Page 5 - Tax Act First Look: The Complex New World Of The Qualified Business Deduction Rule

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ily tradeable on a secondary type market, is generally taxed as a corporation [IRC section 7704(a), (b)]. Corporate treat- ment is still avoided by a publicly traded partnership if it is predominately holding and managing “passive” assets whereby 90% or more of its gross income con- stitutes “qualifying income” for this pur- pose [IRC section 7704(c)(2)]. Individual items of taxable income or loss, as well as “bottom-line” income or loss under IRC section 702(a)(8), are passed through to partners based on a daily prorated portion of each such part- ner’s/member’s (for a limited liability company) share of such partnership items. Losses are deductible to the extent of a partner’s basis in the partnership interest, with an excess loss carried for- ward indefinitely in accordance with IRC section 704(d). Other limitations apply with respect to the current deductibility of losses [e.g., IRC sections 465 (at-risk rules), 469 (passive-activity loss rules), 163(d) (investment interest limitation)]. A partner’s tax basis, as adjusted, in a partnership interest gener- ally equals the sum of: 1) the partner’s capital contributions to the partnership
based on cost or “book” principles; 2) the partner’s distributive share of part- nership income; plus 3) the partner’s share of partnership liabilities deter- mined in accordance with Section 752; less: 1) the partner’s distributive share of losses and certain other nondeductible expenses; 2) any reduction in share of such partner’s liabilities which are treat- ed as constructive distributions; and 3) any actual distributions to the partner.
[IRC sections 704(c), 743(b)].
When a partner sells a partnership
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The law permits partners to allocate items of income, gain, loss, deduction, and credit among the partners—i.e., spe- cial allocations—provided such alloca- tions have substantial economic effect [IRC section 704(b)(2) and correspond- ing regulations]. An allocation has sub- stantial economic effect to the extent that the partner receiving the allocation receives a corresponding economic ben- efit or cost, so that it affects such part- ner’s capital account, which is then used in determining the manner in which the assets of the partners are to be distributed in liquidation. There are, of course, other regulations regarding testing allocations, some of which require items of gain or loss to be allocated to certain partners
The federal income taxation of S cor- porations and their shareholders resem- bles the taxation of partnerships and its partners. It was designed for such pur- pose when enacted into law in 1958. Over the years, the S corporation has been the subject of various ownership limitation reforms that have greatly expanded its use as a preferred business entity for privately owned companies. An S corporation may not have more than 100 shareholders and may issue only a single class of stock. Only indi- viduals (other than nonresident aliens), certain tax-exempt organizations, and certain trusts and estates are permitted shareholders. As a pass-through entity, an S corporation’s items of income, deduction, loss, and credit generally pass
interest to a third party, the transaction is generally treated by the transferor as a capital gain under IRC section 741. Ordinary income is realized, however, to the extent the amount is attributable to the selling partner’s distributive share of unrealized receivables and items subject to recapture [IRC section 751(a)].