows the partnership to prorate income or loss to partners with varying interests, while
the second method sanctions an interim closing of the partnership’s books.
F. Basics of Partnership Distributions
Like shareholders receiving corporate dividend distributions, partners often
receive distributions of the partnership profits, known as operating distributions. Recall
that owners of flow-through entities are taxed currently on their business income
regardless of whether the business distributes it. As a result, partners may require cash
distributions in order to make quarterly estimated tax payments on their shares of
business income. Usually, the general partners (or managing members of LLCs)
determine the amount and timing of distributions; however, the partnership (operating)
agreement may stipulate some distributions.
Partners may also receive liquidating distributions. Because the market for
partnership interests is much smaller than for publicly traded stock, partners may have a
difficult time finding buyers for their interests. Partnership agreements also often limit
purchasers of an interest to the current partner group, to avoid adding an unwanted
partner. If the current partner group either cannot or does not want to purchase the
interest, the partnership can instead distribute assets to terminate a partner’s interest.
These liquidating distributions are similar to corporate redemptions of a shareholder’s
stock. They can also terminate the partnership. We first explore the tax consequences of
operating distributions, and then examine the tax treatment for liquidating distributions.
A distribution from a partnership is an operating distribution when the partners
continue their interests afterwards. Operating distributions are usually made to distribute
the business profits to the partners but can also reduce a partner’s ownership. The
partnership may distribute money or other assets. Let’s look at the tax consequences of
distributions of money, and then at the tax consequences of distributing property other
than money. When the partnership distributes property (other than money) with a basis
that exceeds the remaining outside basis (after the allocation to any money distributed),
the partner assigns the remaining outside basis to the distributed assets,29 and the
partner’s outside basis is reduced to zero.30 The first allocation of outside basis goes to
money, then to hot assets, and finally to other property.31 In this case, the partner’s basis
in the property received in the distribution will be less than the property’s basis in the
hands of the partnership.
The tax issues in liquidating distributions for partnerships are basically twofold:
(1) to determine whether the terminating partner recognizes gain or loss and (2) to
allocate his or her outside basis to the distributed assets. The rationale behind the rules for
liquidating distributions is simply to replace the partner’s outside basis with
the-underlying partnership assets distributed to the terminating partner. Ideally, there will
be no gain or loss on the distribution, and the asset bases will be the same in the partner’s
hands as they were inside the partnership. Of course, this case rarely occurs. The rules
therefore are designed to determine when gain or loss must be recognized and to allocate
the partner’s outside basis to the distributed assets.
In general, neither partnerships nor partners recognize gain or loss from
liquidating distributions. However, there are exceptions. For example, when a terminating
partner receives more money in the distribution than her outside basis, she will recognize
gain.33 See Example 21-11 for an illustration in the context of operating distributions. In
contrast to operating distributions, a partner may recognize a loss from a liquidating
distribution, but only when two conditions are met. These conditions are (1) the
distribution includes only cash, unrealized receivables, and/or inventory; and (2) the
partner’s outside basis is greater than the sum of the inside bases of the distributed
assets.34 The loss on the distribution is a capital loss to the partner. Commonly, the
terminating partner’s share of partnership debt decreases after a liquidating distribution.
Any reduction in the partner’s share of liabilities is considered a distribution of money to
the partner and reduces the outside basis available for allocation of basis to other assets,
including inventory and unrealized receivables.
If the partnership distributes only money, inventory, and/or unrealized receivables
(ordinary income property) and the partner’s outside basis is greater than the sum of the
inside bases of the distributed assets, the partner recognizes a capital loss.36 The partner
assigns a basis to the distributed assets equal to the partnership’s inside basis in the assets
and the remaining outside basis is equal to the recognized loss. To prevent a partner from
converting a capital loss from her investment into an ordinary loss, the tax law prohibits
increasing her basis in unrealized receivables and inventory and requires the partner to
recognize a capital loss.
In liquidating distributions when the partner’s outside basis is less than the inside
bases of the distributed assets and the partnership distributes money and any property
other than money, the partner reduces the basis in the distributed assets other than money
but does not recognize gain or loss. Because the tax law does not restrict reducing bases
of ordinary income assets, distributions of hot assets and other property will cause
reductions in basis. However, the tax law does prescribe a particular sequence for the
required reductions.
