R5 - Flow-Through Entity Taxation and Multi-Jurisdictional Tax Issues

Question 1

What is the required tax year for a partnership in the absence of an election to adopt an annual accounting period?

Answer 1

A partnership must have the same taxable year as the common taxable year of the partners that, in the aggregate, have an interest greater than 50% (majority interest).
- The required tax is determined based on the “testing day,” the first day of the partnership’s tax year (not considering the majority interest rule)

Question 2

When can the partnership change the required tax year after the “majority-interest” tax year-end is elected?

Answer 2

The partnership does not have to change to another tax year for two years following the year of change.

Question 3

What is the required tax year if the “majority-interest” tax year end cannot be elected?

Answer 3

1. The tax year is the tax year of all of the principal partners of the partnership (those owning 5% or more of the income or capital of the partnership).
2. If unable to use the first exception, adopt the tax year that causes the least aggregate deferral of income to the partners.

Question 4

How is a Limited Liability Corporation (LLC) treated for federal income tax purposes?

Answer 4

An LLC can be treated as a partnership, corporation, or sole proprietorship.

Question 5

How is the LLC taxed when it has at least two owners?

Answer 5

An LLC is taxed as a partnership unless an election is made to have the LLC taxed as a C corporation.

Question 6

How is the LLC taxed when there is a single member?

Answer 6

1. A single-member LLC is considered a disregarded entity for federal income tax purposes.
2. It is treated as a sole proprietorship if the owner is an individual, and included in the corporation’s taxable income if the owner is a C corporation.

Question 7

How is a change in the number of members of an LLC affects the entity’s classification?

Answer 7

A change in the number of members of an LLC that has been elected to be a corporation does not affect the entity’s classification. Both LLCs and corporations can have a single owner.

Question 8

When is a foreign person treated as a U.S resident?

Answer 8

Foreign persons are usually only taxed on their US-source income. A foreign individual may be treated as a U.S. resident, which means the individual is subject to U.S. taxation on worldwide income.

Question 9

What is the test to determine if a foreign person is treated as a U.S. resident?

Answer 9

1. Green card test: A foreign individual is considered a resident of the United States of he or she is a lawful permanent resident of the U.S. in accordance with US immigration laws.
2. Substantial Presence Test: A foreign individual is considered a resident of the U.S. if he or she is substantially present in the U.S. for:
   - At least 31 days during the current year; and
   - At least 183 days for a 3-year period, applying a weighted average:
   a. Days in the current year * 1
   b. Days in the immediate preceding year * 1/3
   c. Days in next preceding year * 1/6

Question 10

Are cash distributions to a partner reported as part of his AGI?

Answer 10

No, cash distributions to a partner are included on the schedule K-1 for calculation of partner’s basis in his partnership interest (like equity)

Question 11

How is the partnership’s basis calculated?

Answer 11

Partner’s basis:

Decrease Increase
1. withdrawals and distributions 1. Investments into
partnership
2. losses reduce basis but only to zero 2. All income earned
taxable or non-taxable
3. Repayment of loans will 3. Loans made to the
decrease partner’s basis partnership
4. Liabilities transferred to partnership,
assumed from partner
by other partners 4. Ownership % of partners
debts (going to the bank
and get a loan)

Question 12

What is the formula to calculate the apportionment factor to apportion income to a state?

Answer 12

Property (avg) + Payroll from + sales from a state
from a state a state
÷ Total Property ÷ Total Payroll ÷ Total Sales
divided by 3
= apportionment factor

Question 13

When can a S corporation status terminate?

Answer 13

1. Shareholder holding more than 50% of the stock (voting and nonvoting) consent to a voluntary revocation.
2. The corporation fails to meet the qualifications for S corporation.
3. More than 25% of the corporation’s gross receipts are from passive income for 3 consecutive years (but only if the corporation has prior C corp E&P).

Question 14

How is the percentage electing to revoke calculated?

Answer 14

% electing to revoke = Total of shareholders filing consent to revoke (voting + nonvoting C/S)/Total # of shareholders (total shares of voting + nonvoting stock in the S-corp)

If the % is less than 50%, the S corp did not terminate.

Question 15

How many shareholders are allowed in an S-corp?

