REG-05 87ec71a

REG
5
Flow-Through Entity Taxation and
Multi-jurisdictional Tax Issues
Module
1 S Corporations 3
2 Partnerships: Part 1 17
5 Multi-jurisdictional Tax Issues 49
6 International Tax Issues 63

NOTES
R5–2 © Becker Professional Education Corporation. All rights reserved.

1
MODULE1 S Corporations
S Corporations REG 5
- 1120-S due on March 15

1 S Corporations - S hareholder pays the tax (K-1)
Small, closely held corporations, if eligible, may elect to be taxed as an S corporation,

a flow‑through entity taxed in a manner similar to partnerships. In effect, all the income, gains,
losses, and deductions of the corporation are passed (or flowed) through to the shareholders.
The individual owners are taxed on their proportionate share of the S corporation earnings
regardless of whether the earnings are distributed to them.
1.1 Formation
When a corporation is formed, it is by default taxed as a C corporation. It is treated as an
S corporation for tax purposes if a valid S corporation election is filed. Form 2553
Realized and recognized gain/loss to the corporation and shareholders upon contribution of
assets in exchange for stock are computed in the same manner as for a C corporation.
1.2 Property Contributions to an S Corporation

Although setting up an S corporation affords a company many tax advantages similar to those
of partnerships, some S corporation traits remain the same as for C corporations. Taxability
of shareholder contributions to an S corporation are governed under Section 351, in the same
manner as C corporations. That is, a contribution is nontaxable if it is:
Same NBV
1. a contribution of property (not services);
rules as 2. solely in exchange for stock; and
Taxable (FMV)
C corp.
3. after the transfer, the shareholder (or group of shareholders transferring in an integrated
transaction) has control of the corporation through 80 percent stock ownership.
A transfer that does not meet these requirements will be treated as a taxable sale (gain
recognized for FMV received over shareholder basis in assets contributed). Note that the
requirements for Section 351 are fairly easily met upon formation of the S corporation but may
be harder to meet upon subsequent contributions of property by individual shareholders or new
shareholders.
The S corporation's basis in any property contributed is the same as the contributing
shareholder's basis. The shareholder's initial stock basis is the amount of any cash contributed,
plus the adjusted basis of any property contributed, plus the fair market value (FMV) of any
services contributed in exchange for stock.
© Becker Professional Education Corporation. All rights reserved. Module 1 R5–3

1 S Corporations REG 5
Example 1 Contributions to S Corporations
Facts: Ray contributes property with FMV of $20,000 and an adjusted basis to Ray of
$10,000 in exchange for stock in Falcon Corporation, an existing S corporation. Immediately
after the transfer, Ray owns 20 percent of Falcon's stock.
Required: Determine Ray's realized gain or loss on the exchange and his basis in the
S corporation stock.
Solution: $10,000 realized gain ($20,000 FMV – $10,000 adjusted basis of property
contributed). Need 80% to be tax-free
Ray will have a $10,000 realized gain. Because Ray did not have 80 percent or more
ownership in Falcon after the exchange, he is required to recognize the gain on the
exchange of property for stock.
Ray will have a $20,000 basis in Falcon ($10,000 carryover basis plus $10,000 gain
recognized). Falcon's basis in the property received is also $20,000.
2 Eligibility
To qualify as an S corporation, the following requirements must be met:
1. Qualified Corporation
The corporation must be a domestic corporation. An S corporation may own any interest
in a C corporation (even 100 percent), but the S corporation may not file a consolidated tax
return with the C corporation. An S corporation may also create a qualified S subsidiary in
which the S corporation owns 100 percent of the stock; the two S corporations would file as
one entity for tax purposes.
2. Eligible Shareholders USA

yy Eligible shareholders must be individuals, estates, or certain types of trusts.
100 U.S. yy An individual shareholder may not be a nonresident alien.

people, yy Qualified retirement plans and 501(c)(3) charitable organizations may be shareholders.
& only yy Neither corporations nor partnerships are eligible shareholders.
common
stock 3. Shareholder Limit
There may be no more than 100 shareholders. Family members may elect to be treated
as one shareholder. Family members include common ancestors, lineal descendants of
common ancestors, and their current or former spouses.
4. One Class of Stock Common stock

There may be no more than one class of stock outstanding. However, differences in
common stock voting rights are allowed. Preferred stock is not permitted.
R5–4 Module 1 © Becker Professional Education Corporation. All rightsSreserved.

Corporations
REG 5 1 S Corporations
3 Electing S Corporation Status
3.1 When Election Takes Effect By March 15 (retroactive to beg. of year)

All shareholders (voting and nonvoting) must consent to a valid election on Form 2553, which
the company files with the IRS. If the election is filed by the 15th day of third month, it is effective
as of the first day of the tax year. For a calendar year corporation, an S election filed by March 15
is effective on January 1 of that year. If the election is filed after March 15, it is effective on
January 1 of the following year.
3.2 New Shareholders

After the election is in effect, the consent of a new shareholder is not required. The S corporation
status continues until there is a voluntary or involuntary termination.
4 Effect of S Corporation Election on Corporation
4.1 S Corporation Tax Year General Rule: Dec. 31 is required year-end

S corporations file Form 1120S and must adopt the calendar year, unless a valid business
purpose for a different taxable year (fiscal year) is established. The return is due by the 15th day
of the third month (March 15) after the close of the tax year.
4.2 No Tax on Corporation: Each shareholder reports income and pays tax (K-1)
Generally, there is no tax at the corporation level; all earnings are passed through to
shareholders and taxed at the individual shareholder level. There are certain exceptions.
4.3 Certain Corporation-Level Taxes

Although S corporations generally do not pay tax, there are three different taxes that may be
imposed if the S corporation was previously taxed as a C corporation.
4.3.1 LIFO Recapture Tax

C corporations that elect S status must include in taxable income for the last C corporation
Exception year the excess of inventory computed using the FIFO method over the inventory computed
S corp. using the LIFO method. The resulting tax on the C corporation may be paid in four equal
pays tax annual installments, the first of which is due with the final C corporation return. The remaining
installments are paid by the S corporation.
4.3.2 Built-in Gains Tax

Overview
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:
y
Was Now
A C corporation elects S corporation status; and
y The fair market value of the corporate assets exceeds the adjusted basis of corporate = Appreciated
assets on the election date.
FMV > basis assets

The net unrealized built-in gain is the excess of the fair market value of corporate assets over
adjusted basis of corporate assets at the time the corporation converts from a C corporation
to an S corporation. When those assets are later disposed of, the S corporation may have to
pay tax on the built-in gain. The amount of built-in gain recognized in any one year is limited to
the total net unrealized built-in gain less any built-in gain previously recognized.
Exemptions From Recognition of Built-in Gain
An S corporation is exempt from a tax on built-in gains under any of the following
circumstances:
yy The S corporation was never a C corporation.
*
yy The sale or transfer does not occur within five years of the first day that the S election
No S corp. is effective.
tax on
yy The S corporation can demonstrate that the appreciation in the asset being sold or
built-in transferred occurred after the S election.
gain IF yy The S corporation can demonstrate that the distributed asset was acquired after the
S election.
yy The total net unrealized built-in gain has been completely recognized in prior tax years.
Calculation of Tax
The tax is 21 percent (the C corporation tax rate) of the lesser of:
yy Recognized built-in gain for the current year; or
yy The taxable income of the S corporation if it were a C corporation.
4.3.3 Tax on Passive Investment Income

An S corporation is subject to an income tax imposed at the corporate rate (21 percent) on the
S corp. lesser of net income or excess passive investment income if the following two tests are met:
taxed on From prior years as C corp.
The S corporation has accumulated C corporation earnings and profits (i.e., accumulated
current earnings attributable to prior periods in which the corporation was a C corporation); and
income IF Passive investment income (e.g., royalties, dividends, interest, rents, and annuities but not
gains on sales of securities) exceeds 25 percent of total gross receipts.
5 Effect of S Corporation Election on Shareholders
5.1 Pass-Through of Income and/or Losses (to Shareholder/K-1)

5.1.1 Overview
Like partnerships, S corporations flow through ordinary business income or loss and separately
stated items of income, gain, loss, and deductions to the shareholders. Allocations to shareholders
are made on a per-share, per-day basis. And losses limited to basis
Unlike partnerships, an S corporation shareholder's share of ordinary business income is not
subject to self-employment tax, even if the shareholder is actively involved in the operations of
the business.

Corporations
Example 2 Allocation on Per-Share, Per-Day Basis
Facts: The Duffy Corporation, an S corporation, is owned equally by three shareholders, Rick,
Tim, and Peter. The corporation is on a calendar-year basis. On February 1, Year 5, Peter sold
his one-third interest in Duffy Corporation to George. For the year ended December 31, Year 5,
the corporation had ordinary business income of $120,000 and no separately stated items.
Required: Calculate each shareholder's ordinary business income allocation for the year.
Solution: For Year 5, the income of the corporation should be allocated as follows:
Rick ($120,000 × 1/3) $ 40,000
Tim ($120,000 × 1/3) 40,000
Peter (31 days / 365 days × $40,000) 3,397 1 month 1x/3 income
George (334 days / 365 days × $40,000) 36,603 11 months 1x/3 income
Total $120,000
5.1.2 Separately Stated Items : on a K-1 to each shareholder

The following S corporation items flow through separately to the shareholder in a manner
similar to a partnership (see Schedule K-1 for a complete list):
Rental real estate income or loss (Schedule E)
Interest income - Shareholder is taxed when
(Schedule B) earned/reported
Dividend income
Royalties (Schedule E)
Net short-term capital gain or loss
Net long-term capital gain or loss (Schedule D) - Not when distributed to
Net Section 1231 gain or loss
them or received
Charitable contributions (Schedule A)
Section 179 expense deduction
5.1.3 Section 199A Qualified Business Income (QBI) Deduction = 20% deduction of net income
A below-the-line deduction of 20 percent of qualified business income may be available on
ordinary business income flowed-through from an S corporation.

Example 3 Ordinary Business Income and Separately Stated Items
Facts: Gray Corporation, an S corporation, had the following items of income and
deduction for the year: Net income
Gross income $150,000 $150,000
Cost of goods sold 70,000 <70,000>
Interest income 10,000 Schedule B -
Section 1231 gain 5,000 Schedule D -
Salary expense 40,000 <40,000>
Depreciation expense (MACRS) 10,000 <10,000>
Charitable contributions 5,000 Schedule A -
$30,000
Required: Calculate Gray Corporation's ordinary business income and separately stated
items for the year.
Solution: Ordinary business income: $30,000 (gross income of $150,000 less COGS of
$70,000, salaries of $40,000, and MACRS depreciation of $10,000)
Separately stated items:
Interest income $10,000
Section 1231 gain 5,000
Charitable contributions 5,000
5.2 Fringe Benefits

5.2.1 Deductible Fringe Benefits
Fringe benefits for non-shareholder employees and those employee shareholders owning
2 percent or less of the S corporation are deductible by the S corporation in calculating ordinary
business income.
5.2.2 Nondeductible Fringe Benefits Include in that

The cost of fringe benefits for shareholders owning over 2 percent is not deductible by the
shareholder's
S corporation, unless the corporation includes the benefits in the employee/shareholder's income and
W-2 income. report on K-1
Pass Key
Similar to a partnership, shareholders in an S corporation must include on their individual

income tax return their distributive share of each separate "pass-through" item.
Taxed like
a bank
Shareholders are taxed on these items, regardless of whether or not the items have been account
distributed (withdrawn) to them during the year.

Corporations
5.3 Shareholder Basis in S Corporation Stock

The calculation of a shareholder's basis in S corporation stock is generally the same as partnerships:
Note B Initial stock basis (contributions)

S corp. nonrecourse + Additional contributions
debt does not A + Income items (ordinary business income, separately Includes tax-free items
increase shareholder stated income/gain items, and tax-exempt income)
(at-risk) basis S − Distributions to shareholders

− Nondeductible expenses
− Loss/deduction items (ordinary business loss, separately
stated loss/deduction items)
E = Ending basis in S corporation stock
Unlike partnerships, S corporation shareholders do not include any S corporation debt in their
stock basis. However, an S corporation shareholder does have separate debt basis in loans from
the shareholder to the S corporation. = Include (debt basis)
Stock basis cannot be reduced below zero. This affects both the pass‑through of S corporation
losses/deductions and the tax treatment of distributions to shareholders.
Basis
5.4 Limitations on Pass-Through of Losses : Deduct up to +
Direct loans
For an S corporation shareholder to deduct a loss, the shareholder must clear four hurdles,
in this order:
1. Tax basis limitation
2. At-risk limitation
3. Passive activity loss (PAL) limitation
4. Excess business loss limitation
The tax basis and at-risk limitations are applied at the entity level, and limit the ability of
S corporation shareholders to flow through losses to individual income tax returns. The PAL and
excess business loss limitations are applied at the individual tax return level.
5.4.1 Tax Basis Limitation

A loss can only be flowed through to an S corporation shareholder's individual income tax return
to the extent of the shareholder's tax basis. This includes the shareholder's stock basis and basis
+ in any direct loans from the shareholder to the S corporation.
A loss in excess of the shareholder's tax basis is suspended until tax basis is reinstated in future
years. Tax basis can be reinstated by any of the items that increase stock basis: income, gains,
and additional contributions. Any increases in future years reinstate the debt basis first, then
stock basis.
A suspended loss due to insufficient tax basis can be carried forward indefinitely. However, any
suspended losses due to insufficient tax basis remaining when the shareholder disposes of his
or her S corporation stock are lost. Forever Sale
Not used
5.4.2 At-Risk Limitation

An S corporation shareholder's ability to flow through losses may be further limited by the
amount of the shareholder's risk of financial loss in the business. The at-risk amount is typically
the same as the shareholder's stock basis and debt basis. A shareholder's at-risk amount may be
lower than his or her stock and debt basis if the taxpayer takes out a nonrecourse loan (where
the shareholder is not personally liable) to make a contribution or to make a direct loan to the
S corporation. The contribution or loan would be included in the shareholder's tax basis, but not
in the shareholder's at-risk amount (at-risk basis).
A loss in excess of a shareholder's at-risk basis is suspended until the at-risk basis is reinstated
in future years, and is carried forward indefinitely. Any suspended losses due to insufficient
at‑risk basis remaining when the shareholder disposes of his or her stock can be offset against
any gain from selling the stock. Sell
Pass Key
An S corporation shareholder is permitted to pass through for deduction on the

shareholder's individual income tax return the pro rata share of the S corporation loss
subject to the following limitation:
Stock basis (reduced by any distributions) + Debt basis (direct shareholder loans to S corporation)
Illustration 1 Stock Basis and At-Risk Amount
Gearty is a shareholder in an S corporation. He contributed $12,000 in cash and land with

a basis of $25,000 and a fair market value of $100,000. He also loaned the S corporation
$15,000, which Gearty borrowed from another source on a nonrecourse basis. Gearty has
$10,000 as his pro rata share of S corporation income that was not distributed. Gearty's
stock basis:
$12,000 (cash contributed)
25,000 (basis in land contributed) NBV
10,000 (undistributed share of income)
$47,000 stock basis
Gearty has debt basis of $15,000 for the loan to the S corporation, so his total tax basis is
$62,000 ($47,000 stock basis + $15,000 debt basis). However, the loan to the S corporation
is not included in his at-risk amount. Because he obtained the funds through a nonrecourse
loan and is not personally liable, he is not at risk of financial loss. Gearty's at-risk amount is
$47,000, the amount of his stock basis only.