In our final scenario, the partnership distributes other property in addition to or
instead of money and/or inventory and unrealized receivables, and the partner’s outside
basis is less than the combined inside bases of the distributed property. The terminating
partner does not recognize gain or loss; rather, he decreases the basis in the other property
distributed. The process for assigning basis to the distributed assets is similar to the
method we described above, although the required basis decrease is focused on the other
property rather than the hot assets.
G. Disproportionate Distributions
Up to this point in the chapter, our distribution examples have either assumed or
represented that each partner received a pro rata share of the partnership’s unrealized
appreciation in its ordinary assets, as specified in the partnership agreement based on the
partner’s capital interests. In practice, distributions may not always reflect each partner’s
proportionate share.45 Both operating and liquidating distributions can be
disproportionate distributions. Without going into all the details of these complex rules,
let’s briefly discuss the implications of distributions in which partners receive either more
or less of their share of the unrealized appreciation or losses in so-called hot assets [assets
defined in IRC §751(b) as substantially appreciated inventory and unrealized
receivables].46 Note that the definition of hot assets for purposes of disproportionate
distributions includes only substantially appreciated inventory, not all inventory [as is the
case under §751(a), the definition we used to characterize the gain in dispositions of
partnership interests]. Inventory is considered substantially appreciated if its fair market
value is more than 120 percent of its basis.
Suppose a partner receives less than her share of-the appreciation in hot assets in a
liquidating distribution. This may occur, for example, if a partner receives only cash in a
liquidating distribution from a partnership with hot assets. Rather than only applying the
rules we discussed above, the partner must treat part of the distribution as a sale or
exchange. Basically, the disproportionate distribution rules treat the partner as having
sold her share of hot assets to the partnership in exchange for “cold” [non-§751(b)]
assets. This deemed sale generates an ordinary gain or loss to the partner on the deemed
sale, essentially equal to her share of the appreciation or depreciation in the portion of hot
assets not distributed to her. From the partnership’s perspective, the partnership is
deemed to have purchased the hot assets from the partner in exchange for cold assets.
Therefore, the partnership recognizes a capital or §1231 gain or loss equal to the
remaining partners’ inherent gain or loss in the distributed cold assets. The effects are
reversed if a partner receives more than her share of the appreciation in a partnership’s
hot assets. The rules are meant to ensure that partners cannot convert ordinary income
into capital gain through distributions. Thus, they require that partners will ultimately
recognize their share of the partnership ordinary income regardless of the form of their
distributions.
H. Special Basis Adjustments
Recall that when a partner sells her partnership interest, the partnership’s inside
basis is generally unaffected by the sale. This creates a discrepancy between the new
investor’s outside basis (cost) and her share of the partnership’s inside basis, which
artificially changes the potential income or loss at the partnership level. For example,
earlier in the chapter Greg Randall purchased Chanzz’s 30 percent interest in CCS for
$82,800 (see the what-if scenario in-Example 21-5). Greg’s outside basis after the
acquisition is $106,800, reflecting the cash payment of $82,800 and his share of CCS’s
debt at the time of the acquisition, $24,000. However, Greg’s share of CCS’s inside basis
in its assets is $105,000 (see Example 21-7). This is the outcome because the sale does
not affect CCS’s inside basis and Greg simply steps into Chanzz’s shoes for determining
his share of the inside basis. The discrepancy reflects Chanzz’s unrecognized share of
appreciation of CCS’s assets (which Greg paid full value for) as of the sale date and
causes Greg to be temporarily overtaxed when CCS sells these appreciated assets.
Even without a §754 election in effect, the partnership must adjust its bases if the
partnership has a substantial built-in loss at the time a partner sells her partnership
interest. A substantial built-in loss exists if the partnership’s aggregate inside basis in its
property exceeds the property’s fair market value by more than $250,000 when a transfer
of an interest occurs or when the purchasing partner would be allocated a loss of more
than $250,000 if the partnership assets were sold for fair market value immediately after
the sale.50 An analogous event—a substantial basis reduction—may occur for
distributions, which also triggers a mandatory basis adjustment. Although the election is
made under §754, the actual authorization of the special basis adjustment is governed by
two separate code sections, depending on which situation gives rise to the adjustment: (1)
sale of partnership interest [§743(b)], or (2) distributions [§734(b)]. These two sections
determine how much of an adjustment will be made, and §755 then stipulates how the
adjustment is allocated among the partnership assets.