Answer 15

1. An S corp is allowed a maximum of 100 shareholders.
2. Members of the same family and their estates are counted as 1 shareholder.
3. A shareholder dies, the estate of the shareholder without risking to lose eligibility.

Question 16

What happens if an S corp shareholder sells the interest in the S corp to a C corp?

Answer 16

The S corp would lose its S corp status because a C corp cannot become a shareholder of an S corp.

Question 17

What is the formula to compute the allocation of the non-separately income when the S corp status terminates?

Answer 17

income allocation = (# days as S corp/360 or 365) * non-separately computed income

Question 18

What is the due date of an S corp and partnership to submit the tax return?

Answer 18

March 15 is the due date to submit tax return.

Question 19

Are S corps taxed on their income and capital gains?

Answer 19

No, S corps are not taxed on their income or capital gains. The income and capital gains flow through the shareholders.

Question 20

Does a revocation of an S corp status requires unanimous consent from shareholders?

Answer 20

No, it does not require unanimous consent from shareholders.

Question 21

Does election of the S corp status requires unanimous consent of the shareholders?

Answer 21

Yes, election of S corp status requires unanimous consent of shareholders.

Question 22

When is an S corp taxed?

Answer 22

When the S corp sells appreciated property (value in excess of basis) at the time of S corp election, if it was once a C corp.

If S corp status from the inception, no need to worry about built in gains.

Question 23

What is the formula to compute the built-in gain and what tax rate is used to compute the tax on the built-in gain?

Answer 23

Built-in gain = FMV property - NBV property * 21% (tax rate)

21% is the highest corporate tax rate

Question 24

If the S corp has earnings and profits from when it was a C corp and part of this relates to passive income, is the S corp taxed?

Answer 24

Yes, the S corp is taxed on the passive income that exceeds 25% of gross receipts at the 21% rate (highest corporate tax rate)

Question 25

What is considered passive income?

Answer 25

dividends, interest, royalties, and rents.

Question 26

Is the S corp status revoked if more than 25% of the S corp’s gross receipts come from passive investment income?

Answer 26

Yes, S corp status is revoked if more than 25% of the S corp’s gross receipts come from passive investment income for 3 consecutive years and the S corp had C corp earnings and profits (from its days as a C corp) for each of those 3 years.

Question 27

When are transactions between a partner and partnership taxable (e.g., sales b/w partner and partnership, providing services to partnership?

Answer 27

Transactions between partner and partnership are taxable when the partner’s interest is 50% or below. Thefore, capital gains and losses (difference b/w FMV and basis of property) are calculated and taxed. This is considered a transaction of partnership and an unrelated party.

Question 28

When are transactions between a partner and partnerhsip considered a related party transaction?

Answer 28

A related party transaction between the partner and the partnership happens when the partner owns more than 50% partnership interest in capital and profits.

Question 29

How are losses treated under related party transaction between the partner and the partnership?

Answer 29

Capital losses between the controlling partner and the partnership are disallowed (not allowed)

Question 30

How are gains treated under related party transaction between the partner and the partnership?

Answer 30

Related party gains are treated as taxable ordinary income if the property is not a capital asset in the hands of the tranferee.

Question 31

Are US taxes withheld from a foreing person engaged in US trade or business?

Answer 31

The foreign person is subject to US taxation on income connected with the US trade or business. Business income is taxed on a net basis (gross income less allowed deduction and expenses) at a US graduted rate.

Question 32

What are the separately stated items reported in a partner’s AGI in the Form 1040?

Answer 32

Separately stated items include the following:
1. interest income
2. dividend income
3. Capital gains and losses
4. Net section 1231 gain (loss)
5. Charitable contributions
6. Section 179 expense deduction
7. Investment interest expense
8. Partner’s health insurance premium (included as part of the guaranteed payments)
9. Retirement plan contribution to partners.
10. Tax credits (reported by partnership but claimed by partners)

Question 33

Are cash distributions to partners included in the partner’s AGI in the Form 1040?

Answer 33

No, cash distributions are not included in the partner’s AGI; it is included on the Schedule K-1 for calculation of the partner’s basis in his partnership interest.

Question 34

What are the non-separated stated items reported by a partner in the K-1 under Form 1065?