Corporations
Example 4 S Corporation Tax Basis Limitation
Beg. basis
Facts: Anna's stock basis in her S corporation stock at the end of Year 1 is $30,000. Anna
also loaned the S corporation $10,000 from her personal savings in Year 1. In Year 2, the
S corporation incurred an ordinary business loss, and Anna's share of the loss was $75,000. Year 2
The S corporation had ordinary business income in Year 3, and Anna's share was $50,000. Year 3 income
There were no other changes to Anna's stock basis (separately stated items, contributions,
or distributions), and the S corporation did not make any payments on the loan from Anna
in Years 2 and 3.
Required: Calculate the amount of ordinary income or loss that is flowed through to
Anna's individual income tax return each year and her tax basis in her S corporation stock
at the end of Year 2 and Year 3.
Solution:
Year 2: Anna can flow through $40,000 of her $75,000 share of the Year 2 S corporation
loss for deduction on her individual income tax return (subject to the PAL and excess
business loss limitations). The loss can be flowed through to the extent of her $30,000 stock
basis and $10,000 debt basis, reducing the basis of both to zero at the end of Year 2. The
remaining $35,000 ($75,000 – $40,000) is suspended until her tax basis is reinstated.
Year 3: The $50,000 ordinary business income is flowed through to be taxed on Anna's
individual income tax return. The income reinstates her debt basis to $10,000 first, then
the remaining $40,000 increases her stock basis. The suspended loss of $35,000 can now
be flowed through for deduction on her income tax return (subject to the PAL and excess
business loss limitations). Her Year 3 ending stock basis is $5,000 ($40,000 – $35,000).
Her Year 3 ending tax basis is $15,000 ($5,000 stock basis + $10,000 debt basis).
Prior S corp income

5.5 Accumulated Adjustments Account (AAA) : which can be withdrawn
tax-free (first)
The accumulated adjustments account (AAA) is the accumulated earnings and profits during
the years the corporation is an S corporation. Distributions may not reduce AAA below zero.
However, AAA may be negative due to S corporation losses and deductions.
5.5.1 Increases to AAA

Ordinary business income
Separately stated income and gain items (other than tax-exempt income)
5.5.2 Decreases to AAA

Ordinary business losses
Separately stated losses and deductions
Nondeductible expenses (other than expenses related to tax-exempt income)
Distributions (may not reduce AAA below zero)
Basis Loan Suspended Total
Beg. $30,000 $10,000 — $40,000
Year 2 <30,000> <10,000> <35,000> <75,000>
Year 3 40,000 10,000 — 50,000
Use suspended loss <35,000> — —
End. $5,000 $10,000 -0- $15,000
5.5.3 Other Adjustments Account

The other adjustments accounts (OAA) is an account that is designed to keep a cumulative record
of items that affect S corporation shareholders' stock basis but do not affect AAA. These include:
Tax-exempt interest on municipal bonds and related expenses
Permanent
differences Tax-exempt life insurance proceeds and related nondeductible premiums
Federal taxes paid or accrued in an S corporation year that relate to C corporation years
The OAA does not impact the taxability of S corporation distributions.
5.6 Distributions to Shareholders

Because S corporations are only subject to a single level of tax, distributions from an
S corporation are generally not taxable to the shareholders, as the shareholder has already been
taxed on the income when it passes through on the shareholder's K-1 each year. However, if an Exception
S corporation has prior C corporation earnings and profits (E&P) from before the S election was
made, distributions may be taxable.
The rules for determining the taxability of distributions are presented below.
S Corporation With No C Corporation E&P

Always Distribution Tax Result Treatment
been an
1st To extent of stock basis Not subject to tax, reduces basis in stock Return of capital
S corp.
Taxed as long-term capital gain
2nd In excess of stock basis Capital gain distribution
(if stock held for > one year)
Illustration 2 Taxability of Distributions With No C Corporation E&P
Feline Corporation, a calendar year S corporation since its formation in Year 1, has two equal
shareholders, Carlin and Radon. During Year 5, Carlin received distributions from Feline
Corporation of $22,000. At December 31, Year 5, after all adjustments to stock basis had been
made except for distributions, Carlin's basis in his Feline stock was $18,000. For Year 5, Carlin
will treat $18,000 of the distributions as a nontaxable return of capital (reduction of basis of
stock) and $4,000 in excess of his stock basis as a long-term capital gain.
1st distribution deemed from S corp. earnings/already taxed to shareholder on K-1

S Corporation With C Corporation E&P
Distribution Tax Result Treatment
Not subject to tax, reduces S corporation profits
Because 1st To extent of S corporation AAA
basis in stock (already taxed)
it was
C corp. 2nd To extent of C corporation E&P
Taxed as a dividend, does not Prior C corporation taxable
in past reduce basis in stock dividend distribution
To extent of S corporation Not subject to tax, reduces Nontaxable income/related
3rd
OAA basis in stock expenses
Not subject to tax, reduces
4th To extent of stock basis Return of capital
basis in stock
5th In excess of stock basis Taxed as long-term capital gain Capital gain distribution

Corporations
Illustration 3 Taxability of Distributions With C Corporation E&P
The New Elect Corporation was a C corporation until it elected S status on January 1, Year 2. New
Elect had accumulated C corporation E&P of $20,000 at December 31, Year 1. For the period
Year 2 to Year 8, New Elect had ordinary business income of $100,000 and had made shareholder
distributions of $60,000. New Elect's AAA balance at December 31, Year 8, was $40,000
($100,000 – $60,000). In Year 9, New Elect had ordinary business income of $50,000 and made
distributions to shareholders of $120,000. The tax result of the Year 9 distribution is as follows:
1. To extent of S Corporation AAA
($40,000 + $50,000 Year 9 income = $90,000) Nontaxable
2. To extent of C corporation E&P ($20,000) Taxable dividend
3. Excess ($10,000) ontaxable reduction in basis of stock,
N
any in excess of stock basis is taxable LTCG.
$120,000
6 Termination of S Election
6.1 Terminating Event

S corporation status will terminate as a result of any of the following:
Shareholders holding more than 50 percent of the stock (voting and nonvoting) consent to a
voluntary revocation. - Corp. or partnership owner
The corporation fails to meet any of the qualifications for S status.
- Foreign owner
- More than 100 owners
C S Excess passive investment income: More than 25 percent of the corporation's gross receipts
and are from passive investment income for three consecutive years (but only if the corporation
3 strikes has prior C corporation E&P).
and
you are 6.2 Effective Date of Termination
out
When a majority of the shareholders elect to terminate the S election, the S corporation can
specify an effective date when the revocation is filed with the IRS. If no date is specified and
the revocation is filed by March 15, the revocation is effective January 1 of the current year.
If the revocation is filed after March 15, the effective date is January 1 of the following year.
If the corporation fails to meet any of the requirements, S corporation status is terminated
immediately.
With excess passive income, S corporation status is terminated at the beginning of the
fourth year.
6.3 Short Tax Years

Termination of an S corporation election can result in two short tax years, where the corporation
is an S corporation for part of the year and a C corporation for part of the year. This can occur
if the corporation revokes the election and specifies an effective date, or if the corporation fails
to meet one of the requirements for S status. The corporation must allocate the income for the
year between the S corporation and the C corporation in one of two ways:
Allocate based on the relative number of days
Close the books on the date of conversion

Example 5 S Corporation Termination
Facts: Small Corporation is a calendar year S corporation, which has maintained a valid
S election since the corporation was formed 10 years ago. On February 1 of the current
year, Small admits Large Corporation, a C corporation, as a 40 percent shareholder.
Required: Determine the impact of Small Corporation's admittance of Large as a
shareholder on the S election.
Solution: Because Large Corporation is a C corporation, Small would no longer meet the
requirements of an S corporation, and its S election would be terminated on February 1,
the date Large Corporation is admitted as a shareholder. Small Corporation's income in the
year of termination must be allocated between a short S corporation tax year and a short
C corporation tax year.
- Wait 5 years
6.4 Reelecting S Status - Ask IRS permission
Once an S corporation election has been terminated, the corporation must wait until the beginning
of the fifth year after the year of termination before it can elect S corporation status again.
7 Liquidation of an S Corporation
The liquidation of an S corporation is treated the same as the liquidation of a C corporation.
7.1 Consequences to an S Corporation

In a liquidating distribution, the corporation will recognize gain or loss on the distribution of
property as if the property was sold at fair market value (FMV):
FMV of assets distributed Report on K-1 to

< Basis in assets > shareholder and
increase their basis
Taxable gain/loss
Note: Distributions to related parties (as defined in IRC Section 267) do not qualify for loss recognition.
7.2 Consequences to Shareholders

Distributions from an S corporation in complete liquidation of the S corporation are treated
as payments in exchange for stock.
The shareholder's adjusted basis in the stock is subtracted from the amount realized (cash
and FMV of property received from the corporation) to calculate the gain or loss.

Corporations
If the shareholder assumes corporate liabilities or receives property subject to a liability, the
amount realized is reduced by the amount of the liabilities assumed:
Cash received
K-1
FMV of property received
< Liabilities assumed >
Amount realized
< Basis in stock >
Increase
Taxable gain (loss)
The shareholder's stock basis in this calculation is determined after all of the other activity
of the S corporation for the year has been taken into account (share of taxable income, etc.).
The character of the gain/loss recognized to the shareholder will depend on the
shareholder's holding period in the S corporation stock and whether the stock is a capital
asset to the shareholder.
Example 6 Liquidation of S Corporation
Facts: XYZ Corp., a calendar year S corporation, makes a liquidating distribution of a

building with FMV of $100,000 and a basis to XYZ of $60,000 to its sole shareholder, W. XYZ
also had ordinary business income for the year of $10,000. W has a basis in his XYZ stock of
$30,000 at the beginning of the year.
Required: Determine the tax consequences of the liquidating distribution to XYZ
Corporation and to its sole shareholder, W.
Solution: Consequences to XYZ: XYZ recognizes a gain of $40,000 on the distribution of the
building ($100,000 FMV – $60,000 basis), which flows through to Shareholder W.
Consequences to W: W recognizes the $40,000 gain that flows through from the S corporation.
W's basis in his XYZ stock immediately before the distribution is $80,000:
Beginning basis $30,000
Ordinary business income 10,000 FMV Basis
XYZ gain on distribution of building 40,000 = $100,000 - $60,000
$80,000
W's gain on the distribution is $20,000 ($100,000 FMV of building received as a distribution
less $80,000 stock basis).

NOTES
Question 1 MCQ-01966
Bristol Corp. was formed as a C corporation on January 1, Year 1, and it elected S corporation
status on January 1, Year 3. At the time of the election, Bristol had accumulated C corporation
earnings and profits, which have not been distributed. Bristol has had the same 25 shareholders
throughout its existence. In Year 6, Bristol's S corporation election will terminate if it:
a. Increases the number of shareholders to 100.
b. Adds a decedent's estate as a shareholder to the existing shareholders.
c. Takes a charitable contribution deduction.
d. Has passive investment income exceeding 90 percent of gross receipts in each of
the three consecutive years ending December 31, Year 5.
Lane Inc., an S corporation, pays single-coverage health insurance premiums of $4,800 per
year and family coverage premiums of $7,200 per year. Mill is a 10 percent shareholder-
employee in Lane. On Mill's behalf, Lane pays Mill's family coverage under the health
insurance plan. What amount of insurance premiums is includable in Mill's gross income?
a. $0
b. $720
c. $4,800
d. $7,200

Corporations
2
MODULE2 Partnerships: Part 1
Partnerships: Part 1 REG 5
1 Partnerships
A partnership is a flow-through entity, which means that the income is taxed

only once when it "flows through" to the partner. Unincorporated business Formation
entities such as general partnerships, limited partnerships, and limited liability
Operation
companies (LLCs) are generally treated as partnerships under the Subchapter K
rules of the Internal Revenue Code.
Taxation
1.1 Partnership Formation Distribution
When a partnership is formed, the partners contribute money, other property,
or services in return for their ownership interests. A new partner may also Liquidation
obtain an interest by making a contribution after the partnership is formed and
already operating.
Generally, no gain or loss is recognized on a contribution of property to a partnership in return
for a partnership interest.
Contribution of Property in Exchange

Example 1
for Partnership Interest
Facts: A taxpayer contributes land in exchange for a partnership interest. The land has an
adjusted basis of $30,000 and FMV of $50,000 at the time of transfer.
Required: Determine the amount of gain or loss recognized by the taxpayer.
Solution: No gain is recognized by the taxpayer on the transfer.
1.1.1 Partnership Interest 1

A partnership interest is an equity interest in a partnership. It can consist of a capital interest, a
2 profits interest, or both.
Capital interest is a right to share in the net assets of the partnership when it liquidates.
Profits interest is a right to share in the future profits or losses of the partnership.
1.1.2 "Profits Interest "Acquired for Services Provided = FMV = -0-

When a partner receives a profits interest in exchange for services provided, the partner does
not recognize any compensation as ordinary income. A profits interest is a right to uncertain
future profits, which is not measurable at the time the profits interest is received, and has no
liquidation value.

2 Partnerships: Part 1 REG 5
Example 2 Profits Interest Acquired for Services Provided
Facts: A taxpayer receives a 20 percent partnership profits interest in exchange for services
provided. On the day he is admitted to the partnership, the partnership's assets have a
basis of $20,000 and a liquidation value of $80,000. FMV = -0-
Required: Determine the amount of income, gain, or loss recognized by the taxpayer.
Solution: The taxpayer will not have to recognize income at the time the profits interest is
exchanged for the services provided.
1.2 Exceptions to Nonrecognition of Gain (Taxable Events for Partners)

1.2.1 Capital Interest Acquired for Services Provided = Taxable FMV
When a partner provides services to a partnership in exchange for a capital interest, the
compensation he receives for the services provided is the liquidation value of the capital
interest, which is the amount the contributing partner would receive if the partnership were
to liquidate. The liquidation value of the capital interest is included in the partner's taxable
ordinary income.
The partnership either deducts or capitalizes, depending on the nature of the services provided,
the amount "paid" for the services, which is the liquidation value of the capital interest provided
in exchange for the services. The deduction is allocated among the partners that existed before
the new service partner.
Example 3 Capital Interest Acquired for Services Provided
Facts: A taxpayer receives a 20 percent partnership capital interest in exchange for services
provided. On the day he is admitted to the partnership, the partnership's assets have a
basis of $20,000 and a liquidation value of $80,000.
Required: Determine the amount of income, gain, or loss recognized by the taxpayer.
Solution: He will recognize ordinary income of $16,000 (20 percent of $80,000).
1.2.2 Property Subject to an (Excess) Liability

When property is contributed that is subject to a liability (nonrecourse secured debt), the excess
of the liabilities assumed by the other partners over the contributed basis is treated as taxable
boot and is a gain to the partner.
R5–18 Module 2 © Becker Professional Education Corporation. AllPartnerships:

rights reserved.Part 1
REG 5 2 Partnerships: Part 1
2 Basis
2.1 Partner's Basis in Partnership Interest ("Outside Basis")

2.1.1 Partner's Initial Basis in Partnership Interest
A partner's initial basis in the partnership interest is the same as an S corporation shareholder's
initial stock basis with one exception: debt. A partner includes in the basis of his or her
partnership interest the partner's share of partnership liabilities.
Cash contributed
Property contributed (adjusted basis)
Services provided (FMV, if capital interest)
Existing
< Liabilities transferred to partnership, assumed by other partners >
liabilities that
+ Partner's share of partnership liabilities
were in the
Partner's initial basis in partnership interest
partnership &
new partner
2.1.2 Allocation of Partnership / LLC Debt will take on
A partner's share of partnership debt is included in his or her basis in the partnership interest.
How partnership or LLC debt is allocated to partners or LLC members depends on two things:
the type of debt and the type of owner.
Recourse debts: Debts for which a partner has personal liability, which means that
the creditor can go after the partner's personal assets if the debt is not satisfied by the
partnership. A general partner is personally liable for the recourse debts of the partnership.
A limited partner or LLC member has limited liability, so they are generally not personally
liable for the debts of the partnership unless they personally guarantee the debt. Recourse
debts are only allocated to partners or LLC members who have personal liability for = Only general
the debt.
partner's share
Nonrecourse debts: Typically secured by property. The creditor only has the right to
take the secured property, not the personal assets of partners or LLC members, if the
partnership defaults on the debt. Nonrecourse debts are allocated to all partners or LLC
members based on their relative profit-sharing ratio. General & limited partner's share
Allocation of Partnership Debt to Partners
Type of Owner Recourse Debt Nonrecourse Debt
General partner Yes (personal liability) Based on profit-sharing ratio
Limited partner Only if personal guarantee Based on profit-sharing ratio
LLC member Only if personal guarantee Based on profit-sharing ratio

Illustration 1 Allocation of Partnership / LLC Debt to Partners / LLC Members
1 AB Partnership has two equal partners, General Partner A and Limited Partner B. If AB
Partnership takes out a $100,000 loan, how does it impact Partner A and Partner B's basis
in their partnership interests?
If the loan is a recourse loan, the entire $100,000 loan is allocated to Partner A, and
increases her basis in her partnership interest, because she is a general partner and has
personal liability for the debts of the partnership. None of the recourse loan is allocated
to Partner B because she is a limited partner and does not have personal liability for
partnership debts.
If the loan is a nonrecourse loan secured by property, the debt is allocated between the
two partners based on their 50 percent profit-sharing ratio. Each partner increases her
basis in her partnership interest by $50,000 ($100,000 × 50%).
2 Assume instead that the business is an LLC, with two equal LLC members: = Limited liability company
If the loan is a recourse loan, neither LLC member increases her basis in her LLC interest (no personal
for the loan, unless one (or both) owners personally guarantee the LLC recourse loan. liability)
LLC members, like limited partners, do not have personal liability for partnership debts.
If the loan is a nonrecourse loan secured by property, the debt is allocated between the
two LLC members in the same manner as a partnership. Each LLC member increases her
basis in her LLC interest by $50,000 ($100,000 × 50%).
2.1.3 Property Subject to an (Excess) Liability = Boot/loot