The special basis adjustment can either increase or decrease the basis in the
partnership assets. A positive basis adjustment will increase the basis in the partnership
assets (1) when a partner receiving distributed property recognizes a gain on the
distribution (for instance, in operating distributions where the partner receives money in
excess of her outside basis), and (2) when a partner receiving distributed property takes a
basis in the property less than the partnership’s basis in the property. The positive
adjustment will equal the sum of the gain recognized by the partners receiving distributed
property and the amount of the basis reduction.
A negative basis adjustment will decrease the basis in partnership assets (1) when
a partner receiving distributed property in a liquidating distribution recognizes a loss on
the distribution, and (2) when a partner receiving distributed property takes a basis in the
property greater than the partnership’s basis in the property. The negative adjustment will
equal the sum of the recognized loss and the amount of the basis increase made by the
partners receiving the distribution. Recall from our previous discussion of distributions
that negative adjustments can occur only in liquidating distributions. Only then does a
partner recognize a loss or increase the distributed property’s basis over its basis prior to
the distribution.
I. S Corporation Elections
The same rules for forming and contributing property govern S and C
corporations. As discussed in the Corporate Formation, Reorganization, and Liquidation
chapter, §351 and related provisions apply when one or more persons transfer property to
a corporation (C-or S) in return for stock, and immediately after the transfer, these
persons control the corporation. These rules allow shareholders meeting the requirements
to defer gains they realize when they transfer appreciated property to the corporation in
exchange for stock. Note that similar rules apply to formations and property contributions
to partnerships under §721. One important difference, however, is that partnership tax
rules do not impose a control requirement to defer gains (see the Forming and Operating
Partnerships chapter for partnership contributions).
Unlike C corporations and partnerships, S corporations are limited as to type and
number of owners (shareholders).2 Only U.S. citizens or residents, estates, certain trusts,
and certain tax-exempt organizations may be shareholders. No corporations or
partnerships can be shareholders.3 S corporations may have no more than 100
shareholders; family members and their estates count as one shareholder. Family
members include a common ancestor (not more than six generations removed) and her
lineal descendants and their spouses (or former spouses).4 Under this broad definition,
great-grandparents, grandparents, parents, children, brothers and sisters, grandchildren,
great-grandchildren, aunts, uncles, cousins, and the respective spouses are family
members for this purpose. A practical implication of these limits is that large, publicly
traded corporations cannot elect to be treated as S corporations.
Even when the corporation makes the election on or before the 15th day of the
third month of its tax year, the election will not be effective until the subsequent year if
(1) the corporation did not meet the S corporation requirements for each day of the
current tax year before it made the S election, or (2) one or more shareholders who held
the stock in the corporation during the current year and before the S corporation election
was made did not consent to the election (e.g., a shareholder disposes of his stock in the
corporation in the election year before the election is made and fails to consent to the S
election).
J. S Corporation Terminations
The corporation can make a voluntary revocation of the S election if shareholders
holding more than 50 percent of the S corporation stock (including nonvoting shares)
agree.12-The corporation files a statement with the IRS revoking the election made under
§1362(a) and stating the effective date of the revocation and the number of shares issued
and outstanding. In general, voluntary revocations made on or before the 15th day of the
third month of the year are effective as of the beginning of the year. A revocation after
this period is effective the first day of the following tax year. Alternatively, a corporation
may specify the termination date as long as the date specified is on or after the date the
revocation is made.
A corporation’s S election is automatically terminated if the corporation fails to
meet the requirements. The termination is effective on the date it fails the S corporation
requirements. If the IRS deems the termination inadvertent, it may allow the corporation
to continue to be treated as an S corporation if, within a reasonable period after the
inadvertent termination, the corporation takes the necessary steps to meet the S
corporation requirements. If an S corporation has earnings and profits from a previous C
corporation year (or through a reorganization with a corporation that has earnings and
profits), its election is terminated if the S corporation has passive investment income in
excess of 25 percent of gross receipts for three consecutive years. If the S corporation
never operated as a C corporation or does not have C corporation earnings and profits
(either by prior distribution of C corporation earnings and profits, or simply by not
having earnings and profits at the effective date of the S election), this provision does not
apply.