Answer 34

1. ordinary business income
2. Business expenses:
   
   • Salary
   • Rent expense
   • Depreciation exp (MACRS)
   • Business interest exp: the interest expense on a bank line of credit is business interest expense, which is included in ordinary income.
   • Section 1245 gain on sale of an asset (ordinary income)
3. Guaranteed payments (treated as a deduction to ordinary business income-subtracted)

Question 35

How is the basis on an S corp computed?

Answer 35

Decreases Increases
1. Withdrawals and distributions 1. Investment into S. corp
2. Losses 2. All income earned
whether taxable or non-
taxable
3. Stockholder paid back for loan 3. Stockholder loan made
to S corp.

Question 36

Can a partner have a negative basis when the liability allocated to the partner and assumed by the partnership is greater than the adjusted basis?

Answer 36

No, a partner cannot have a negative basis, so the calculation is the same but the partner will recognize a gain and the basis of zero.

Adjusted basis = property basis - mortgage. If negative, the basis is zero, and partner recognizes the gain

Gain = negative basis + %ownership of mortgage allocated to partner.

Question 37

What are the separated stated items in an S corp?

Answer 37

1. Rental real estate income/loss
2. Interest income
3. Dividend income
4. Royalties
5. Net ST capital gain or loss
6. Net LT capital gain or loss
7. Net section 1231 gain or loss
8. Charitable contribution
9. Section 179 expense deduction

Question 38

What are considered non-deductible expenses in an S corp?

Answer 38

Penalties and fines

Question 39

What is a partner’s at-risk basis?

Answer 39

A partner’s at-risk basis is the same as the partner’s tax basis in his/her partnership interest, with the exception of certain nonrecourse that is included in tax basis but not in at-risk basis.

Question 40

What type of debt is included in the partner’s at-risk basis?

Answer 40

At-risk basis includes a partner’s allocable share of recourse debt and nonrecourse debt that qualified nonrecourse financing (QNF).
- QNF is a real estate mortgage obtained from an unrelated commercial lender.
- Other nonrecourse debt is not included in at-risk basis.

Question 41

How is a loss in excess of the partner’s at-risk basis treated?

Answer 41

• A loss in excess of a partner’s at-risk basis is suspended until the at-risk basis is reinstated in future years, and it’s carried forward indefinitely.
• Any suspended at-risk losses are offset when the partner disposes of the partnership interest against any gain from selling the partnerhip.

Question 42

What is a Limited Liability Company (LLC)?

Answer 42

It is a separate legal entity from its owners. LLC members are not personally liable for the obligations of the business.

Question 43

What is a limited partnership?

Answer 43

At least one general partner is personally liable for all partnership debt.

Question 44

Can a sole proprietorship become a single LLC?

Answer 44

Yes, a sole proprietorship may become a single member LLC if it files articles of organization with the state.

Question 45

Can a change in the number of members of an LLC that has elected the classification of corporation affect the entity’s classification?

Answer 45

No, a change in the number of members of an LLC that has elected the classification of corporation does not affect the entity’s classification. Both LLCs and corporations can have a single owner.

Question 46

How is the increase in earnings invested in US property by a Controlled Foreign Corporation (CFC) calculated?

Answer 46

The average adjusted basis of the CFC’s US property for the tax year (calculated at the close of each quarter) is compared with the adjusted basis at the end of the preceding tax year. See formula below:

Average Adjusted Basis = (sum of adjusted basis for Q1, Q2, Q3, Q4)/4 quarters
less Beginning Balance Adjuted basis
= Increase in earnings invested in US property.

Note: The beginning balance adjusted basis might be used during the first quarter if the purchase of new C/S happens in a different quarter.

Question 47

What is the Advance Pricing Agreement (APA)?

Answer 47

The APA is a binding contract between the IRS and the taxpayer by which the IRS agrees not to seek a transfer pricing adjustment for a covered transaction if the taxpayer files its return for a covered year consistent with the agreed transfer pricing model

Question 48

How does the partner recognize a cash distribution greater than the partner’s basis in the partnership interest?

Answer 48

The partner recognizes a capital gain for the excess. A distribution cannot reduce the basis in the partnership interest below zero.

Question 49

What type personal interests cannot be itemized (deductible)?