When property that is subject to a liability (nonrecourse secured debt) is contributed to a
partnership and the subsequent decrease in the partner's individual liability exceeds his or her
partnership basis, the excess amount is treated like taxable boot, which means there is a taxable
gain to the partner.
Pass Key
In a partnership, it is important to remember to subtract only the liabilities assumed by the

other partners and not the entire liability.
Corp. tax
Reduce basis
by 100% of
liability put in

Illustration 2 Contributed Property With Excess Liability
Becker and Peter admit Tim to their partnership as a one-third partner. Tim contributes
a building that is worth $500,000 but has a basis of $100,000. There is a mortgage of
$225,000 on the building, assumed by the partnership.
Original cost: $100,000

Today FMV: $500,000
Mortgage: $225,000
Tim Becker Peter
Basis
$ 100,000 "Rollover" cost basis
< 150,000 property
R4_Building_Contributed
> Liabilities assumed by others ($225,000 × 2/3)
with excess liability
$ -50,000 "Net basis" (if below zero, boot)
$ 50,000 Gain (boot)—taxable gain to partner Tim
$ -0- Basis—of partner Tim's partnership interest
R4_Boot_Contributed property with excess liability

Pass Key
A partner's basis in a partnership interest can never begin with a negative balance (when
liabilities assumed by partnership are greater than the adjusted basis (NBV) of assets
contributed). The excess liability is treated as taxable boot, and the recognized gain
increases the partner's basis in the partnership interest to a "zero" starting point.
Use "old" contributed property

2.1.4 Holding Period of Partnership Interest
holding period (PP&E)
If the property contributed was previously a capital asset or Section 1231 asset in the hands of
the partner, the partner's holding period for his partnership interest includes the holding period
of the property contributed. If the property is an ordinary income asset (i.e., inventory), the
holding period begins on the date the property is contributed to the partnership.
Exception
2.1.5 Subsequent Adjustments to Basis in Partnership Interest
A partner's basis in his or her partnership interest is adjusted each year for the partner's share
of the following items:
Increase basis:
yy Additional contributions
yy Income and gain items
yy Increases in partnership debt

Prior example
Decrease basis: FMV $500,000
y Distributions NBV <100,000>
y Loss and deduction items Built-in gain $400,000
y Decreases in partnership debt
Allocate to
2.1.6 Special Allocation: Built-in Gain or Loss on Contributed Property Tim when sold
When a partner contributes property with an FMV that is higher or lower than the property's
adjusted basis, a built-in gain (or loss) exists at the date of contribution. Upon the subsequent
sale of that property, the "built-in" gain or loss that existed at the date of contribution must be
specially allocated to the contributing partner. (Note that any post-contribution gains or losses
are allocated among all the partners in the partnership.)
Example 4 Contribution of Property With Built-in Gain
Facts: In Year 1, Joan contributed property with an adjusted basis of $100,000 and an FMV
of $150,000 to Morton Partnership in exchange for a 20 percent partnership interest. In
Year 3, Morton Partnership sold the property to an unrelated party for $180,000.
Required: Calculate the amount of gain recognized by Joan in Year 1 and Year 3 related to
the contributed property.
Solution:
Year 1: Joan does not recognize any gain for the difference between the FMV and adjusted
basis of the property contribution. However, the $50,000 built-in gain ($150,000 FMV – $100,000
adjusted basis) will be specially allocated to Joan when the property is subsequently sold. The
partnership's basis in the property is Joan's adjusted basis of $100,000.
Year 3: The total gain allocated to Joan is $56,000.
Sales price $ 180,000

Adjusted basis (100,000)
Gain realized 80,000 FMV NBV
Pre-contribution built-in gain (50,000) = $150,000 - $100,000
Post-contribution gain 30,000
Pre-contribution built-in gain × 100% $ 50,000

Post-contribution gain × 20% ownership 6,000 = $30,000 x 20%
Total gain allocated to Joan 56,000
2.2 Partnership's Basis in Contributed Property ("Inside Basis") Greater of

NBV
Debt
The partnership's basis in the contributed property is the contributor's basis, or carryover assumed
basis (plus any gain recognized by the incoming partner, if a special election is made). The
partnership's holding period for contributed property includes the time held by the partner,
regardless of the character of the contributed property.

Pass Key
"Outside basis" is the basis a partner has in the ownership interest in the partnership.
This partnership interest has a tax basis similar to ownership interests in other property.
"Inside basis" refers to the basis that the partnership itself has in the assets it owns.
This inside basis can come from contributions made by the partners. As a general rule,
the basis of an asset contributed by a partner would carry over and be the basis of the
asset in the hands of the partnership. In addition, inside basis can come from asset
purchases the partnership makes with partnership funds.
Example 5 Calculation of Inside and Outside Basis
Facts: In Year 1, Jeff contributes the following items in exchange for a one-third interest in
KNC Partnership:
$10,000 cash.
Building with FMV of $300,000 and adjusted basis to Jeff of $100,000. The building is
subject to a liability of $90,000. x 2/ = $60,000
3
In Year 2, Jeff contributes another building with FMV of $600,000 and an adjusted basis
to Jeff of $300,000.
The partnership had $150,000 of net income in Year 2. x 1/3 = $50,000
Required: Determine Jeff's initial outside basis in his partnership interest in Year 1, and
his outside basis in his partnership interest at the end of Year 2. Also determine the
partnership's inside basis and holding period in Jeff's contributed assets.
Solution:
Jeff's initial outside basis in his KNC Partnership interest is $50,000, calculated as follows:
$10,000 cash, plus $100,000 adjusted basis of building, less $60,000 liabilities assumed
by other partners ($90,000 × 2/3).
KNC's inside basis in the building contributed by Jeff in Year 1 is the adjusted basis in
Jeff's hands, $100,000. KNC's holding period in the building will start when the property
was initially acquired by Jeff.
Jeff's outside basis in his partnership interest at the end of Year 2 is $400,000, calculated
as follows:
$50,000 beginning basis, plus $300,000 adjusted basis of contributed building, plus
$50,000 share of partnership income in Year 2 ($150,000 × 1/3).
The partnership will again take a carryover basis of $300,000 and carryover holding
period in the new building.
Jeff's partnership basis
Cash $10,000
Building NBV 100,000
Less: liability others assume <60,000>
($90,000 x 2 /3 ) 40,000
Year 1 basis 50,000
2nd building: NBV 300,000
Less: liabilities others assume <-0->
© Becker Professional Education Corporation. All rights reserved. 300,000 Module 2 R5–23
Share of income ($150,000 x 1 /3 ) 50,000
Year 2 basis $400,000
3 Partner's Tax Basis in Partnership Interest
Formation
Cash Operation
FMV services = Taxable
B Beginning Capital Account
NBV assets
< liability transferred
Taxation
Distribution
to partnership > % assumed
by other Liquidation
partners
Ordinary business
income
A + % All Income Separately stated

income and gains
Tax-exempt income Increases basis
Ordinary business loss

< % All Losses Separately stated losses Up to zeroing out
and Deductions >* and deductions partner basis
S
Nondeductible expenses
Cash Like a bank account

< Distributions >* Property: adjusted basis Withdrawals = Nontaxable
(NBV)
NBV
E Ending Capital Account
+ % Partnership Liabilities
(recourse and nonrecourse) Your share of liabilities
increases your "basis"
Ending Tax Basis in
Partnership Interest
* Tax basis cannot be reduced below zero

Note
S corp. nonrecourse liabilities
do not increase shareholder
basis (at-risk)
Pass Key
It is important to remember the difference between capital account and basis in

partnership interest:
Basis in partnership interest = Capital account + Partner's share of partnership liabilities

4 Partnership Tax Returns = 1065 Due March 15
A partnership is not subject to income taxes, but it still must file a partnership
tax return (Form 1065). A Form 1065 is an informational return (including Formation
Schedules K and K-1) that provides detailed information about partnership
Operation
income and expenses and indicates the amount and type of each partner's
distributive share of ordinary business income (loss) and separately stated
Taxation
income, gain, loss, and deduction items. Each partner is liable only for taxes
due on his distributive share of partnership income, as reported on Schedule Distribution
K-1, regardless of whether the distribution is actually made to the partner.
Liquidation
4.1 Accounting Periods of the Partnership
Adoption of Partnership Tax Year
y Calendar Year (Generally Required): A partnership return is due on March 15.
y Fiscal Year: Consistent with tax year of majority of partners.
When Partnership Terminates
A partnership terminates when:
Partnership
ends on y Operations cease.
that date
y There are fewer than two partners (i.e., the partnership becomes a sole proprietorship).
4.2 Transactions Between Partner and Partnership

4.2.1 Partner Not Acting in Capacity of Partner
Generally, if a partner enters into a transaction (other than in the capacity as a partner) with his
or her partnership (such as providing services to the partnership, or sales between a partner
and partnership), the transaction is deemed to have occurred between the partnership and an
unrelated party, subject to the following limitations:
Related Party Loss (WRaP) Is Disallowed = W R aP
When addressing related party transactions (WRaP), losses (directly or indirectly) between
a controlling partner (over 50 percent interest in capital or profits) and his controlled
partnership from the sale or exchange of property are not allowed.
Related Party Gain Is Ordinary Income
Gains (directly or indirectly) between a controlling partner (over 50 percent interest in capital
or profits) and his or her controlled partnership, or between two controlled partnerships,
from the sale or exchange of assets shall be treated as taxable ordinary income if the
property is not a capital asset in the hands of the transferee.
4.2.2 Constructive Ownership

Ownership of capital or interest in the profits of a partnership shall be determined by certain
rules of constructive ownership as defined in Section 267 of the Internal Revenue Code.

Able, Bill, and Connor admit Dan as a 25 percent partner in the ABC&D partnership. Able,
Bill, and Connor each own 25 percent after Dan is admitted as a partner. Dan contributes a
parcel of land with a basis to Dan of $50,000 and a fair market value of $150,000. The land
is subject to a liability of $60,000 assumed by the partnership. Able, Bill, Connor, and Dan
are all general partners and will share profits and losses equally.
What is Dan's gain recognized and basis in his partnership interest, and what is the impact
of Dan's contribution on the other partners' basis in their partnership interests?
Dan's Gain Dan's Partnership Basis Impact on Basis of Other Partners

a. $0 $5,000 Increase by $15,000 each
b. $10,000 $50,000 Remains the same
c. $5,000 $45,000 Decreases by $15,000 each
d. $0 $40,000 Remains the same
Ball and Baig are equal general partners in the firm of Games Associates. On January 1 of
the current year, each partner's basis in their Games partnership interest was $50,000.
During the year, Games borrowed $80,000, for which Ball and Baig are personally liable.
Games sustained an ordinary business loss of $30,000 for the current year. The basis of
each partner's interest in Games at the end of the current year is:
a. $35,000
b. $50,000
c. $65,000
d. $75,000

3
1 Determination of Partner's Share of Income,

Credits, and Deductions
1.1 Reporting Partnership Income (Schedule K-1) Each partner gets one
A partner must include on an individual income tax return the partner's distributive share of
ordinary business income or loss and each separately stated item of income, gain, loss, and
deduction. The following chart shows which partnership items will be reported separately
on Form 1065 and which will pass through to each individual partner's income tax return
as separately stated items to be treated by each individual partner according to his or her
own circumstances.
Each partner reports their share of net Appears On
income/loss on Schedule E 1065 K K-1
Business income 
< Business expenses > 
< Guaranteed Payments > Expense to partnership
1. Ordinary business income or loss   
E
2. Guaranteed payments to partners To that partner as income
  
3. Net rental real estate income or loss E  
4. Interest income B  
5. Dividend income B  
6. Capital gains and losses D  
7. Net Section 1231 gain (loss) D  
8. Charitable contributions A  
9. Section 179 expense deduction Depreciation  
10. Investment interest expense  
11. Partners' health insurance premiums (included as part of
Adjustments guaranteed payments)   
on partner's
tax return 12. Retirement plan contributions for employees 
13. Retirement plan contributions for partners  
14. Tax credits (reported by partnership but claimed by partners)  

Ordinary Income Calculation

Example 1
and Other Separately Stated Items
Net income
Facts: A partnership had the following items of income and deductions for the year:
Gross business income $250,000 $250,000
Dividend income 8,000 Schedule B —
Salary expense 50,000 <50,000>
Rent expense 15,000 <15,000>
Depreciation expense (MACRS) 10,000 <10,000>
Section 179 expense 30,000 K-1 —
Charitable contributions 20,000 Schedule A —
Required: Determine the partnership's ordinary business income or loss and separately
stated items for the year. $175,000
Solution: Ordinary business income for the year is $175,000, calculated as follows:
Gross business income $250,000
Salary expense (50,000)
Rent expense (15,000)
Depreciation expense (MACRS) (10,000)
The separately stated items reported on Schedule K are:
Dividend income $ 8,000
Section 179 expense (30,000)
Charitable contributions (20,000)
Pass Key
A frequently tested concept on the CPA Examination is the timing of taxable income to a
partner. An easy way to remember the timing of taxable income and basis impact is to
associate the partnership interest to a bank account:
Event Tax Consequence Impact on Basis

Income Taxable Increase
Withdrawals Nontaxable Decrease
- Partner who receives it K-1 income

1.2 Guaranteed Payments - Partnership expense
Guaranteed payments are reasonable compensation paid to a partner for services provided or
use of capital without regard to the partner's profit- or loss-sharing ratio. They are allowable tax
deductions to the partnership and taxable income to the partner.

1.2.1 Tax Treatment of Guaranteed Payments

Partnership Tax Deduction: Guaranteed payments are allowable tax deductions to the
partnership for services (guaranteed salary) or for the use of capital (guaranteed interest)
without regard to partnership income or profit- and loss-sharing ratios (this includes the fair
market value of capital partnership interests issued in exchange for services contributed).
Partner Taxable Income: Guaranteed payments are also included on Schedule K-1, as ordinary
income to the partner (they may also be included as part of net earnings from self-employment).
Guaranteed payments for services are not included in qualified business income (QBI) for = 20% deduction
purposes of the Section 199A QBI deduction for flow-through business entities. of net business
income
1.2.2 Retirement Payments
Payments received by a retired partner that are not in liquidation of a partnership interest
(but are merely retirement benefit payments) are treated as follows:
Ordinary income to the recipient; and
Deductions to the partnership.
1.3 Tax Elections: Partnership decides (not the partner)

Most elections that affect the calculation of taxable income are made by the partnership. Some
of these elections are:
Organizational expenditures and start-up costs (discussed below).
Accounting methods (cash or accrual).
Tax year (fiscal, if not calendar). Dec. 31
Depreciation methods (MACRS, straight-line, etc.).
Elections out of installment sale treatment.
Section 754 election for optional basis adjustment of partnership assets.
A B A = $5,000/excess 180 months
1.4 Organizational Expenditures and Start-up Costs
B = $5,000/excess 180 months
1.4.1 Calculation
The partnership may elect to deduct up to $5,000 each of organizational expenditures and
start-up costs. Each $5,000 amount is reduced by the amount by which the organizational
expenditures or start-up costs exceed $50,000, respectively. Any excess organizational
expenditures or start-up costs are amortized over 180 months (beginning with the month in
which the active trade or business begins).
1.4.2 Costs Included Phase out

Allowable organizational expenditures include fees paid for legal services in drafting the partnership
agreement, fees paid for accounting services, and fees paid for partnership filings. Start-up costs
include training costs, advertising costs, and testing costs incurred prior to the opening of the business.
1.4.3 Syndication Costs (Nondeductible) = Raising capital

Syndication costs (e.g., offering materials) are not deductible.
1.5 Section 199A Qualified Business Income (QBI) Deduction

A below-the-line deduction of 20 percent of qualified business income may be available on
ordinary business income flowed through from a partnership or LLC.

