1 OWL CORP, a C Corporation, has one 100% owned subsidiary, also a C Corporation. Both corporations have been in business for several years. OWL CORP wishes to make an S election. May it do so? Explain your answer.
2. Explain what makes a trust a “grantor trust” and the reasons a grantor trust is a permitted S Corporation shareholder.
3. Distinguish between a Partnership and C Corporation by explaining the advantages and disadvantages of each.
4. Explain the differences in the calculation of a partner’s outside basis and capital account balance. Specifically describe how capital accounts are used to determine whether a special allocation has economic effect and is substantial.
5. After graduating from FAU, Alban and Natalia form an LLC classified as a partnership for federal income tax purposes. Alban contributes $10,000 cash and a depreciable asset with an adjusted basis of $40,000 and a fair market value of $90,000. Natalia contributes $50,000 cash and land with an adjusted basis of $70,000 and a fair market value of $50,000. What are Alban’s and Natalia’s outside basis and their capital account balances at formation of the partnership?
6. David’s outside basis in his partnership interest is $20,000. What are the income tax consequences to David (outside basis, gain or loss, if any) if the partnership makes the following operating distributions to David? Consider each distribution independently from the other. A) The partnership distributes $25,000 of cash to David. B) The partnership distributes land with a basis of $25,000 and a fair market value of $50,000.
7. Explain the following: 1) the concept of “carried interest”; 2) the tax consequences and advantages to an investment partnership manager who is compensated with carried interest; and 3) the criticisms of the current tax treatment.
8. Identify and explain two (2) partnership (or partner) events or transactions, including the applicable internal revenue code provision for each, that require an inside basis adjustment if the partnership has a Section 754 election in place.
9. What is an unrealized receivable? What are the income tax consequences to a partner receiving a partnership distribution of an unrealized receivable?
10. Debbie is a partner in a CPA firm and her distributive share of partnership income for 2022 is $175,000. Debbie is single and a Florida resident. Is Debbie allowed to take the Section 199A deduction for 20% of her qualified business income? Discuss and explain.
No, OWL CORP cannot make an S election for its subsidiary. An S corporation is a special tax status granted by the IRS, allowing a corporation to avoid double taxation by passing its income, losses, deductions, and credits through to its shareholders. However, to qualify as an S corporation, there are strict eligibility criteria that both the parent corporation (OWL CORP) and its subsidiary must meet. One key requirement is that an S corporation cannot own another corporation, partnership, or certain types of trusts as a subsidiary. In this case, since OWL CORP has a 100% owned subsidiary, both corporations cannot collectively qualify for S corporation status. As a result, OWL CORP cannot make an S election for its subsidiary.
A grantor trust is a trust in which the grantor (creator of the trust) retains control over the trust assets and is responsible for the trust’s income tax liabilities. In a grantor trust, the income and deductions of the trust are treated as if they belong to the grantor for tax purposes. A grantor trust is a permitted S corporation shareholder because the IRS only allows individuals, certain trusts, and estates to be shareholders of an S corporation. Since the grantor is treated as the owner of the trust’s income and deductions in a grantor trust, the trust’s income is attributed to the grantor, allowing the trust to qualify as a permissible S corporation shareholder.
Advantages
Pass-Through Taxation: Partnerships don’t pay income tax at the entity level. Profits and losses flow through to individual partners, avoiding double taxation.
Flexibility: Partnerships offer flexibility in allocating profits and losses among partners.
Limited Formalities: Partnerships have fewer formalities compared to corporations.
Investment Diversity: Partnerships can have diverse ownership structures, attracting various types of investors.
Disadvantages
Self-Employment Taxes: General partners are subject to self-employment taxes on their share of partnership income.
Limited Liability: Limited partners may have limited liability, but general partners have unlimited personal liability for partnership debts.
Management Disputes: Disagreements among partners can lead to management issues.
Advantages
Limited Liability: Shareholders’ liability is generally limited to their investment in the corporation.
Perpetual Existence: C corporations can exist indefinitely, making them suitable for long-term businesses.
Easier Capital Raising: C corporations can issue various classes of stock, making it easier to attract investors.
Disadvantages
Double Taxation: C corporations are subject to corporate income tax, and shareholders are taxed again on dividends received.
Complex Taxation: Corporate tax regulations are complex, leading to higher compliance costs.
Less Flexibility: C corporations have less flexibility in allocating income and losses compared to partnerships.
The partner’s outside basis is the partner’s initial investment in the partnership, increased by their share of partnership income and additional contributions, and decreased by distributions and the partner’s share of partnership losses. The capital account is an accounting record that reflects a partner’s equity in the partnership.
The capital account balance is used to determine if a special allocation of partnership income or loss has economic effect. A special allocation is considered substantial and has economic effect if the partner’s capital account balance, after considering the allocation, is positive and the partner has a reasonable opportunity to receive the economic benefit represented by the positive balance.
Alban’s Outside Basis: Cash: $10,000 Depreciable Asset (Adjusted Basis): $40,000
Total Outside Basis: $50,000
Natalia’s Outside Basis: Cash: $50,000 Land (Adjusted Basis): $70,000
Total Outside Basis: $120,000
Alban’s Capital Account Balance: Cash: $10,000 Depreciable Asset (Fair Market Value): $90,000
Total Capital Account Balance: $100,000
Natalia’s Capital Account Balance: Cash: $50,000 Land (Fair Market Value): $50,000
Total Capital Account Balance: $100,000
A) Distribution of $25,000 Cash: No gain or loss is recognized. David’s outside basis decreases by $25,000 to $20,000 – $25,000 = -$5,000.
B) Distribution of Land with $25,000 Basis and $50,000 FMV: David recognizes a gain of $25,000 ($50,000 FMV – $25,000 Basis). His outside basis increases by the gain amount to $20,000 + $25,000 = $45,000.
Carried Interest: Carried interest is a share of profits that investment managers receive as compensation for managing investment funds. It’s usually tied to the fund’s performance.
Tax Consequences and Advantages: Carried interest is often taxed at the favorable capital gains rate rather than the ordinary income rate, providing tax advantages to investment managers. This can lead to lower tax liabilities on their compensation.
Criticisms: Critics argue that the current tax treatment of carried interest allows wealthy investment managers to pay lower tax rates on what is essentially their service income. They believe this results in unfair tax benefits for the wealthy and calls for reform in taxing carried interest as ordinary income.
Two events requiring an inside basis adjustment under Section 754 election are:
Distribution of Property: When the partnership distributes property with a basis different from its inside basis, an adjustment is made to the inside basis of partnership assets to reflect the change in total partnership value.
Transfer of Interest: If a partner transfers their interest (e.g., sells, gifts) in the partnership, a Section 754 election allows an adjustment to the basis of partnership assets to account for the potential disparity between inside and outside basis.
An unrealized receivable is an amount owed to a partnership that has not been collected at the time of a distribution. When a partner receives a distribution of an unrealized receivable, it’s treated as a distribution of cash. The partner recognizes gain only if the fair market value of the unrealized receivable exceeds the partner’s outside basis. Otherwise, there’s no gain, and the partner’s outside basis decreases by the amount of the distribution.
Yes, Debbie is allowed to take the Section 199A deduction for 20% of her qualified business income (QBI). The Section 199A deduction is available to eligible taxpayers, including owners of pass-through entities like partnerships. Since Debbie is a partner in a CPA firm, her distributive share of partnership income qualifies as QBI, and she can claim the deduction, subject to certain limitations based on her taxable income and the nature of the business
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