For purposes of the passive investment income test, gross receipts is the total
amount of revenues received [including net capital gains from the sale of capital assets
and gain (not offset by losses) from the sale of stock and securities] or accrued under the
corporation’s accounting method, not reduced by returns, allowances, cost of goods sold,
or deductions. Passive investment income (PII) includes gross receipts from royalties,
rents, dividends, interest (including tax-exempt interest), and annuities.15 While net
capital gain income is included in gross receipts, it is not considered passive investment
income.-S corporation election terminations due to excess passive investment income are
effective on the first day.
After terminating or voluntarily revoking S corporation status, the corporation
may elect it again, but it generally must wait until the beginning of the fifth tax year after
the tax year in which it terminated the election.17 Thus, if the election was terminated
effective the first day of the tax year, the corporation must wait five full years to again
become an S corporation. The IRS may consent to an earlier election under a couple of
conditions: (1) if the corporation is now more than 50 percent owned by shareholders
who were not owners at the time of termination, or (2) if the termination was not
reasonably within the control of the corporation or shareholders with a substantial interest
in the corporation and was not part of a planned termination by the corporation or
shareholders. Given the potential adverse consequences of an S election termination, the
corporation should carefully monitor compliance with the S corporation requirements.
K. Operating Issue
Like partnerships, S corporations determine their accounting periods and make
accounting method elections at the entity level. An S corporation makes most of its
elections (like electing out of bonus depreciation) in conjunction with the filing of its
annual tax return and some by filing a separate request with the IRS. (For example, an
application to change accounting methods is filed on Form 3115, separate from the S
corporation’s tax return.) For an S corporation previously operating as a C corporation,
all prior accounting methods carry over to the S corporation. Recall that both C
corporations and partnerships face restrictions on using the cash method. S corporations
do not. They may choose the cash, accrual, or hybrid method unless selling inventory is a
material income-producing factor for them. In that case they must account for gross profit
(sales minus cost of goods sold) using the accrual method, even if they are otherwise
cash-method taxpayers. Hence, they would use the hybrid method.
S corporations, like partnerships, are flow-through entities, and thus their profits
and losses flow through to their shareholders annually for tax purposes. As we discussed
in the Forming and Operating Partnerships chapter, partnerships have considerable
flexibility in making special profit and loss allocations to their partners. In contrast, S
corporations must allocate profits and losses pro rata, based on the number of outstanding
shares each shareholder owns on each day of the tax year.19 An S corporation generally
allocates income or loss items to shareholders on the last day of its tax year.20 If a
shareholder sells her shares during the year, she will report her share of S corporation
income and loss allocated to the days she owned the stock (including the day of sale)
using a pro rata allocation. If all shareholders with changing ownership percentages
during the year agree, the S corporation can instead use its normal accounting rules to
allocate income and loss (and other separately stated items, discussed below) to the
specific periods in which it realized income and losses.
Like partnerships, S corporations are required to file tax returns (Form 1120S)
annually. In addition, on Form 1120S, Schedule K-1, they supply information to each
shareholder detailing the amount and character of items of income and loss flowing
through the S-corporation.21 Shareholders must report these income and loss items on
their tax returns even if they do not receive cash distributions during the year. S
corporations determine each shareholder’s share of ordinary business income (loss) and
separately stated items. Like partnerships, ordinary business income (loss) (also referred
to as nonseparately stated income or loss) is all income (loss) exclusive of any separately
stated items of income (loss). Separately stated items are tax items that are treated
differently from a shareholder’s share of ordinary business income (loss) for tax
purposes.
The character of each separately stated item is determined at the S corporation
level rather than at the shareholder level. The list of common separately stated items for S
corporations is similar to that for partnerships, with a couple of exceptions. (For example,
S corporations do not report self-employment income and do not have guaranteed
payments.) Exhibit 22-1 lists several common separately stated items. See Form 1120S,
Schedule K-1 (and related instructions) for a comprehensive list of separately stated
items.22 Similar to partners in a partnership, S corporation shareholders are allowed a 20
percent deduction for qualified business income, calculated and subject to limitations at
the shareholder level. See the Entities Overview chapter for a discussion of the deduction.
Informational items related.