2 Loss Limitations
As with an S corporation shareholder, a partner in a partnership must clear four hurdles in order
to deduct a loss:
1. Tax basis limitation
Partnership level issues
2. At-risk limitation
3. = Real estate losses
Passive activity loss (PAL) limitation
4. Excess business loss limitation = NOL
The tax basis and at-risk limitations are applied at the entity level, and limit the ability of partners
to flow through losses to their individual income tax return. The PAL and excess business loss
limitations are applied at the individual tax return level.
2.1 Tax Basis Limitation

A loss can only be flowed through to a partner's individual income tax return to the extent of the
partner's tax basis in his or her partnership interest. A loss in excess of the partner's tax basis in
his or her partnership interest is suspended until basis is reinstated in future years.
Basis can be reinstated by any of the items that increase a partner's basis in a partnership
interest. This includes the partner's share of:
Ordinary business income
Separately stated income and gains
Additional contributions
Increase in partnership debt
A partner's share of partnership debt that is included in the partner's basis in his or her
partnership interest depends on:
the type of partner (general partner, limited partner, or LLC member); and
the type of debt (nonrecourse, or secured; recourse; or personally guaranteed).
A suspended loss due to insufficient tax basis can be carried forward indefinitely. However, any
suspended losses due to insufficient tax basis remaining when the partner disposes of his or her
partnership interest are lost. Sells
Example 2 Tax Basis Loss Limitation
Facts: On January 1, Year 1, Becker and Conviser formed a partnership with each
contributing the following property:
Basis FMV
Becker $30,000 $30,000
Conviser 6,000 30,000
The partners have agreed to share profits and losses equally. During Year 1, each partner
withdrew $3,000; and for the year ended December 31, Year 1, the partnership's ordinary
business loss was $8,000.
(continued)

(continued)
Required: Determine how much of the ordinary business loss each partner can flow
through to their individual income tax returns for deduction in Year 1.
Solution: Conviser's Year 1 loss would be limited to his basis, $3,000, calculated as follows:
Becker Conviser
Original contributions (NBV) $30,000 $ 6,000
Less: distributions (3,000) (3,000)
Basis at end of tax year before loss pass-through 27,000 3,000
Each partner's share of $8,000 ordinary business loss $ (4,000) (4,000)
Conviser's loss limited to basis (3,000)
Basis in partnership interest at end of tax year $23,000 $ 0
Suspended loss due to insufficient tax basis carried forward
until basis is reinstated (4,000 – 3,000) $(1,000)
2.2 At-Risk Limitation

A partner's ability to flow though losses may be further limited by the amount of the partner's
at-risk amount. The at-risk amount (at-risk basis) is the same as the partner's tax basis in his or
her partnership interest, with the exception of certain nonrecourse debt that is included in tax
basis but not in at-risk basis.
At-risk basis includes a partner's allocable share of recourse debt and nonrecourse debt that
qualifies as qualified nonrecourse financing (QNF). Qualified nonrecourse financing is a real
estate mortgage obtained from an unrelated commercial lender. Other nonrecourse debt is not
included in at-risk basis.
Partnership Debt Included in Partner's Tax Basis and At-Risk Basis

Type of Partnership Debt Tax Basis At-Risk Basis
Recourse debt Yes (if general partner or Yes (if general partner or
personal guarantee) personal guarantee)
Qualified nonrecourse financing Yes Yes
Other nonrecourse debt Yes No
A loss in excess of a partner's at-risk basis is suspended until the at-risk basis is reinstated in
future years, and is carried forward indefinitely. Any suspended losses due to insufficient at-risk
basis remaining when the partner disposes of the partnership interest can be offset against any
gain from selling the partnership interest.
Loss allowed when sold

Example 3 Allocation of Nonrecourse and Recourse Debt to Partners
Facts: ABC Partnership has three equal partners. A and B are general partners, and C
is a limited partner. In the current year, ABC Partnership borrowed $60,000 in qualified
nonrecourse financing (QNF) debt, $30,000 in other nonrecourse (secured) debt, and
General $20,000 in recourse (unsecured) debt. ABC (basis increase)
partners ABC (basis increase) (at-risk increase)
A&B Required: Calculate the increase in each partner's tax basis in their partnership interest
(basis increase) and their at-risk basis for the partnership debt.
(at-risk increase) Solution: The recourse debt is allocated equally between the two general partners because
they have personal liability for the partnership's recourse debts. None of the recourse
debt is allocated to the limited partner because the limited partner does not have personal
liability for the partnership's recourse debts. The recourse debt is included in both the tax
basis and the at‑risk basis for the two general partners.
The qualified nonrecourse financing (QNF) and other nonrecourse debt are allocated to all
the partners based on their one-third profit-sharing ratio. Both types of nonrecourse debt
are included in the partners' tax basis in their partnership interest but only the QNF debt is
included in their at-risk basis.
Partner A: (General partner)
Increase in tax basis: $40,000
($20,000 recourse × 1/2) + ($60,000 QNF × 1/3) + ($30,000 other nonrecourse × 1/3)
Same Increase in at-risk basis: $30,000
($20,000 recourse × 1/2) + ($60,000 QNF × 1/3)
Partner B: (General partner)
($20,000 recourse × 1/2) + ($60,000 QNF × 1/3) + ($30,000 other nonrecourse × 1/3)
Increase in at-risk basis: $30,000
($20,000 recourse × 1/2) + ($60,000 QNF × 1/3)
Partner C: (Limited partner)
($60,000 QNF × 1/3) + ($30,000 other nonrecourse × 1/3)
Increase in at-risk basis: $20,000
($60,000 QNF × 1/3))
2.3 Passive Activity Loss (PAL) Limitation

Even if a loss clears the tax basis and at-risk hurdles and is flowed through to the partner's
individual income tax return, deduction may be further limited by the passive activity loss (PAL)
limitation and/or the overall excess business loss limitation.
Passive activities include rental real estate (unless an exception is met) and flow-through
entities in which the taxpayer does not materially participate. Passive activity losses (PALs) can
only offset passive activity income. A net PAL for the year is suspended and carried forward
indefinitely to offset future passive activity income. Any suspended PALs remaining when the
owner disposes of the activity can be offset against any other sources of income (active, passive,
or portfolio).
Fully deduct in year you sell it
(Against any income)
2.4 Excess Business Loss Limitation

Even if a loss clears the tax basis, at-risk, and PAL hurdles, deduction may still be limited by the
excess business loss limitation. Under the excess business loss limitation, a taxpayer combines
all business income and losses (active and passive) for the year. The maximum net business loss
that may be deducted is $578,000 for MFJ taxpayers and $289,000 for all other taxpayers (2023).
Any excess business loss is carried forward as a net operating loss (NOL), and is subject to the 80 %
percent of taxable income limitation for NOLs.
2.5 Loss Carryforward Summary

Suspended loss due to insufficient tax basis:
y Carryforward to offset future income when tax basis is reinstated
y Suspended losses disappear when dispose of partnership interest
Suspended loss due to insufficient at-risk basis:
y Carryforward to offset future income when at-risk basis is reinstated
y Use to reduce gain from sale when dispose of partnership interest
Suspended passive activity loss:
y Carryforward to offset future passive activity income
y Use to offset other sources of income when dispose of passive activity
Excess business loss:
y Carryforward as an NOL to offset future income
y Subject to 80 percent of future taxable income limitation
Tax Basis, Calculation of At-Risk Amount, and Loss

Example 4
Limitations With Active Participation in Business
Facts: Rachel, a single taxpayer, created a limited liability company (LLC), which she elected
to have taxed as a partnership, to sell her handmade necklaces. Rachel had an initial cash
contribution to the business of $20,000. Additionally, Rachel was allocated $5,000 of recourse
debt that she had personally guaranteed and $8,000 of nonrecourse debt (not qualified
nonrecourse financing). In the first year of operation, Rachel was allocated $35,000 of
ordinary business loss from the LLC. Rachel has no other active or passive business activities.
Required: Calculate Rachel's tax basis and "at-risk" amount in the LLC. Calculate how much of
the loss from the LLC she can deduct on her individual income tax return considering all four of
the business loss limitations.
Solution: Rachel's tax basis in the LLC is $33,000 ($20,000 cash contribution + $5,000
recourse debt + $8,000 nonrecourse debt). Rachel's at-risk amount is $25,000 ($20,000 cash
contribution + $5,000 recourse debt). Exclude the nonrecourse of $8,000
First, Rachel's loss is limited to her tax basis in the LLC of $33,000. Rachel must then consider
the at-risk limitation. The $33,000 loss, which cleared the tax basis hurdle, is now limited to her
at-risk amount of $25,000. Rachel may pass through for deduction $25,000 of the $35,000 loss.
The $2,000 loss suspended by the tax basis limitation ($35,000 – $33,000) is carried forward and
can only be used when her tax basis is reinstated. The $8,000 loss limited by the at‑risk criteria
is carried forward until the partner generates additional at-risk amounts to utilize the loss.
The business is not a passive activity so Rachel is not subject to the PAL limitation. Rachel does
not have any other business income or losses, so her combined business loss is $25,000. This
amount is well below the $289,000 excess business loss limitation amount for single taxpayers
(2023), so she can deduct the $25,000 loss on her individual income tax return.

Tax Basis, Calculation of At-Risk Amount,

Example 5
and Loss Limitations With Passive Activity
PAL
Facts: Rachel, a single taxpayer, created a limited liability company (LLC), which she elected
to have taxed as a partnership, to sell rental real estate. Rachel is not an active participant
in the business. Rachel has no other active or passive business activities.
Rachel had an initial cash contribution to the business of $100,000. Additionally, Rachel
was allocated $20,000 of recourse debt that she had personally guaranteed and $30,000
of nonrecourse debt (not qualified nonrecourse financing). In the first year of operation,
Rachel was allocated $50,000 of ordinary business loss from the LLC.
Required: Calculate Rachel's tax basis and "at-risk" amount in the LLC. Calculate how much of
the loss from the LLC she can deduct on her individual income tax return considering all four
of the business loss limitations.
Solution: Rachel's tax basis in the LLC is $150,000 ($100,000 cash contribution + $20,000
recourse debt + $30,000 nonrecourse debt). Rachel's at-risk amount is $120,000 ($100,000
cash contribution + $20,000 recourse debt). Exclude: $30,000 nonrecourse debt
When considering whether she can deduct her $50,000 loss from the partnership on her
individual tax return, she easily clears the tax basis and at-risk hurdles. However, because
the activity is passive and Rachel has no passive income from other sources, she is not
able to deduct any of the $50,000 loss. The passive activity loss is suspended and carried
forward until she generates passive income or until she sells the LLC that has generated
the loss. Because the entire loss is suspended due to the PAL limitation, the excess
business loss limitation does not come into play.
3 Nonliquidating Distributions: Like a bank account withdrawal
A nonliquidating distribution to a partner (also referred to as a current

distribution, or an operating distribution) is generally nontaxable, both to the Formation
partner and the partnership.
Operation
In general, distributions of cash or property to a partner reduce the partner's
basis in the partnership interest by the cash or adjusted basis (NBV) of the Taxation
property distributed. The basis in the partnership interest is reduced first by
cash distributions, then by property distributions. Distribution
3.1 Property Distribution Liquidation
A partner's basis in property distributed is generally the same as in the hands

of the partnership. However, the basis of the property may be reduced if the Stop at zero
partner does not have sufficient basis in his or her partnership interest.
3.1.1 Basis in Partnership Interest Greater Than Adjusted Basis of Property Distributed: Use NBV
to reduce
When a partner's basis in the partnership interest (after any cash distribution) is greater than the basis
adjusted basis of property distributed, the partner's basis in the partnership interest is reduced
by the adjusted basis in the property. The partner's basis in the property distributed is the same
as the partnership's basis in the property.

3.1.2 Basis in Partnership Interest Less Than Adjusted Basis of Property Distributed: Stop at
zero basis in
When a partner's basis in the partnership interest (after any cash distribution) is less than the partnership
adjusted basis of property distributed, the partner's basis in the property distributed is reduced.
A distribution cannot reduce the basis in the partnership interest below zero. The partner's basis
in the property distributed is equal to the remaining basis in the partnership interest (after any
cash distribution). The basis in the partnership interest after the distribution is zero.
Cash
<Basis>
3.2 Cash Distribution Excess = Gain
If a partner receives a cash distribution that is greater than the partner's basis in his or her
partnership interest, the partner recognizes a capital gain for the excess. A distribution cannot
reduce the basis in the partnership interest below zero. For a property distribution, the partner
can take a lower basis in the property distributed to prevent the partnership basis from
being reduced below zero. However, the basis in cash cannot be reduced, so a gain must be
recognized by the partner to prevent the partnership basis from being reduced below zero.
Example 6 Basis Determination for Nonliquidating Distribution
Facts: Olinto's basis in his partnership interest was $30,000. He received a nonliquidating
operating distribution of $24,000 cash plus a parcel of land with a fair market value of
$12,000 and partnership basis of $9,000.
Required: Determine Olinto's basis in the land distributed and his basis in his partnership
interest immediately after the distribution.
Solution: Olinto's basis in the land is $6,000 and his basis in his partnership interest after
the distribution is zero.
The basis of property received in a distribution, other than in liquidation of a partner's
interest, will typically be the same as the basis in the hands of the partnership immediately
prior to distribution. However, in no case may the partner's basis in the property
distributed exceed the basis in his partnership interest (after any cash distribution).
Basis in partnership interest adjusted prior to distribution $ 30,000
Amount of cash distributed (24,000)
Remaining basis after cash distribution 6,000
Property distributed: land (partnership's basis $9,000) (6,000)
Stop at zero
Basis in partnership interest after distribution $ 0
The basis in the partnership interest may not be reduced below zero. Therefore, the land has
a basis of $6,000 in the hands of the partner, the remaining basis in his partnership interest.
Note: No gain
3.3 Distribution of Multiple Assets
When multiple assets are distributed to a partner and the partner's basis in his or her partnership
interest is less than the adjusted basis of the assets distributed, the partner's remaining basis in
his or her partnership interest must be allocated among the assets distributed. This prevents the
partner's basis in the partnership interest from being reduced below zero.
Basis is assigned first to cash, then "hot assets," then other property. Hot assets are assets that result in
ordinary income when sold, including inventory and unrealized receivables (for cash basis taxpayers).

Example 7 Nonliquidating Distribution of Multiple Assets
Facts: Olinto's basis in his partnership interest was $30,000. He received a nonliquidating
operating distribution consisting of the following assets:
Partnership Fair Market

Asset Basis Value
Cash $24,000 $24,000
Inventory 5,000 6,000
Land 9,000 12,000
Total $38,000 $42,000
Required: Determine Olinto's basis in the property distributed and his basis in his
partnership interest immediately after the distribution.
Solution: The partnership's total basis in the assets distributed of $38,000 is more than
Olinto's basis in his partnership interest of $30,000, so Olinto's basis in the property
distributed will be reduced. The distribution cannot reduce his basis in Olinto's partnership
interest below zero. The $30,000 basis in his partnership interest is allocated first to cash,
then hot assets distributed (inventory), then other property distributed (land).
Partner's Basis in Partnership Interest:

Basis in partnership interest prior to distribution $30,000
Cash distributed (24,000)
Remaining basis after cash distribution 6,000
Hot assets distributed: inventory (partnership's basis) (5,000)
Remaining basis after cash and hot asset distribution 1,000
Other property distributed: land (partnership's basis $9,000) (1,000)
Basis in partnership interest after distribution $ 0 Stop at zero
Partner's Basis in Assets Distributed:
Cash $24,000
Inventory 5,000
Land 1,000
$30,000

4 Limited Liability Companies
A limited liability company (LLC) is a separate legal entity from its owners. As with corporate
shareholders, LLC "members" are not personally liable for the obligations of the business. All
members of an LLC have "limited liability," which is different from a limited partnership, where
at least one general partner is personally liable for all partnership debts.
4.1 Formation
The business owner files articles of organization with the state where the LLC is organized, which
is similar to the formation of a corporation. The following list summarizes some of the key points
a business owner should consider when trying to decide whether or not to organize a business
as an LLC:
An LLC provides similar protection from liabilities as a corporation but does not have the
"double taxation" of a corporation if the LLC is taxed as a partnership.
LLC members generally have the right to amend the LLC operating agreement, provide input,
and manage LLCs, yet corporate shareholders generally do not have these same rights.
An LLC cannot become a public company. It must convert to a corporation before issuing
an IPO.
S corporations have restrictions on the type and number of shareholders they may have.
LLCs do not have these same restrictions.
A sole proprietorship may become a single member LLC if it files articles of organization
with a state.
4.2 Taxation Only one owner

2 or more members
For federal income tax purposes, an LLC is treated as one of the following: a partnership,
corporation, or sole proprietorship. The Internal Revenue Code does not specifically address
taxation of limited liability companies. A limited liability company with at least two owners is
taxed as a partnership unless an election is made to have the LLC taxed as a C corporation.
Elect Such an election is made on Form 8832, Entity Classification Election. A single member LLC
is considered a disregarded entity for federal income tax purposes. 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.
Jody's basis in her partnership interest was $50,000 immediately before she received a
current (nonliquidating, or operating) distribution of $20,000 cash and property with an
adjusted basis to the partnership of $40,000 and a fair market value of $35,000.
What is Jody's basis in the distributed property?
a. $0
b. $30,000
c. $35,000
d. $40,000

Jody's basis in her partnership interest was $50,000 immediately before she received a
current (nonliquidating, or operating) distribution of $20,000 cash and property with an
adjusted basis to the partnership of $40,000 and a fair market value of $35,000.
What amount of taxable gain must Jody report as a result of this distribution?
a. $0
b. $5,000
c. $10,000
d. $20,000

4
1 Liquidation of a Partnership
There are three ways in which a partner may liquidate a partnership interest:
Formation
1 Complete withdrawal (liquidating distribution)
Operation
2 Sale of partnership interest
3 Retirement or death Taxation
1 of 3 1.1 Complete Withdrawal (Liquidating Distribution) Distribution
In a complete liquidation, the partner's basis for the distributed property is Liquidation
the same as the adjusted basis of the partner's partnership interest, reduced
by any cash or cash equivalents received. The adjusted basis needs to be
determined immediately before the partner's liquidation, after all other items of partnership
income/loss and liabilities assumed have been taken into account for the year.
1.1.1 Nontaxable Liquidation
Rule
Beginning capital account
Partner's share of income < loss > up to withdrawal Zero out
to get out
Partner's capital account
Partner's share of partnership liabilities
Adjusted basis in partnership interest at date of withdrawal
< Cash distribution >
Remaining basis to be allocated to assets distributed
1.1.2 Gain or Loss Recognition

Gain Recognized = Exception = Ca$h Basis
The partner recognizes gain only to the extent that money received exceeds the partner's
basis in the partnership interest.
Loss Recognized = Exception = Only ca$h Basis No other items received
The partner recognizes loss if money, unrealized receivables (for cash basis taxpayers), or
inventory are the only assets received and if the partner's basis in the partnership interest is
more than the partnership's basis in the assets received.