Answer 49

1. A personal note to a bank or person for borrowed funds
2. Life insurance loans
3. Bank credit cards or other revolving charge accounts.
4. A purchase of personal property such as autos, television sets, clothes, etc.
5. Interest on federal, state, or local tax underpayments
6. Interest on a home equity loan not used to improve home.

Question 50

What type of personal interest can be itemized (deductible)?

Answer 50

1. Home mortgage interest: Deductions are allowed for “qualified residence interest” on a first or a second home.
2. Home equity loan in relation to buying, constructing, or improving the taxpayer’s principal and second home.

Question 51

Is a nonliquidating distribution to a partner taxable?

Answer 51

A nonliquidating distribution to a partner (current distribution, operating distribution) is nontaxable, both to the partner and the partnership.

Question 52

How are partnership losses in excess of partner’s basis recorded?

Answer 52

When partnership losses allocated to a partner exceed the partner’s basis, the losses are suspended and carryforward to be deducted on the years the partner has a basis.

Question 53

Are fringe benefits paid by an S corporation deductible?

Answer 53

Fringe benefits (e.g., insurance premiums) are dedutible by an S corp in two forms:
1. Only for non-shareholder employee and employee-shareholders owning 2% or less of the S corp.
2. The S corp includes the fringe benefis as part of gross income from the S corp for the individual receiving the benefits (i.e., included as part of income on the shareholder’s W-2)

Question 54

What is the Base Erosion and Anti-Abuse Tax (BEAT)?

Answer 54

It imposes a minimum tax on large US corporations that have an average annual gross receipts of at least $500 million for the 3 years taxable period ending with the preceding taxable year.

Question 55

When is an S corp exempted from recognizing a built-in gain?

Answer 55

1. The S corp was never a C corporation.
2. The sale or transfer does not occur within 5 years of the first day that the S election is effective.
3. The S corp can demostrate that the appreciation in the asset being sold or transferred occurred after the S election.
4. The total net unrealized built-in gain has been completely recognized in prior tax years.

Question 56

What are hot assets in a partnership?

Answer 56

Hot assets are receivables and appreciated inventory

Question 57

How are hot assets recognized by the partner when there is a sale of the partnership share?

Answer 57

When the partner sales the partnership share and the partnership has hot assets, the partner reports ordinary income (e.g., receivable amount *% partner’s share).

Question 58

How is the capital gain or loss from the sale of a partnership reported?

Answer 58

Cash received from the sale of partner’s share
plus: debt relief (share of partner’s liability)
= Amount realized
less: Partner’s basis
= Capital Gain/loss

Question 59

How is the US nonbusiness income of a foreign person taxed?

Answer 59

The foreign person’s US nonbusiness income is taxed at the 30% tax rate. Formula to determine the tax and taxable income is as follows:

US nonbusiness income
- (US nonbusiness income*tax rate)
=US nonbusiness income, net of tax

Question 60

When a partner performs services and receives partnership interest, how are the services performed valued?

Answer 60

Whenever a partner provides a service, the FMV of what you receive is ordinary income.

Question 61

When an S corporation is terminated, how much time does the S corp has to reelect the S corp status?

Answer 61

The corporation must wait until the beginning of the 5th year of termination before it can elect S corporation status again.

Question 62

What are shareholders of an S corporation?

Answer 62

Shareholders of an S corporation must be:
1. individuals
2. estates
3. A voting trust
4. a grantor trust
5. A bankruptcy estate

Question 63

What entity allows owners with limited liability while avoiding federal taxation of income at the entity level?

Answer 63

The subchapter S corp grants shareholders the benefit of the limited liability while taxed like a partnership.

Question 64

What are the types of foreign income applicable to the foreign tax credit limitation?

Answer 64

1. Passive category income (dividends, interest, rents, royalties)
2. General category income (active business income)
3. Foreign branch income
4. Global intangible low-taxed income

Question 65

What is the purpose of sourcing foreign income into separate categories?

Answer 65

To prevent a company from using excess credits from high-tax foreign business profits to offset low-taxed passive investment income.

Question 66

How are profits and losses allocated when the agreement is absent to the contrary?

Answer 66

All partners have equal rights to share in the profits of the partnership.