L. Shareholder’s Basis
An S corporation shareholder calculates his or her-initial basis upon formation of
the corporation, like a C corporation shareholder. (See the Corporate Formation,
Reorganization, and Liquidation chapter for a review.) Specifically, the shareholder’s
basis in stock received in the exchange equals the tax basis of the property transferred,
less any liabilities assumed by the corporation on the property contributed (substituted
basis). The shareholder’s stock basis is increased by any gain recognized; it is reduced by
the fair market value of any property received other than stock.24 If, on the other hand,
the shareholder purchased the S corporation stock from another shareholder or the
corporation, the new shareholder’s basis is simply the purchase price of the stock.
While C corporation rules govern the initial stock basis of an S corporation
shareholder, subsequent calculations more closely resemble the partnership rules.
Specifically, an S corporation shareholder’s stock basis is dynamic and must be adjusted
annually to ensure that (1) taxable income/gains and deductible expenses/losses are not
double-counted by shareholders either when they sell their shares or when they receive S
corporation distributions (for example, because shareholders are taxed on the S
corporation’s income annually, they should not be taxed again when they receive
distributions of the income) and (2) tax-exempt income and nondeductible expenses are
not ultimately taxed or deducted.
S corporation shareholders may not deduct losses in excess of their stock basis.
Recall they are not allowed to include debt in their basis; partners are. This restriction
makes it more likely that the tax-basis limitation will apply to S corporation shareholders
than to similarly situated partners. Losses not deductible due to the tax-basis limitation
are not necessarily lost. Rather, they are suspended until the shareholder generates
additional basis. The carryover period for the suspended loss is indefinite. However, if
the shareholder sells the stock before creating additional basis, the suspended loss
disappears unused.
Shareholders can mitigate the disadvantage of not including S corporation debt in
their stock basis by loaning money directly to their S corporations. These loans create
debt basis, separate from the stock basis. Losses are limited first to the shareholders’ tax
bases in their shares and then to their bases in any direct loans made to their S
corporations.29 Specifically, if the total amount of items (besides distributions) that
decrease the shareholder’s basis for the year exceeds the shareholder’s stock basis, the
excess amount decreases the shareholder’s debt basis. Like stock basis, debt basis cannot
be decreased below zero. In subsequent years, any net increase in basis for the year
restores first the shareholder’s debt basis (up to the outstanding debt amount) and then the
shareholder’s stock basis. If the S corporation repays the debt owed to the shareholder
before the shareholder’s debt basis is restored, any loan repayment in excess of the
shareholder’s debt basis will trigger a taxable gain to the shareholder.
Like partners in partnerships, S corporation shareholders are subject to the at-risk
rules. They may deduct S corporation losses only to the extent of their at-risk amount in
the S corporation, as defined in §465. With one notable exception, an S corporation
shareholder’s at-risk amount is the sum of her stock and debt basis. The primary
exception relates to nonrecourse loans and is designed to ensure that shareholders are
deemed at risk only when they have an actual risk of loss. Specifically, an S corporation
shareholder taking out a nonrecourse loan to make a capital contribution (either cash or
other property) to the S corporation generally creates stock basis (equal to the basis of
property contributed) in the S corporation but increases her amount at risk by only the net
fair market value of her property, if any, used as collateral to secure the nonrecourse
loan.30 The collateral’s net fair market value is determined at the loan date.
The voluntary or involuntary termination of a corporation’s S election creates a
problem for shareholders with suspended losses due to the basis and at-risk rules. The
reason: These losses are generally not deductible after the S termination date.
Shareholders can obtain some relief provided by §1366(d) (3), which allows them to treat
any suspended losses existing at the S termination date as occurring on the last day of the
post-termination transition period (PTTP). In general, the PTTP begins on the day after
the last day of the corporation’s last taxable year as an S-corporation and ends on the later
of (a) one year after the last S corporation day or (b) the due date for filing the return for
the last year as an S corporation (including extensions).
For years beginning after 2017, taxpayers are not allowed to deduct an “excess
business loss” for the year. Rather, excess business losses are carried forward to
subsequent years as a net operating loss carryforward. The excess business loss limitation
applies to losses that are otherwise deductible under the basis, at-risk, and passive loss
rules. An excess business loss for the year is the excess of aggregate business deductions
for the year over the sum of aggregate business gross income or gain of the taxpayer plus
a threshold amount. The threshold amount for a tax year is $500,000 for married
taxpayers filing jointly and $250,000 for other taxpayers. The amounts are indexed for
inflation. In the case of partnership or S corporation business losses, the provision applies
at the shareholder level.