Basis $24,000
Cash <5,000>
Remain to RE $19,000
Illustration 1 Liquidating Distributions: Impact on a Partner
Tag's basis in his KJT partnership interest was $24,000. Tag received a liquidating
distribution of $5,000 in cash and real estate with an FMV of $20,000 and an adjusted basis
to the partnership of $10,000. Tag has a basis in the real estate of $19,000 ($24,000 basis in
his partnership interest less $5,000 cash received).
Basis $24,000 Alternative scenario: If Tag had instead received $25,000 in cash as well as the real estate,
Cash <25,000> Tag would recognize a $1,000 gain ($24,000 basis in his partnership interest less $25,000
Gain -$1,000 cash received). The real estate received would have zero basis to Tag.
Alternative scenario: If Tag had received $20,000 in cash and no real estate, Tag would Basis $24,000
recognize a loss of $4,000 ($24,000 basis in his partnership interest less $20,000 cash Cash <20,000>
received), because there were no other assets distributed which allocate his remaining End. loss $4,000
basis in his partnership interest.
Got nothing else
Alternative scenario: If the property Tag had received was unrealized receivables or
inventory instead of real estate, he would recognize a $9,000 loss ($24,000 basis in his
Basis $24,000 property interest less $5,000 cash received less $10,000 basis of property received). Tag
Cash <5,000> would have a basis in the unrealized receivables or inventory of $10,000, the same as the
19,000 basis in the hands of the partnership.
AR inv. <10,000>
Loss $9,000
1.2 Distribution of Multiple Assets
When multiple assets are distributed to a partner in a liquidation, the remaining basis in the
partner's partnership interest must be allocated among the assets distributed. Basis is assigned
first to cash, then hot assets, then other property. If multiple assets are distributed within a
property category (hot assets and/or other property), the basis is allocated among the assets
using a three-step process. The three-step process used depends on whether the partner's basis
in the partnership interest (outside basis) is less than, or more than, the partnership's basis in
the assets distributed (inside basis).
1.2.1 Liquidating Distribution With Multiple Hot Assets Only

If the liquidating distribution includes multiple hot assets, but not any other property, the
partner's basis in the partnership interest is allocated to the assets only if the basis in the
partnership interest (outside basis) is less than the partnership's basis in the assets distributed
(inside basis).
As noted earlier, if the partner's basis in the partnership interest (outside basis) is more than the
partnership's basis in the assets distributed (inside basis), the partner recognizes a loss and the
partner's basis in the assets are the same as the basis in the hands of the partnership.
1.2.2 Partner's Basis in Partnership Interest (Outside Basis) Less Than

Partnership's Basis in Assets Distributed (Inside Basis)
Step 1: Assign a basis to all assets equal to the partnership's basis in the assets.
Step 2: Adjust the basis of any assets in the last property category (other property, or hot
assets if no other property) that have depreciated in value down to fair market value.
Step 3: Allocate any basis in the partnership interest remaining after Step 2 among all the
assets in the last property category based on relative adjusted basis of the assets after the
Step 2 adjustment.

Distribution of Multiple Assets—Outside Basis

Example 1
Less Than Inside Basis
Facts: Gearty's basis in his partnership was $229,000. He received a liquidating distribution
consisting of the following assets:
Partnership Fair Market

Asset Basis Value
s
Les
Cash $ 4,000 $ 4,000
Inventory 10,000 15,000
Land—Lot A 200,000 150,000 Lower FMV <$50,000>
Land—Lot B 100,000 300,000 Higher FMV $200,000
Total $314,000 $469,000
Required: Determine Gearty's basis in the property distributed and his basis in his
Solution: Gearty's basis in his partnership interest of $229,000 is less than the
partnership's total basis in the assets distributed of $314,000, so his basis in the property
received will be reduced. His basis in his partnership interest must be zero (0) after the
liquidating distribution.
The $229,000 basis in his partnership interest is allocated among the assets using the
three-step process:

Basis in partnership interest prior to distribution $ 229,000
Step 1: Assign basis to all assets equal to partnership's basis in assets (314,000)
(85,000) Write-down
Step 2: Decrease basis of Lot A land to $150,000 FMV 50,000
needed
Step 3: Allocate remaining basis in partnership interest to Lot A and Lot B Bal. to be
land based on relative bases in the assets after adjustment in Step 2 (35,000) written down
A 150,000 = 60% Lot A: 200,000 – 50,000 = 150,000 ÷ 250,000 = 60% × 35,000 21,000 60% A
B 100,000 = 40% Lot B: 100,000 ÷ 250,000 = 40% x 35,000 14,000 40% B
250,000 Basis in partnership interest after liquidating distribution
250,000
$ 0
300,000
Cash Inventory Land—Lot A Land—Lot B Total
Step 1 $4,000 $10,000 $200,000 $100,000 $314,000
Step 2 (50,000) (50,000)
Step 3 (21,000) (14,000) (35,000)
Total $4,000 $10,000 $129,000 $86,000 $229,000 Original basis
in partnership
Zero out
to get out

1.2.3 Partner's Basis in Partnership Interest (Outside Basis) More Than

Partnership's Basis in Assets Distributed (Inside Basis)
Step 1: Assign a basis to all assets equal to the partnership's basis in the assets.
Step 2: Adjust the basis of any assets in the last property category (other property, or hot
assets if no other property) that have appreciated in value up to fair market value.
Step 3: Allocate any basis in the partnership interest remaining after Step 2 among all the
assets in the last property category based on relative fair market value.
Distribution of Multiple Assets—Outside Basis

Example 2
More Than Inside Basis
Facts: Same facts as Example 1, but Gearty's basis in his partnership interest is $529,000.
Required: Determine Gearty's basis in the property distributed and his basis in his
Solution: Gearty's basis in his partnership interest of $529,000 is more than the
partnership's total basis in the assets distributed of $314,000, so his basis in the property
received will be increased. His basis in his partnership interest must be zero (0) after the
liquidating distribution.
The $529,000 basis in his partnership interest is allocated among the assets using the
three-step process:

Basis in partnership interest prior to distribution $ 529,000
Step 1: Assign basis to all assets equal to partnership's basis in assets (314,000)
215,000 Excess basis
Step 2: Increase basis of Lot B land to $300,000 FMV (200,000)
Step 3: Allocate remaining basis in partnership interest to Lot A and Lot B
land based on relative FMV 15,000 Remaining
Lot A: (150,000 ÷ 450,000) × 15,000 1/ (5,000)
excess
3
Lot B: (300,000 ÷ 450,000) × 15,000 2/ (10,000)
3
Basis in partnership interest after liquidating distribution $ 0 Zero out
450,000 to get out
Cash Inventory Land—Lot A Land—Lot B Total
Step 1 $4,000 $10,000 $200,000 $100,000 $314,000
Step 2 200,000 200,000
Step 3 5,000 10,000 15,000
Total $4,000 $10,000 $205,000 $310,000 $529,000

Pass Key
The CPA Examination will require candidates to understand the difference in basis rules for
nonliquidating and liquidating distributions.
Reduction of Basis in
Distribution Basis of Property Received Partnership Interest
Adjusted basis of property
Nonliquidating Adjusted basis of property
(stop at zero)
Liquidating Partnership interest Must "zero-out" account To get out
1.3 Consequences to a Partnership

As a result of liquidation, the partnership itself does not recognize any entity level gain or loss
on the distribution of assets. Any gain or loss recognition on liquidating distributions are made
at the partner level. In addition, because a partnership itself is not subject to income taxes and
is a "flow-through" entity, all effects of winding-up the affairs and liquidating the partnership
are passed on to the partners. This includes any gain or loss on sale of any assets, expenses of
liquidating the partnership, etc. All of these items will be included in the partners' adjusted basis
immediately before their liquidating distributions.
2 of 3 2 Sale of Partnership Interest
As a general rule, the partner has a capital gain or loss when transferring a partnership interest
because a partnership interest is a capital asset to the partner.
2.1 Gain or Loss on Transfer (General Rule: Capital Gain or Loss)

A partner who sells or exchanges his interest in the partnership has a recognized gain or loss.
The gain or loss is measured by the difference between the amount realized for the sale and
the adjusted basis of the partnership interest. If any partnership liabilities are allocated to the
partnership interest and transferred to the buyer, they are considered part of the amount realized.
2.2 Capital Gain or Loss Calculation
Beginning capital account

Share of income < loss > up to sale
Net to zero
Capital account at sale date
Share of partnership liabilities
Adjusted basis in partnership interest Cash received
< Amount realized > FMV of property received
Capital Gain or loss Relief from share of partnership liabilities

Example 3 Calculating Amount Realized on Sale of Partnership Interest
Facts: Kristi sold her interest in the KJT partnership to a new partner, John, for $15,000
cash. John agreed to assume her $5,000 share in partnership liabilities.
Required: Determine the amount realized on the sale of Kristi's partnership interest.
Solution: The amount realized in the transaction was $20,000 ($15,000 cash plus $5,000
relief from partnership liabilities). The $20,000 will be compared with the basis of Kristi's
partnership interest in order to determine her gain or loss.
2.3 Exception (Ordinary Income, Not Capital Gain)

Any gain that represents a partner's share of "hot assets" is treated as ordinary income, rather than
capital gain, since the subsequent sale of these assets by the partner will result in ordinary income.
As with partnership distributions, hot assets include inventory and unrealized receivables for
cash basis taxpayers. For the sale of a partnership interest, hot assets also include potential
depreciation recapture for partnership depreciable assets (as if the asset was sold at a gain
based on the asset's FMV when the partnership interest is sold).
2.4 Allocation of Partnership Income or Loss

When a partner sells his or her partnership interest to a new partner during a tax year, the Per day,
partners' shares of partnership income, gains, losses, and deductions must be allocated pro rata
between the selling partner and the buying partner based on the number of days. per %
Example 4 Proration of Partnership Income
Facts: Partner A, a 20 percent partner, sells her entire partnership interest to New Partner B
on March 31 of the current year. The partnership reported $80,000 of partnership income for
the entire tax year.
Required: Determine A's and B's shares of partnership income for the year.
Solution:
Old: Partner A: $80,000 × 20% share × 90 days / 365 days = $3,945 (rounded) = 3 months
New: Partner B: $80,000 × 20% share × 275 days / 365 days = $12,055 (rounded) = 9 months
365
3 of 3 3 Retirement or Death of a Partner
Payments to a retiring partner (or to the interest successor of a deceased partner) in liquidation
of his or her entire partnership interest are allocated between payment for an interest in
partnership assets and other payments.
Payments for the interest in partnership assets result in capital gain or loss.
If payments are measured by partnership income, they are treated as partnership income
regardless of the period over which they are paid. Thus, such payments are taxable as
ordinary income to the retired partner as if he or she continued to be a partner.

4 Section 754 Election and Section 743(b)

Basis Adjustment
Partnerships have the option to make a Section 754 election when there is a transfer of a
partnership interest by sale or exchange, or upon the death of a partner. This election can be
made when there is a difference between a partner's share of inside basis in the partnership
assets and the partner's outside basis in his or her partnership interest.
Transfer of Partnership Interest
In the case of a Section 754 election being made by reason of sale or exchange, a
Section 743(b) basis adjustment follows. The Section 743(b) adjustment equals the
difference between the value of the outside basis to the transferee partner (e.g., purchase
price) and the partner's share of the partnership′s inside basis of the assets. This
adjustment, which can be either positive or negative, is prorated over the partnership assets
under the rules set forth in Section 755 (beyond the scope of this material). The goal of the
adjustment is to make the transferee have an inside basis in the partnership assets equal to
his or her outside basis. The adjustment is specially allocated only to the transferee and has
no effect on the partnership′s income or loss. Once the election is made, it remains in effect
for all future transactions (being revoked only with permission from the IRS). Alternatively,
even in the absence of a Section 754 election, the IRS mandates a 743(b) adjustment when
there is a substantial built-in loss at the time of purchase (inside basis exceeds outside basis
by $250,000 or more).
Example 5 Transfer of Partnership Interest
Facts: Oscar purchased Bernice's 25 percent interest in Handly Partnership for $500,000.
At the time of sale, Handly made a 754 election to adjust the basis of the partnership asset.
Immediately before the sale, the inside basis in the partnership asset (a building) was
$1,200,000 and the fair market value was $2,000,000.
Got $300,000 $500,000
Required: Calculate the basis adjustment required under Section 743(b), and describe the
consequences of a future sale of the asset.
Solution: The 743(b) basis adjustment is $200,000 ($500,000 purchase price of partnership
interest less $300,000, which is Oscar's 25 percent interest in the $1,200,000 inside basis of
the partnership assets), allocated entirely to Oscar. The basis adjustment is entirely a tax
concept and does not impact the book value of the partnership′s assets.
If the building is subsequently sold at fair market value of $2,000,000, a tax gain would
be recognized in the amount of $600,000 ($2,000,000 less $1,400,000 adjusted basis
with step‑up). The $600,000 gain would be allocated to the other partners besides Oscar.
No gain is allocated to Oscar.
Bernice "old" partner was paid $500,000
Oscar "inside" 1,200,000 x 25% - 300,000
5 Liquidation of an LLC Adjustment $200,000
The liquidation of an LLC and the consequences to its members will be treated the same as
either a corporation or a partnership, whichever form the LLC elected to take for federal income
tax purposes upon formation.