Question 67

How to determine the ownership interest in a foreign corporation of a US person in order to prevent shifting income to low-tax jurisdictions to avoid US taxes?

Answer 67

A US shareholder is any US person owning at least 10% of the foreign corporation’s stock (vote or value)

Question 68

When is foreign corporation considered a controlled foreign corporation (CFC)?

Answer 68

A foreign corporation is considered a CFC if more than 50% of its stock is owned by US shareholders.

Question 69

What is a foreign subsidiary?

Answer 69

This is a separate legal entity, incorporated under the laws of the foreign host and sub’s profits are taxed by the host country.

Question 70

What are the federal tax consequences related to the foreign subsidiary?

Answer 70

1. income earned by the sub is not taxed until the earnings are brought back to the US as a form of dividend. This way, the US company has control over when foreign profits are recognized.
2. Certain types of income earned are not allowed to be deferred and are subject to immediate taxation (e.g., passive ivestment income)
3. Rules of transfer pricing are followed becasue profit recognition b/w parent and sub might be deferred.

Question 71

What is a foreign branch?

Answer 71

1. It is an unincorporated foreign entity that is viewed as an extension of the domestic corporation.
2. It is not a separately legal entity
3. Earnings from the branch are taxed by the foreign country

Question 72

What are the federal tax consequences related to a foreign branch?

Answer 72

1. Profits (or losses) earned by the branch are treated as being earned directly by the domestic corporation and taxed in full when earned.
   
   • Losses incurred may offset domestic income earned by the US company.
2. A credit against taxes is allowed for the lesser of foreign tax imposed by the branch’s host country or the foreign tax credit limitation.
3. Retmittance of branch profits back to the domestic corporation is generally not a taxable event for federal tax purposes, as the profits are taxed when earned.
   - Once exception would be any related foreign currency exchange gains or losses that occur upon repatriation).

Question 73

Are distributions from an S corporation taxable to the shareholder?

Answer 73

No, distributions from an S corp are not subject to taxation. However, distributions maybe taxable if the distribution exceeds the shareholder’s basis in the corporate stock.
1. The distribution first reduces the shareholder’s basis, but not below zero.
2. The amount received in excess of the basis in the stock is taxed as a capital gain (capital gain distribution), and provided long-term and short-term treatment, depending on the lenght of time the shareholder held the stock as an investment.

Question 74

What is the homestead exemption about?

Answer 74

The homestead exemption is used by states to protect certain property of the debtor to ensure that the debtor does not become destitute.
- Homestead exeption is up to certain amount from the liens of most creditors. The exclusion does not apply to persons with purchase money security interest (PMSIs)
- If taxpayer fails to pay federal taxes, the IRS can file a lien on all of the taxpayer’s property, including property exempt from levy under state law.

Question 75

When does a built-in gain results in an S corporation?

Answer 75

A distribution or sale of an S corporation’s assets may result in a corporate-level tax on any built-in gain. An unrealized built-in gain results when the following two conditions occur:
1. A C corporation elects S corp status
2. The FMV of the corporate assets exceeds the adjusted basis of corporate assets on the election date.

Question 76

How is the gain on sale of the property contributed to the partnership allocated to the partner?

Answer 76

The gain on sale of the property initially contributed by the partner to the partnership is allocated as follows:
1. Calculate the realized gain on sale
Sale of land
less: basis
= Gain realized

2. Calculate the pre-contribution built-in gain.
   Pre-contribution built-in gain:
   FMV @ date of contribution
   less: basis @ date of contribution
   = Pre-contribution built-in gain
3. Determine the post-contribution built-in gain
   Post-contribution buitl-in gain = Gain realized - pre-contribution built-in gain
4. Calculate the gain allocated to the partner:
   pre-contribution built-in gain (the entire amount)
   Plus: Post cotnribution built-in gain * partner’s ownership %
   = Total gain allocated to partner.

Question 77

What is the advantage of a Limited Liability Company to be taxed as a partnership rather than an S corp?

Answer 77

LLC taxed as a partnership can distribute appreciated property tax-free to the partners (in general, a non liquidating distribution to a partner is nontaxable).

An S corp cannot distribute appreciated property to its shareholders without a gain. The gain is taxable.