When a shareholder does work as an employee of and receives a salary from an S
corporation, the S corporation treats this salary payment like that made to any other
employee: For Social Security taxes, it withholds 6.2 percent of the shareholder’s salary
or wages subject to the wage limitation ($128,400 in 2018), for Medicare taxes, it
withholds 1.45 percent of the shareholder’s salary or wages, and for the additional
Medicare tax, it withholds .9 percent on any shareholder salary or wages above
$200,000.34 In addition, the S corporation must pay its portion of the Social Security tax
(6.2 percent of the shareholder’s salary or wages subject to the $128,400 wage limitation
in 2018) and Medicare tax (1.45 percent of the shareholder’s salary or wages, regardless
of the amount of salary or wages). In contrast to shareholder-employees, S corporations
are not subject to the additional Medicare tax on employee salary or wages.
Just like partners in a partnership, S corporation shareholders are subject to a 3.8
percent net investment income tax on their share of an S corporation’s gross income from
interest, dividends, annuities, royalties, rents, a trade or business that is a passive activity
or a trade or business of trading financial instruments or commodities, and any net gain
from disposing of property (other than property held in a trade or business in which the
net investment income tax does not apply), less any allowable deductions from these
items.35,36 Likewise, any gain from the sale of S corporation stock (or distributions in
excess of basis) is subject to the net investment income tax to the extent it is allocable to
assets held by the S corporation that would have generated a net gain subject to the net
investment income tax if all S corporation assets were sold at fair market value.
M. Distributions
The rules for determining the shareholder-level tax consequences of operating
distributions depend on the S corporation’s history; specifically whether, at the time of
the distribution, it has accumulated earnings and profits from a previous year as a C
corporation. (See the Corporate Taxation: Nonliquidating Distributions chapter for a
discussion of C corporation earnings and profits.) We consider both situations—with and
without accumulated earnings and profits.
Two sets of historical circumstances could apply here: (1) An entity may have
been an S corporation since inception, or (2) it may have been converted from a C
corporation but not have C corporation accumulated earnings and profits at the time of
the distribution. In both cases, as long as there are no C corporation accumulated earnings
and profits, the rules for accounting for the distribution are very similar to those
applicable to distributions to partners. That is, shareholder distributions are tax-free to the
extent of the shareholders’ stock basis (determined after increasing the stock basis for
income allocations for the year43). If a distribution exceeds the shareholder’s stock basis,
the shareholder has a capital gain equal to the excess distribution amount.
When an S corporation has accumulated earnings and profits (E&P) from prior C
corporation years, the distribution rules are a bit more complex. These rules are designed
to ensure that shareholders cannot avoid the dividend tax on dividend distributions out of
C corporation accumulated E&P by simply electing S corporation status and then
distributing the accumulated E&P. For S corporations in this situation, the tax laws
require the corporation to maintain an accumulated adjustments account (AAA) to
determine the taxability of S corporate distributions.
S corporation distributions from the AAA (the most common distributions) are
treated the same as distributions when the S corporation does not have E&P. They are
nontaxable to the extent of the shareholder’s basis, and they create capital gains if they
exceed the shareholder’s stock basis. If an S corporation makes a distribution from
accumulated E&P, the distribution is taxable to shareholders as a dividend. (See the
Corporate Taxation: Nonliquidating Distributions chapter for the calculation of corporate
E&P.) Once an S corporation’s accumulated E&P is fully distributed, the remaining
distributions reduce the shareholder’s remaining basis in the S corporation stock (if any)
and are nontaxable. Any excess distributions are treated as capital gain.
Recall the special tax rules relating to suspended losses at the S corporation
termination date. Similarly, §1371(e) provides for special treatment of any S corporation
distribution in cash after an S election termination and during the post-termination
transition period (PTTP). Such cash distributions are tax-free to the extent they do not
exceed the corporation’s AAA balance and the individual shareholder’s basis in the
stock. The PTTP for post-termination distributions is generally the same as the PTTP for
deducting suspended losses, discussed above. For determining the taxability of
distributions, the PTTP generally begins on the day after the last day of the corporation’s
last taxable year as an S corporation; it ends on the later of (a) one year after the last S
corporation day or (b) the due date for filing the return for the last year as an S
corporation (including extensions).