On December 31 of the current year, after receipt of his share of partnership income,
Clark sold his interest in a limited partnership for $30,000 cash and relief of all partnership
liabilities. On that date, the adjusted basis of Clark's partnership interest was $40,000,
consisting of his capital account of $15,000 and his share of the partnership liabilities
of $25,000. The partnership has no unrealized receivables or substantially appreciated
inventory. What is Clark's gain or loss on the sale of his partnership interest?
a. Ordinary loss of $10,000.
b. Ordinary gain of $15,000.
c. Capital loss of $10,000.
d. Capital gain of $15,000.
The adjusted basis of Vance's partnership interest in Lex Associates was $180,000
immediately before receiving the following distribution in complete liquidation of Lex:
Fair Market
Basis to Lex Value
Cash $100,000 $100,000
Real estate 70,000 96,000
What is Vance's basis in the real estate?

a. $96,000
b. $83,000
c. $80,000
d. $70,000
Baker is a partner in BDT with a basis in his partnership interest of $60,000. BDT made a
liquidating distribution of land with an adjusted basis of $75,000 and a fair market value of
$40,000 to Baker. What amount of gain or loss should Baker report?
a. $35,000 loss
b. $20,000 loss
c. $0
d. $15,000 gain

Fern received $30,000 in cash and an automobile with an adjusted basis and fair market
value of $20,000 in a liquidating distribution from EF Partnership. Fern's basis in the
partnership interest was $60,000 before the distribution. What is Fern's basis in the
automobile received in the liquidation?
a. $0
b. $10,000
c. $20,000
d. $30,000

NOTES
5
MODULE5 Multi-jurisdictional Tax Issues
Multi-jurisdictional
Tax Issues REG 5
Federal
1 Affiliated Groups and Transfer Pricing
An affiliated group of businesses having operations in several countries and conducting
sales between affiliates could have a pricing structure that (i) intentionally or unintentionally
understates income in some or all of those countries, including the United States; and (ii) results
in some countries not receiving as much income tax.
Illustration 1 Sales Between Affiliates
Holding Company, a U.S.-based company, owns 100 percent of the stock of three subsidiaries,
each in a different country:
M Company, a manufacturer in Country M having an income tax rate of 10 percent
W Company, a wholesaler and distributor in Country W having an income tax rate of 20 percent
R Company, a retailer in the U.S. having an income tax rate of 30 percent
Facts:
1. Country M and Country W use the U.S. dollar for their currencies.
2. M Company manufactures and sells widgets both to W Company and to unrelated parties.
W Company sells those widgets at wholesale to unrelated parties. W Company also sells
those widgets to R Company. R Company sells the widgets at retail to unrelated parties for
$9 per widget.
3. M Company's cost of goods sold is $1 per widget.
Assumptions: For purposes of this example (and to simplify this example), assume the following:
1. None of the subsidiaries has any selling, general, or administrative expenses.
2. Countries M and W do not impose any withholding on dividends paid by companies in
those countries to shareholders in other countries.
3. There is no income tax on dividends received.
Set forth below is how Holding Company, in order to minimize income taxes, would ideally want
to structure each sale between the subsidiaries:
Sells to W Outsider Outsider
To R Consolidated
M Company W Company R Company Corporate Group
Tax rate: 10% 20% 30%
Sales $9.00 $9.00 $9.00 $9.00
COGS (1.00) (9.00) (9.00) (1.00)
EBT $8.00 $0 $0 $8.00
Tax Non USA (0.80) Non USA 0 0 (0.80)
N.I. $7.20 $0 $0 $7.20
(continued)
Want all the
income reported
here & pay the lowest tax
5 Multi-jurisdictional Tax Issues REG 5
(continued)
Although Country M's taxing authorities would not be displeased with this pricing structure (as
the corporate group's entire profit is subject to Country M's income tax), the IRS (and the taxing
authorities in Country W) would not be pleased with this pricing structure because the corporate
group is not paying any income tax to the United States (or to Country W).
To address this situation, the Internal Revenue Code (Sections 482 and 6662(e)(3)) provides the
IRS with the authority (i) to adjust the income and deductions (including COGS) of M Company,
W Company, and R Company to prevent evasion of taxes or to clearly reflect income; and (ii) to
impose penalties with respect to those adjustments. As a result, with respect to R Company's
sales of widgets, the IRS would most likely reduce R Company's COGS, and R Company would
then pay income tax to the U.S. Treasury.
Additional Explanatory Note: The corporate group knows that every widget that the group (via
R Company) sells to end users/customers will bring the group $9. So, if we ignore IRC Section 482,
the group wants to set up an intercompany pricing arrangement that will minimize the group's
income taxes due, per sale, to all countries. The best way to do so is to have M sell to W at $9;
next W sells to R at $9; and then R sells to the end customer at $9. In this manner, the entire profit
of the corporate group is reported by M, the company subject to the lowest income tax rate.
1.1 Definitions
U.S. federal tax
A "controlled taxpayer" is any one of two or more taxpayers owned or controlled directly or
indirectly by the same interests, and the definition includes a taxpayer that owns or controls = SUB
the other taxpayers.
"Uncontrolled taxpayer" means any one of two or more taxpayers not owned or controlled
directly or indirectly by the same interests.
"Controlled" includes any kind of control, direct or indirect, whether legally enforceable or
not, and however exercisable or exercised, including control resulting from the actions of
two or more taxpayers acting in concert or with a common goal or purpose. A presumption
of control arises if income or deductions have been arbitrarily shifted.
For purposes of the IRS's authority to make these adjustments with respect to controlled
transactions, "taxpayer" means any person, organization, or business, whether or not
subject to any tax imposed by the IRC.
Parent SUB
"Controlled transaction" or "controlled transfer" means any transaction or transfer between
two or more members of the same group of controlled taxpayers. SUB SUB
"Uncontrolled transaction" means any transaction between two or more taxpayers that are
not members of the same group of controlled taxpayers. Company Ouside
"Uncontrolled comparable" means the uncontrolled transaction or uncontrolled taxpayer customer
that is compared, under any applicable pricing methodology, with a controlled transaction
or with a controlled taxpayer. (Example: Under the comparable profits method, an
uncontrolled comparable is any uncontrolled taxpayer from which data are used to
establish a comparable operating profit.)
1.2 IRS Distribution/Apportionment/Allocation

To prevent the evasion of taxes or to clearly reflect the income of two or more organizations,
trades, or businesses that are directly or indirectly owned by the same interests, the Internal
Revenue Code (IRC) authorizes the IRS to adjust (the IRC uses "distribute, apportion, or allocate")
upward or downward the gross income, deductions, credits, and allowances between or among
such organizations, trades, or businesses.
R5–50 Module 5 Multi-jurisdictional

© Becker Professional Education Corporation. Tax Issues
All rights reserved.
REG 5 5 Multi-jurisdictional Tax Issues
These organizations, trades, or businesses need not be incorporated, organized in the United
States, or affiliated. The IRS's authority to make these adjustments also extends to members of
an affiliated group that file a consolidated U.S. income tax return.
1.3 Arm's-Length Standard Applies

The IRS adjustments, necessary to determine "true taxable income" (as opposed to the taxable
to
income that the taxpayer reported on the taxpayer's income tax return), apply to controlled related
transactions and controlled transfers. The purpose of these adjustments is to assure that
reported prices (as adjusted per this authority given to the IRS) that one affiliate ("controlled
party
taxpayer") charges to another affiliate yield results that are consistent with the results that transactions
would have been realized if uncontrolled taxpayers had engaged in the same transaction under
the same circumstances (the "arm's-length" standard).
Related
1.3.1 Consistent Results
party
A controlled transaction or controlled transfer meets the arm's-length standard if the results
of the transaction or the transfer are consistent with the results that would have been realized transaction
if uncontrolled taxpayers had engaged in the same transaction or transfer under the same results =
circumstances (the "arm's-length" result).
Company/customer
1.3.2 Comparable Transactions and Standards of Comparability
transaction
Because identical transactions can rarely be located, whether a transaction produces an
arm's-length result generally will be determined by reference to the results of comparable
results
transactions. Various standards of comparability (applicable pricing methodologies) are
allowable and are set forth in U.S. Treasury regulations. The most common pricing methods
are listed below.
Comparable Uncontrolled Price (CUP): Only for tangible property (sales, purchases,
and leases).
yy CUP based upon reference to published market data.
Comparable Uncontrolled Transaction (CUT): Only for intangible property (regarding
royalty payments).
Resale Price: Tangible property only.
Cost Plus: Tangible property only.
Comparable Profits Method: Based upon operating margin, gross margin, return on
assets, or return on capital.
1.4 Transfer Pricing Issues

The IRS often makes adjustments when there are transfer pricing issues. Transfer pricing issues
exist under the following circumstances:
A U.S.-based taxpayer transfers, sells, purchases, or leases tangible property or intangible Related
property to or from an affiliate that either:
party
yy is not subject to U.S. income tax; or
yy does not file a consolidated income tax return with the U.S.-based taxpayer.
A U.S.-based taxpayer enters into loan agreements or service contracts with an affiliate Related
that either:
party

Related
A U.S.-based taxpayer shares costs with an affiliate that either:
party
1.5 IRS Options

These adjustments include the ability of the IRS to do the following:
Modify the basis of assets; and
Require the taxpayer to recognize income with respect to an otherwise tax-free transaction
(such as a tax-free, like-kind exchange or a tax-free incorporation of a business).
1.6 Authority of the IRS to Make Adjustments

The IRS's authority to make these adjustments extends to any case in which, either by
inadvertence or design, the taxable income of a controlled taxpayer is other than what the
taxable income would have been if the taxpayer had been dealing at arm's-length with an
uncontrolled taxpayer.
This authority is not limited to cases of improper accounting, fraud, sham transactions,
or devices and schemes designed to reduce or avoid tax by shifting or distorting income,
deductions, credits, or allowances.
However, the courts will reverse such adjustments if the controlled taxpayer shows that
the results of its transactions are within an arm's-length range established by two or more
uncontrolled comparable transactions based upon a single pricing method.
1.7 Limited Right of a Controlled Taxpayer to Make Adjustments

A controlled taxpayer has a limited right to make these same adjustments.
If necessary to reflect arm's-length pricing, in a timely filed income tax return, a controlled
taxpayer may report the result of controlled transactions and of controlled transfers based
upon prices different from those actually charged.
With respect to (i) untimely filed income tax returns, and (ii) amended income tax returns,
the taxpayer cannot make any such adjustments which result in decreasing taxable income.
1.8 Avoidance of Penalties

A taxpayer may owe additional federal income tax due to IRS adjustments with respect
to controlled transactions and controlled transfers. The taxpayer can generally avoid the
"substantial valuation misstatement" penalty and the "gross valuation misstatement" penalty if
any one or more of the following circumstances apply:
1.8.1 Section 482 Study Based on Allowable Pricing Methods

The taxpayer may prepare and document a "Section 482 study" based upon allowable pricing
methods set forth in the U.S. Treasury regulations.
The taxpayer must determine that the prices for controlled transactions and controlled
transfers are in accordance with the allowable pricing methods set forth in the U.S. Treasury
regulations and that the taxpayer's use of such method was reasonable.
The documented study must be completed no later than the date the taxpayer files the
federal income tax return.

1.8.2 Section 482 Study Not Based on Allowable Pricing Methods

The taxpayer may prepare and document a "Section 482 study" that is not based upon allowable
pricing methods set forth in the U.S. Treasury regulations.
The taxpayer must establish that none of such pricing methods was likely to result in a
price that would clearly reflect income, that the taxpayer used another pricing method to
determine such price, and that such other pricing method was likely to result in a price that
would clearly reflect income.
The documented study must be completed no later than the date the taxpayer files the
federal income tax return.
All taxes 1.8.3 Transactions Solely Between Foreign Corporations

are in Penalties may be avoided if any portion of such net increase in federal income tax is attributable
to any transaction solely between foreign corporations unless, in the case of any such
foreign corporations, the treatment of such transaction affects the determination of income from
country sources within the United States or taxable income effectively connected with the conduct of a
trade or business within the United States.
1.9 Competent Authority : Advanced ruling: Get IRS to approve before

transaction
In certain circumstances, the taxpayer can request that the IRS and the taxing officials in is done
the other country or countries together ascertain the appropriate transfer price so that the
taxpayer group is not taxed twice on the same income.
Such a request is a "request for competent authority," and the taxpayer may make
this request any time after an IRS action results in taxation that is inconsistent with the
provisions of any applicable treaty.
1.10 Advance Pricing Agreement Program : Binding agreement with IRS

The IRS website states:
In early 2012, the Advance Pricing Agreement (APA) Program merged with that portion of the Office of
the U.S. Competent Authority (USCA) that resolves transfer pricing cases under the mutual agreement
procedures of the United States' bilateral income tax conventions to form the Advance Pricing
and Mutual Agreement (APMA) Program. APMA's mission is to resolve actual or potential transfer
pricing disputes in a timely, principled, and cooperative manner. (https://www.irs.gov/Businesses/
Corporations/APMA, accessed May 2016.)
An APA normally requires agreement on the following issues:
y Choosing a transfer pricing method (TPM).
y Selecting comparable uncontrolled companies or transactions (comparables).
y Deciding on the years over which comparables' results are analyzed.
y Adjusting the comparables' results because of differences with the tested party.
y Constructing a range of arm's-length results.
y Testing the results during the APA period.
y Agreeing on critical assumptions.
Often two or more approaches to certain issues are possible, and there may be no clear
basis for preferring one approach over another. In such situations, the IRS may give the
taxpayer the taxpayer's preferred treatment of some issues if the taxpayer agrees to the IRS
using its preferred treatment of other issues.

2 State Income Tax Considerations
In addition to federal income tax, a company is also subject to tax in its state of residence, as
well as in any state in which it has nexus.
2.1 Definition of Nexus

Nexus is defined as the minimum level of contact a taxpayer may have with a jurisdiction to be
subject to its tax. This is typically caused by a company having property, payroll, or sales within
a state, and is determined under the laws of each state, which may vary as to what particular
activity will trigger nexus in the state. However, federal law offers some protection to companies
where state taxation is concerned.
2.2 Federal Limitations on a State's Right to Impose Income Tax

Under Public Law No. 86-272, federal law prohibits a state and its political subdivisions
(counties, cities, etc.) from imposing a net income tax on a person's net income derived
from interstate commerce occurring within the state's borders when the following three
circumstances are present:
yy The only business activity of the person within the state consists of the solicitation of
Think orders for sales of tangible personal property;
of yy Those orders are sent outside the state for acceptance or rejection; and
sales yy If those orders are accepted, they are filled by shipment or delivery from a point outside
tax the state.
"Person" includes individuals, corporations, partnerships, and limited liability companies.
The prohibition against the state's imposing a net income tax does not apply to the following:
yy Individuals who are domiciled in, or are residents of, the state; and
yy Corporations which are incorporated under the laws of that state (note that the
"prohibition-does-not-apply" portion of this federal law does not address either
partnerships organized under the laws of that state or limited liability companies
organized under the laws of that state).
yy Companies that are soliciting sales of service or other products that do not qualify as
tangible personal property.
The federal law applies only to prohibit a state from imposing a net income tax if the three
circumstances above are present. This law does not apply to:
yy sales and use taxes;
yy franchise taxes; and
yy gross receipts taxes (sometimes called business and occupation taxes or commercial
activity taxes).
Because this federal law limits the right of a state to tax net income that a person earns
within the state, most, if not all, states:
yy narrowly define "solicitation"; and
yy resolve in favor of the state all ambiguities under the federal law.

The following are examples of activities that may trigger nexus in a state in which a
company operates:
Now yy Owning or leasing tangible personal or real property.
you are yy Sending employees into the state for training or work.
subject yy Soliciting sales in a state.
to yy Providing installation, maintenance, etc., to customers within a state (even through
state a third party).
income tax yy Accepting or rejecting sales orders within the state, or accepting returns.
Example 1 Determination of Nexus
Facts: Hundley Corporation sells computers and is incorporated and resides in California.
In addition to California, Hundley solicits sales in Oregon, Arizona, and Colorado. It provides
installation services to its customers in Arizona, and it conducts employee training at a
facility in Colorado.
Required: Determine with which states Hundley has nexus.
Solution:
California (state of residence and incorporation)
Arizona (provides installation services to customers)
Colorado (conducts employee training)
Hundley likely will be protected from nexus in Oregon by P.L. 86-272, as its only activity in
the state is solicitation of sales for tangible personal property.
2.3 State Allocation and Apportionment of Federal Taxable Income

Once nexus is established, the next step is for the company to determine how much of its total
federal income or loss should be taxable by each state. This is accomplished through the rules
of allocation and apportionment. Although the terms allocation and apportionment are almost
always used in the same phrase, they each perform a separate function, and it is important
to note the difference between the two. Generally, most states require that corporations (and
sometimes, partnerships) use federal taxable income before the NOL deductions and before
the dividends-received deduction as the starting point for allocation and apportionment
calculations. For corporations, this amount is shown on line 28 on page 1 of the IRS Form 1120.
2.3.1 Allocation of Nonbusiness Income : Allocate it to home state

Generally, allocable items of income are "nonbusiness" income. That is, the income does not
relate to the primary business activities of the corporation within the state. "Allocation" refers to
the process of removing the nonbusiness income from the line 28 total and assigning it entirely
to the state where it should be taxed, which is generally the state of the taxpayer's commercial
domicile (or, residence).

Example 2 Allocation of Nonbusiness Income
Facts: A corporation selling shoes at retail in two states has invested excess cash, which is
not working capital, in high-grade stocks and bonds. The corporation plans to liquidate the
investment in 10 years and use the proceeds to pay for the construction in 10 years of a
planned distribution center.
Required: Determine whether the investment income from the stocks and bonds should
be classified as business income or allocated as nonbusiness income.
Solution: Because the investment in stocks and bonds does not relate to the primary
business activities of the corporation, in this situation, the corporation may be able to
allocate entirely to the corporation's home state all dividend income and interest income
(and capital gain or loss from the liquidation). No other state would be able to tax these
items of nonbusiness income.
2.3.2 Apportionment of Business Income : Apportion biz income among states

The portions of line 28 income which are not allocated entirely to one state are apportioned
to all the states in which the corporation does business. Generally, apportionable items
of income are "business" income. That is, the income does relate to the primary business
activities of the corporation within the state.
The income apportioned to a state is usually the product of: 1 2
yy the apportionment factor (based on the corporation's percentage of property, payroll,
and sales in the state); and
3
yy the portion of line 28 income which is apportionable, business income (line 28 income
less allocated income).
2.3.3 Calculation of Apportionment Factor

Each state dictates exactly how the apportionment factor should be determined in
that state, and the methods vary slightly from state to state. However, the standard
apportionment factor formula that is used by many states is calculated in the
following manner:
1 2 3
 Property and rent expense Payroll paid to employees Sales from sources  = Income
 located within the state within the state 
 +
within the state
+ ÷3 to
 Total pro
operty Total payroll Total sales 




that
state

Example 3 Allocation and Apportionment
Facts: A corporation has commercial domicile in Kansas and has the following breakdown
of property, payroll, and sales in the states where it operates:
Property: Payroll: Sales:

Kansas: $400,000 Kansas: $40,000 Kansas: $300,000
Missouri: $50,000 Missouri: $30,000 Missouri $400,000
Oklahoma: $30,000 Oklahoma: $20,000 Oklahoma: $200,000
Nebraska: $20,000 Nebraska: $10,000 Nebraska: $100,000
Total: $500,000 Total: $100,000 Total: $1,000,000
The portion of line 28 income representing allocable dividends and interest income
(nonbusiness income) described above is $10,000; the remaining portion of line 28 income
is $100,000 and relates to business income (and thus is apportionable income). So, total
line 28 income is $110,000.
Required: Determine the corporation's taxable income in each state with nexus.
Solution: In order to determine taxable income for each state, first calculate their
apportionment factors.
Kansas: Missouri:
Property factor: 80% ($400,000 / $500,000) Property factor: 10% ($50,000 / $500,000)
Payroll factor: 40% ($40,000 / $100,000) Payroll factor: 30% ($30,000 / $100,000)
Sales factor: 30% ($300,000 / $1,000,000) Sales factor: 40% ($400,000 / $1,000,000)
Total factor: 50% [(80% + 40% + 30%) / 3] Total factor: 27% [(10% + 30% + 40%] / 3)
Oklahoma: Nebraska:
Property factor: 6% ($30,000 / $500,000) Property factor: 4% ($20,000 / $500,000)
Payroll factor: 20% ($20,000 / $100,000) Payroll factor: 10% ($10,000 / $100,000)
Sales factor: 20% ($200,000 / $1,000,000) Sales factor: 10% ($100,000 / $1,000,000)
Total factor: 15% [(6% + 20% + 20%] / 3) Total factor: 8% [(4% + 10% + 10%] / 3)
In this situation, the home state of Kansas could tax $60,000 of the corporation's line 28
amount: (i) $10,000 nonbusiness income allocated entirely to the home state; and (ii) $50,000
apportioned to the home state (50% apportionment factor × $100,000 apportionable
business income).
The remaining states have taxable income as follows:
Missouri: $27,000 (27% apportionment factor × $100,000 apportionable business income)
Oklahoma: $15,000 (15% apportionment factor × $100,000 apportionable business income)
Nebraska: $8,000 (8% apportionment factor × $100,000 apportionable business income)

2.4 State Income Taxes and Controlled Taxpayers

Most states do not have a statute similar to the IRC's statute authorizing the IRS to make
controlled taxpayer adjustments with respect to transfer pricing issues. However, many states do
have a statute allowing the state taxing authority to require a combination of income of related
members if such combination will better reflect the extent of business done within the state.
State Taxing Authority Combining Income

Illustration 2
of Related Members
Hold Company, located solely in Delaware, owns 100 percent of the stock of OP Company,
operating solely in State X. Hold Company's only business is (i) owning the stock of OP
Company and (ii) lending money to OP Company. Hold Company and OP Company file a
U.S. consolidated income tax return. Because of Hold Company's limited activities, under
Delaware law and under State X law, Hold Company is not liable for income tax to either
state. Because OP Company operates solely in State X, OP Company is not liable for state
income tax in Delaware.
At the end of each business day, OP Company declares and pays a dividend equal to all of
OP Company's cash on hand at the end of that day. At the beginning of each next business
day, Hold Company lends to OP Company sufficient cash for OP Company's operations for
that day. The interest rate is an arm's-length rate. Under the terms of the loan agreement,
OP Company does not have to repay any principal for 10 years.
As a result of Hold Company's daily loans to OP Company, each year OP Company incurs
deductible interest expenses of $10,000,000. Because Hold Company and OP Company file
a U.S. consolidated income tax return, the interest expense incurred by OP Company and
the interest income recognized by Hold Company offset each other. Because the interest
rate that Hold Company charges OP Company is an arm's-length rate and because the two
corporations file a U.S. consolidated income tax return, the IRS makes no transfer pricing,
controlled taxpayer adjustments.
Because of the daily dividends paid to Hold Company followed by the daily loan from Hold
Company to OP Company, on a "separate return" basis, OP Company's line 28 income has
been reduced by OP Company's $10,000,000 interest expense; so OP Company's income
subject to tax by State X also has been reduced by $10,000,000 (State X bases its state
income tax on the taxpayer's separate return line 28 amount).
However, if State X taxing officials have the authority to combine OP Company and Hold
Company, the state tax benefit of OP Company's $10,000,000 interest expense deduction
will be offset by Hold Company's $10,000,000 interest income. The combined line 28
amount will now reflect the true income of OP Company, and OP Company will pay to
State X the appropriate amount of state income tax.

3 Entity Classification and Sourcing of Income
3.1 Entity Classification

A foreign entity is generally classified as either a foreign branch or a foreign subsidiary:
Foreign Foreign branch: This is an unincorporated foreign entity that is viewed as an extension
of the domestic corporation. It is not a separate legal entity; however, earnings from the
taxed branch are generally taxed by the foreign host country as well. Federal tax consequences
now related to a foreign branch are:
y Profits (or losses) earned by the branch are treated as being earned directly by the
domestic corporation and are accordingly taxed in full when earned. This allows
Federal any losses incurred by the foreign branch to offset domestic income earned by the
tax now U.S. company.
& y A credit against taxes is allowed for the lesser of foreign tax imposed by the branch's
foreign host country or the foreign tax credit limitation. Option of deduction
tax y Remittance 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 (one exception
credit or would be any related foreign currency exchange gains or losses that occur upon
deduction repatriation). However, the foreign host country may impose a branch profits tax, which is
basically a withholding tax on branch income remitted back to the domestic corporation.
Foreign Foreign subsidiary: This is a separate legal entity, incorporated under the laws of the
foreign host country. Accordingly, the subsidiary profits are taxed by the host country.
taxed now Federal tax consequences related to the foreign subsidiary are:
y Income earned by the subsidiary is not taxed until the earnings are brought back to the USA
United States in the form of a dividend. In this way, the U.S. company has control over
when foreign profits are recognized.
Federal y Certain types of income earned are not allowed to be deferred and are subject to
tax immediate taxation (e.g., passive investment income).
later y Because the foreign subsidiary is a separate legal entity and taxation on profits may be
deferred, it is important that transactions between the U.S. parent and foreign subsidiary
follow the rules of transfer pricing, or penalties will be imposed.
3.2 Sourcing of Income

3.2.1 Sourcing Rules for Gross Income and Deductions
Sourcing rules determine whether income and deductions are generated from sources within or
outside the United States. For non-U.S. persons, the sourcing rules help to provide limitations on
the income that is subject to U.S. taxation. For U.S. persons, the sourcing rules help to determine
the income that is included in the numerator as foreign taxable income.

The IRC identifies nine items of income that should be treated as sources of income from
within the United States:
1. Interest: Interest from the United States or the District of Columbia and interest
on bonds, notes, or other interest-bearing obligations of noncorporate residents or
domestic corporations.
2. Dividends: The source of dividends is generally determined by the residence of the
corporation paying the dividend.
3. Personal Services: Compensation for labor or personal services performed in the United
States; there is a special exception for individuals temporarily performing services in the U.S.
They must meet the following requirements:
yy The labor or services are performed by a nonresident alien individual temporarily
present in the United States for a period or periods not exceeding a total of 90 days
during the taxable year;
yy Such compensation does not exceed $3,000 in the aggregate; and
yy The compensation is for labor or services performed as an employee of or under a
contract with:
—a
— nonresident alien, foreign partnership, or foreign corporation, not engaged in trade
or business within the United States; or
U.S.
—an
— individual who is a citizen or resident of the United States, a domestic partnership,
income or a domestic corporation, if such labor or services are performed for an office or
place of business maintained in a foreign country or in a possession of the United
States by such individual, partnership, or corporation.
4. Rents and Royalties: Rentals or royalties from property located in the United States or
from any interest in such property, including rentals or royalties for the use of or for the
privilege of using in the United States patents, copyrights, secret processes and formulas,
goodwill, trademarks, trade brands, franchises, and other like property.
5. Disposition of U.S. Real Property Interest: Gains, profits, and income from the disposition
of a United States real property interest.
6. Sale or Exchange of Inventory Property: Gains, profits, and income derived from the
purchase of inventory property outside the United States (other than within a possession of
the United States) and its sale or exchange within the United States.
7. Underwriting Income: Amounts received as underwriting income (as defined in
Section 832(b)(3)) derived from the issuing (or reinsuring) of any insurance or annuity contract.
8. Social Security Benefits
9. Guarantees: Amounts received, directly or indirectly, from:
yy a noncorporate resident or domestic corporation for the provision of a guarantee of
any indebtedness of such resident or corporation, or
yy any foreign person for the provision of a guarantee of any indebtedness of such person,
if such amount is connected with income which is effectively connected (or treated as
effectively connected) with the conduct of a trade or business in the United States.
After the determination of the source of the income (U.S. or foreign), a taxpayer may be required
to allocate and apportion allowable deductions to determine U.S. taxable income and foreign
source taxable income. The foreign source taxable income will be used to calculate the foreign
tax credit limitation.

Foreign income taxes paid by a corporation:

a. May be claimed either as a deduction or as a credit, at the option of the corporation.
b. May be claimed only as a deduction.
c. May be claimed only as a credit.
d. Do not qualify either as a deduction or as a credit.

NOTES
6
MODULE6 International Tax Issues
International
Tax Issues REG 5
1 U.S. Taxation of Foreign Transactions
1.1 Worldwide Tax System

The U.S. tax system is classified as a worldwide tax system because citizens and residents
are generally subject to tax on their worldwide income. Some provisions, however, allow for
the exemption of certain foreign income, which instead follows a territorial-style approach
(described below).
1.2 Territorial Tax System

Under a territorial tax system, a nation only taxes its citizens and residents on income earned
inside its borders. Income earned outside the country's borders is not subject to tax.
Taxation is based on whether a person is actually present in the country and deriving income
from within its borders. This is referred to as source-country taxation.
Most countries that are members of the Organization for Economic Cooperation and
Development (OECD) employ a territorial-style tax system.
In December 2017, the U.S. government passed the Tax Cuts and Jobs Act (TCJA). The act allows
certain U.S. corporations earning dividend income outside U.S. borders to take a 100 percent
dividends-received deduction against such income, thereby exempting the income from
U.S. taxation. This deduction applies to amounts received from certain foreign corporations and
reduces the effective tax rate to zero on this type of income.
1.3 Taxation of Noncitizens and Nonresidents

Taxation of noncitizens and nonresidents generally requires a connection or nexus to the
country. Most nations have rules that define "substantial presence" within the country and
rules that determine when income is treated as "effectively connected" to the country. The rules
provide thresholds for triggering the taxation of foreign persons.
2 Foreign Tax Credit
Under a worldwide tax system, the primary mechanism for mitigating double taxation is the
foreign tax credit. The United States allows U.S. taxpayers to take a foreign tax credit for income
taxes paid to a foreign government.
2.1 Foreign Tax Credit Limitation

If a U.S. taxpayer earns income in a foreign jurisdiction with a higher tax rate than the United
States, no residual taxes will be paid to the U.S. government, but the foreign tax credit will be
limited to the amount of U.S. taxes attributable to the foreign-source income. This helps ensure
that the U.S. tax liability tied to income earned in the United States is not offset by an unlimited
foreign tax credit.

6 International Tax Issues REG 5
Foreign tax paid

The limitation calculation is as follows: or Lesser
Pre-credit U.S. tax on Foreign source income

×
total taxable income Total taxable income *
* Total taxable income includes both foreign source income
and all other taxable income, including domestic income.
2.2 Separate Limitation Calculations

Foreign income is sourced into separate categories to prevent a company from using excess credits
from high-tax foreign business profits to offset low-taxed passive investment income. The foreign
tax credit limitation must be applied separately to each of the following categories of income:
Passive category income (dividends, interest, rents, royalties)
General category income (active business income)
Foreign branch income
Global intangible low-taxed income
2.3 Calculating the Foreign Tax Credit Limitation by Category

Once the income is sourced, the company applies a separate foreign tax credit (FTC) limitation
to each category of income. The formula for computing the separate category limitations is the
same as that for computing the overall limitation, except the numerator is now the separate
category of income: Foreign tax paid
or Lesser
Pre-credit U.S. tax on Separate"category"foreign income
×
total taxable income Total taxable income *
* Total taxable income includes all taxable income from
all foreign categories as well as all other taxable income,
including domestic income.
The foreign tax credit is allowed for a foreign tax that the U.S. deems to be an income tax
(or tax "in lieu of" income tax). This generally includes taxes on wages, interest, dividends,
and royalties. It does not typically include sales taxes, value added taxes, property taxes, or
customs taxes.
The credit allowed for that category is the lesser of the limitation for that category or the
foreign taxes related to that category. The total FTC is then the sum of the credits allowed
for all categories.
A corporation calculates and reports its foreign tax credit on Form 1118 Foreign Tax
Credit—Corporations, and individuals, estates, and trusts use Form 1116 Foreign Tax Credit
(Individual, Estate, and Trust).
Taxpayers can elect to deduct foreign taxes rather than claim the credit, which can
be a good decision if the taxpayer does not expect to utilize the credit in the 10-year
carryforward period.
R5–64 Module 6 International

REG 5 6 International Tax Issues
3 Participation Exemption or Dividends-Received

Deduction
Under a territorial tax system, the primary mechanism for mitigating double taxation is a
participation exemption or dividends-received deduction.
A participation exemption allows the taxpayer to exempt foreign income from taxation.
A dividends-received deduction (DRD) allows the taxpayer to offset dividend income from
foreign sources with a deduction.
Unlike a worldwide tax system, no residual taxes are imposed on a taxpayer earning income
in a low-tax jurisdiction, meaning the taxpayer is subject to the same rate of tax as other
persons operating in the foreign jurisdiction.
A U.S. corporation is allowed to exempt foreign-source dividend payments from U.S. taxation by
taking a 100 percent dividends-received deduction against such income if it owns 10 percent or
more of the dividend-paying foreign corporation.
No residual tax is imposed on dividend repatriations from foreign jurisdictions and the U.S.
government will not collect taxes on the foreign income.
A 10 percent shareholder that is not a U.S. corporation is not eligible for the DRD.
3.1 Special Rules

No foreign tax credit or deduction is allowed on dividends that benefit from the 100 percent
dividends-received deduction.
The deduction is subject to a holding period requirement, which requires that the U.S.
corporation hold the foreign corporation stock for more than 365 days during the 731-day Holding
period beginning 365 days before the ex-dividend date.
1 year in
Certain income is not eligible for the 100 percent dividends-received deduction: last 2 years
yy Subpart F income
yy Global intangible low-taxed income GILTI
yy Income invested in U.S. property
yy Income subject to the transition tax
4 Foreign Activities of U.S. Persons (Outbound Transactions)
When a U.S. person invests abroad, it is considered an outbound transaction. The income
earned outside U.S. borders is generally referred to as foreign-source income.
The definition of a U.S. person includes:
U.S. citizen
U.S. resident alien
U.S. partnership
U.S. corporation
U.S. trusts and estates

U.S. persons can generally defer U.S. taxes on foreign-source income until such income is
repatriated to the United States (e.g., in the form of a dividend). The benefit of deferral usually
applies to income earned abroad through active operations.
4.1 Anti-deferral Rules

The United States has two anti-deferral regimes that result in the current taxation of
foreign‑source income:
U.S. Passive foreign investment company regime
tax Controlled foreign corporation rules/Subpart F regime
now
4.1.1 Passive Foreign Investment Company (PFIC)
A foreign entity is a PFIC if it meets a gross income or asset test:
The income test classifies an entity as a PFIC if 75 percent or more of the foreign
Or corporation's gross income is passive (e.g., dividends, interests, rents, royalties).
The asset test classifies an entity as a PFIC if at least 50 percent of the foreign corporation's
total assets are passive assets (e.g., assets that produce passive income).
Direct and indirect U.S. shareholders of a PFIC are subject to PFIC rules, and PFIC undistributed
earnings are subject to U.S. taxation under one of three methods (designed to eliminate benefit
of deferral):
1. Qualified electing fund
2. Mark-to-market method
3. Excess distribution method
4.1.2 Subpart F Income

The United States generally does not tax foreign business profits earned through a foreign
subsidiary until the subsidiary repatriates those earnings as a dividend.
For taxable years beginning before December 31, 2017, the deferral of such income allowed
U.S. companies to compete in foreign markets without being subject to U.S. residual taxes
until the time of repatriation.
For taxable years beginning after December 31, 2017, U.S. corporations receive a 100 percent
dividends-received deduction for foreign-source dividends paid by a controlled foreign
corporation.
The benefits of deferral and the exemption of foreign-source dividends create opportunities for
shifting income to low-tax jurisdictions to avoid U.S. taxes. The controlled foreign corporation
rules (Subpart F) are intended to curb this behavior. The rules include the following:
A foreign corporation is considered a controlled foreign corporation (CFC) if more than
50 percent of its stock is owned by U.S. shareholders.
A U.S. shareholder is any U.S. person owning at least 10 percent of the foreign corporation's
stock (vote or value). Constructive rules apply in this determination.
Subpart F only applies to a foreign corporation that qualifies as a CFC.
When both the PFIC and Subpart F rules apply, the Subpart F rules supersede the PFIC rules.