Liquidating distributions of a shareholder interest in an S corporation follow
corporate tax rules rather than partnership rules. For a complete liquidation of the S
corporation, the rules under §§331 and 336 (discussed in the Corporate Formation,
Reorganization, and Liquidation chapter) govern the tax consequences. S corporations
generally recognize gain or loss on each asset they distribute in liquidation (recall that S
corporations recognize gain but not loss on operating distributions of noncash property).
These gains and losses are allocated to the S corporation shareholders, increasing or
decreasing their stock basis. In general, shareholders recognize gain on the distribution if
the value of the property exceeds their stock basis; they recognize loss if their stock basis
exceeds the value of the property.
N. S Corporation Taxes and Filing Requirements
Congress enacted the built-in gains tax to prevent C corporations from avoiding
corporate taxes on sales of appreciated property by electing S corporation status. The
built-in gains tax applies only to an S corporation that has a net unrealized built-in gain at
the time it converts from a C corporation. Further, for the built-in gains tax to apply, the S
corporation must subsequently recognize net built-in gains during the built-in gains tax
recognition period.52 The built-in gains tax recognition period is the first five years a
corporation operates as an S corporation. What exactly is a net unrealized built-in gain?
Measured on the first day of the corporation’s first year as an S corporation, it represents
the net gain (if any) the corporation would recognize if it sold each asset at its fair market
value. For this purpose, we net gains and losses to determine whether indeed there is a net
unrealized gain at the conversion date. The corporation’s accounts receivable and
accounts payable are also part of the computation: Under the cash method, accounts
receivable are gain items and accounts payable are loss items. If the S corporation has a
net unrealized gain at conversion, it must compute its net recognized built-in gains for
each tax year during the applicable built-in gain recognition period to determine whether
it is liable for the built-in gains tax.
If taxable income limits the net recognized built-in gain for any year [item (3)
above], we treat the excess gain as a recognized built-in gain in the next tax year, but
only if the next tax year is in the built-in gains tax recognition period. After the net
recognized builtin gain to be taxed has been determined using the limitations above, it
should be reduced by any net operating loss (NOL) or capital loss carryovers from prior
C corporation years.53 This base is then multiplied by the highest corporate tax rate
(currently 21 percent) to determine the built-in gains tax. The built-in gains tax paid by
the S corporation is allocated to the shareholders as a loss. The character of the allocated
loss (ordinary, capital, §1231) depends on the nature of assets that give rise to the built-in
gains tax. Specifically, the loss is allocated proportionately among the character of the
recognized built-in gains resulting in the tax.54 For planning purposes, the S corporation
should consider when to recognize built-in losses to reduce its exposure to the built-in
gains tax. That is, the company could seek to recognize built-in losses in years with
recognized built-in gains, in order to avoid the built-in gains tax.
Note that an S corporation has excess net passive income only when (1) it has net
passive investment income and (2) its passive investment income exceeds 25 percent of
its gross receipts. For purposes of determining excess net passive income, gross receipts
is the total amount of revenues (including passive investment income) received or
accrued under the corporation’s accounting method, and not reduced by returns,
allowances, cost of goods sold, or deductions. Gross receipts include net capital gains
from the sales or exchanges of capital assets and gains from the sales or exchanges of
stock or securities (losses do not offset gains). As defined previously in the chapter,
passive investment income includes gross receipts from royalties, rents, dividends,
interest (including tax-exempt interest), and annuities. Net passive investment income is
passive investment income decreased by any expenses connected with producing that
income.
C corporations that elect S corporation status and use the LIFO inventory method
are subject to the LIFO recapture tax. The purpose of this tax is to prevent former C
corporations from avoiding built-in gains tax by using the LIFO method of accounting for
their inventories. Specifically, a LIFO method corporation would not recognize built-in
gains unless the corporation invaded its LIFO layers during the built-in gains tax
recognition period. The LIFO recapture tax requires the C corporation to include the
LIFO recapture amount in its gross income in the last year it operates as a C
corporation.57 That amount equals the excess of the inventory basis computed using the
FIFO method over the inventory basis computed using the LIFO method at the end of the
corporation’s last tax year as a C corporation. In addition to being included in gross
income (and taxed at the C-corporation’s marginal tax rate), the LIFO recapture amount
also increases the corporation’s adjusted basis in its inventory at the time it converts to an
S corporation. The basis increase reduces the amount of net unrealized gain subject to the
built-in gains tax.