Example 1 Overlap Between PFIC Rules and Subpart F Rules
Facts: Company ABC (a U.S. company) is a 12 percent owner in a foreign corporation, D,

whose primary source of income is investments (80 percent of gross income). The other 12
shareholders of D include six U.S. persons each owning 10 percent (60 percent total) and a
foreign person who owns 28 percent. 6 x 10= 60
Required: Determine the tax treatment of ABC's investment in D. Subpart F = 72%
Solution: In this scenario, D qualifies as both a CFC (owned 72 percent by 10 percent U.S.
shareholders) and a PFIC (with 80 percent passive gross income). Because the Subpart F
rules supersede PFIC rules, D will be treated as a CFC instead of a PFIC and ABC's income
from D will be subject to Subpart F rules, resulting in immediate income recognition of D's
Subpart F income.
PFIC = 80% passive
4.1.3 Foreign Base Company Income

The main purpose of Subpart F is to discourage taxpayers from using foreign corporations
to defer U.S. taxes by accumulating income in foreign "base" companies located in low-tax
jurisdictions. The rules define this "bad income" as foreign base company income.
Foreign base company income includes passive income (i.e., highly mobile investment-type income
that can easily be shifted to a low-tax jurisdiction) or active income tied to a related party.
A U.S. shareholder of a controlled foreign corporation generating foreign base company income
is taxed on a current basis (no deferral and no DRD) with respect to the shareholder's pro rata
share of such income.
4.2 Global Intangible Low-Taxed Income Tax = GILTI

The Tax Cuts and Jobs Act created a new tax on global intangible low-taxed income (GILTI), and it
applies to taxable years beginning after December 31, 2017.
The GILTI tax is a minimum tax imposed on certain low-taxed income that is intended to reduce
the incentive to relocate CFCs to low-tax jurisdictions.
After determining a CFC's Subpart F income, U.S. shareholders must determine whether they
are subject to tax on the CFC's global intangible low-taxed income (GILTI). U.S. shareholders are
taxed in a manner similar to Subpart F inclusions and U.S. corporations are allowed a special
deduction.
4.2.1 Deduction Amount

For 2018–2025, the deduction amount is 50 percent of GILTI (37.5 percent for 2026 and later).
The taxpayer is also allowed to take a foreign tax credit for up to 80 percent of the foreign
taxes deemed paid. This deduction generally results in an effective tax rate of 10.5 percent
(13.125 percent beginning in 2026) on GILTI inclusions, as it halves the statutory corporate tax
rate of 21 percent.
4.2.2 Inclusion Amount

The GILTI inclusion is equal to the U.S. shareholder's share of the CFC's net income, reduced
by the excess of: (i) 10 percent of the CFC's aggregate adjusted basis in depreciable tangible
property used in its trade or business, over (ii) the CFC's net interest expense.
The CFC's aggregate adjusted basis in depreciable, tangible property is measured using the
average amount determined at the close of each quarter.

GILTI
Global Intangible Low-Taxed Income Inclusion
Example 2
and Deduction
Facts: Hughes Corp. (a U.S. corporation) owns 15 percent of EKM Corp. (a CFC). EKM's net
income for Year 1 is $1,500,000 and the adjusted basis of its tangible property at the end
of each quarter is $1,000,000 (first quarter), $1,250,000 (second quarter), $1,225,000 (third$1,500,000
quarter), and $1,150,000 (fourth quarter). <115,625>
Required: Determine Hughes Corp.'s GILTI inclusion and deduction.
10% Avg. assets 1,384,375
Solution: EKM Corp.'s GILTI income is its net income ($1,500,000) less 10 percent of its
average adjusted basis of depreciable tangible property: 10% × [($1,000,000 + $1,250,000 x 15%
GILTI $207,656
+ $1,225,000 + $1,150,000)/4] = $115,625. EKM Corp.'s GILTI income is $1,384,375, which is
$1,500,000 less $115,625.
Because Hughes Corp. is a 15 percent U.S. shareholder, it will include 15 percent of EKM
Corp.'s GILTI income, 15% × $1,384,375 = $207,656.
Hughes Corp. is eligible for a 50 percent GILTI deduction because it is a corporate
shareholder. Its GILTI deduction is $103,828, which is $207,656 × 50%.
4.3 Earnings Invested in U.S. Property

Each U.S. shareholder of a CFC must include in income their pro rata share of:
1. Subpart F income; and
2. earnings invested in U.S. property.
These provisions were enacted to deter U.S. taxpayers from repatriating non-Subpart F earnings
from a CFC through loans and other investments in U.S. property in a tax-free manner.
The impact of these rules is that a U.S. shareholder is taxed on the pro rata share of any
increase in the earnings of the CFC invested in U.S. property.
The term "U.S. property" includes tangible property located in the United States, stock
of a domestic corporation, an obligation of a U.S. person, or any right to use a patent or
copyright in the United States.
The calculation compares average adjusted basis of such property for the tax year with
adjusted basis at the end of the previous year and uses the close of each quarter as a
measuring date.

Example 3 Earnings Invested in U.S. Property
Facts: Blue Corp., a CFC with no prior U.S. property investments, makes a $1 million loan to
its U.S. parent in the second quarter of Year 1. The loan remains outstanding at the end of
Year 1.
Required: Determine Blue Corp.'s increase in earnings invested in U.S. property in Year 1.
Solution: Blue Corp. has an increase of $750,000 invested in U.S. property.
0 million = First quarter

$1 million = Second quarter
$1 million = Third quarter
$1 million = Fourth quarter
$3 million/4 quarters = $750,000
Each U.S. shareholder would be taxed currently on their pro rata share of Blue Corp.'s
increased investment in U.S. property during the taxable year.
4.4 Previously Taxed Income

The current taxation of a CFC's undistributed earnings is coordinated with both the taxation of
actual dividend distributions made by the CFC and the taxation of dispositions of the CFC's stock.
A U.S. shareholder can exclude distributions of a CFC's earnings and profits that were previously
taxed income (PTI) to U.S. shareholders as a result of a Subpart F inclusion, GILTI inclusion, or an
investment in U.S. property.
4.5 Transition Tax USA

The Tax Cuts and Jobs Act created a territorial-style system for certain U.S. corporations
by allowing a 100 percent dividends-received deduction for foreign-source dividends from
controlled foreign corporations (CFCs).
The transition to this new system requires all U.S. shareholders to pay a one-time tax on the
CFC's previously untaxed foreign earnings.
For the last taxable year beginning before January 1, 2018, a one-time deemed repatriation
tax is imposed on accumulated, untaxed earnings of foreign corporations and is taken into
account by all U.S. shareholders who own 10 percent or more of the CFC.
An exception permits S corporations to defer the tax until the S corporation liquidates,
ceases doing business, or the stock of the S corporation is transferred.
4.5.1 Classification of Untaxed Earnings

The CFC's untaxed earnings are divided into two groups:
1. Cash/cash equivalents, which are taxed at 15.5 percent. = The profits they never reinvested
2. All other earnings, which are taxed at 8.0 percent. = The profits that were reinvested

4.5.2 Tax Payments

U.S. shareholders can elect to pay the transition tax in eight installments over eight years,
pursuant to a specified schedule.
Transition Tax Tax

Installment Period Liability Due
Year 1 8%
Year 2 8%
Year 3 8%
Year 4 8%
Year 5 8%
Year 6 15%
Year 7 20%
Year 8 25%
100%
4.6 Base Erosion and Anti-Abuse Tax (BEAT)

The Tax Cuts and Jobs Act created the base erosion and anti-abuse tax (BEAT) to impose a
minimum tax on large U.S. corporations (average annual gross receipts of at least $500 million for
the three-year taxable period ending with the preceding taxable year) with a significant amount
of deductible payments to related foreign affiliates because such deductions reduce the U.S. tax
base. The BEAT is effective for taxable years beginning after December 31, 2017, and is imposed
on a U.S. corporation's modified taxable income.
Modified taxable income is regular taxable income calculated without:
the "base erosion percentage" of any net operating losses (NOLs);
the allowance of deductions for amounts paid or accrued to related foreign persons; or
depreciation or amortization deductions with respect to property acquired from related
foreign persons.
The following rules also apply:
Deductible payments to a CFC are added back in calculating a taxpayer's modified taxable
income even if they are included in the taxpayer's income as Subpart F income.
The tax rate is 5 percent for taxable years beginning in 2018, 10 percent for taxable years
beginning in 2019–2025, and 12.5 percent for years beginning in 2026 or later.
The BEAT does not apply to individuals, S corporations, regulated investment companies
(RICs), or real estate investment trusts (REITs).
In general, the 10 percent BEAT tax will begin to apply when payments to foreign affiliates
exceed taxable income by more than 10 percent. The BEAT applies to the extent that it
exceeds the regular tax liability (reduced by most credits).
A de minimis exception is provided for companies whose foreign related party payments
are low relative to overall deductions (only a base erosion percentage of 3 percent or higher
for most companies).
The BEAT regulations provide three anti-abuse rules that permit the IRS to disregard a
transaction, plan, or arrangement that has the principal purpose of avoiding the BEAT.

4.7 Foreign-Derived Intangible Income Deduction

The Tax Cuts and Jobs Act created a new deduction for certain export activities. Under the new
Export provision, a U.S. corporation can get a deduction for a portion of its foreign-derived intangible
income (FDII). FDII is income from transactions involving non-U.S. persons located outside the
income U.S., including:
the sale of property sold by the taxpayer to any person who is not a U.S. person and is for
foreign use;
services provided by the taxpayer to any person or with respect to property, not located
within the U.S. (including some electronic services); and
property sold to a related party who is not a U.S. person, provided the property is ultimately
sold by the related party to an unrelated party who is not a U.S. person, and the property is
used outside the U.S.
The deduction amount is 37.5 percent for years beginning before 2026 (reduced to 21.875
percent for years after 2026). The deduction for FDII is available only to C corporations that are
not RICs or REITs.
5 U.S. Activities of Foreign Persons (Inbound Transactions)
A foreign person's investment in the United States is considered an inbound transaction.

The United States taxes foreign persons on income derived in the United States, which is
referred to as U.S.-source income.
The definition of a foreign person includes:
Nonresident alien individuals
Foreign corporations
Foreign partnerships
Foreign trusts
Foreign estates
Any other person who does not meet the definition of a U.S. person
A foreign person's U.S.-source income falls into one of two categories—business income or
nonbusiness income.
5.1 Business Income

A foreign person engaged in a U.S. trade or business is subject to U.S. taxation on income
effectively connected with the U.S. trade or business. Business income is taxed on a net basis
(gross income less allowed deductions and expenses) at U.S. graduated rates.
A foreign person with a U.S. trade or business must file Form 1120-F U.S. Income Tax Return of a
Foreign Corporation to report the income earned by the U.S. branch.
If a foreign person organizes U.S. business activities under a U.S. subsidiary, instead of a branch,
then the U.S. subsidiary will be taxed as a U.S. corporation reporting all its income on Form 1120
U.S. Corporation Income Tax Return.

Example 4 Taxation of Foreign Person Business Income
Facts: British Bunting Inc., a British company, has a U.S. branch in Austin, Texas. The
branch makes routine sales to U.S. customers. The gross profits of the U.S. branch are $100
and the cost of goods sold are $40.
Required: Determine British Bunting's U.S. taxable income.
Solution: British Bunting's U.S. taxable income is $60 ($100 gross profit less $40 cost of
goods sold), which will be taxed at U.S. graduated tax rates.
5.2 Nonbusiness Income

Nonbusiness income (investment-type income, such as dividends and interest) is taxed on a
gross basis (deductions and expenses are prohibited) at a 30 percent statutory withholding rate.
Withholding rates may be reduced by income tax treaties.
A foreign person's nonbusiness income is subject to U.S. withholding taxes under one of
two regimes.
5.2.1 U.S. Withholding Tax Regimes for Nonbusiness Income

There are two types of withholding tax regimes for nonbusiness income:
1. Fixed, Determinable, Annual, or Periodic Income (FDAP)
2. Foreign Account Tax Compliance Act of 2010 (FATCA)
FDAP deals with the withholding on foreign persons' investment-type income (e.g., dividends,
interest, royalties):
FDAP income includes dividends, interest, royalties, and compensation from personal
services. Such income is taxed on a gross basis at a statutory rate of 30 percent.
Withholding ensures the collection of taxes from foreign persons, over whom the IRS would
typically not have the jurisdiction to tax.
The U.S. person controlling the payment of U.S. source income to the foreign person is
responsible for withholding the appropriate amount of tax on such payment.
FATCA deals with withholding tax on foreign entities for failure to provide information to
U.S. recipients:
The purpose of FATCA is to help combat tax evasion tied to U.S. persons investing in foreign
entities (e.g., deposits in foreign banks).
FATCA imposes a 30 percent withholding tax on foreign entities that do not provide
information about U.S. persons on Form 8966 FATCA Report.
FATCA applies to foreign financial institutions and nonfinancial foreign entities but does
not apply to payments made to nonresident aliens (i.e., foreign individuals), foreign
governments, international organizations, and certain retirement funds.
5.3 Foreign Person Treated as U.S. Resident

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

5.3.1 Green Card Test

A foreign individual is considered a resident of the United States if he or she is a lawful,
permanent resident of the United States in accordance with U.S. immigration laws.
5.3.2 Substantial Presence Test

A foreign individual is considered a resident of the United States if he or she is substantially
present in the United States for:
at least 31 days during the current year; and
at least 183 days for a three-year period, applying a weighted average:
yy Days in current year × 1
yy Days in immediate preceding year × (1⁄ 3)
yy Days in next preceding year × (1⁄ 6)
Example 5 Substantial Presence Test
Facts: Esther, a citizen of the United Kingdom, stayed in the United States for 122 days in
each of the last three years: Year 1, Year 2, and Year 3.
Required: Determine whether Esther is treated as a U.S. resident for Year 3.
Solution: Esther is treated as a U.S. resident because she is present in the United States for
more than 31 days during Year 3, and she is present for at least 183 days for the three-year
period beginning in Year 1, after applying a weighted average:
Current Year 3: 122 days × 1 = 122 days

Immediate prior Year 2: 122 days × (1⁄ 3) = 40.67 days
Next preceding Year 1: 122 days × (1⁄ 6) = 20.33 days
Total 183 days
5.3.3 First-Year Election

A foreign person is considered a resident of the United States if the individual elects to be
treated as a U.S. resident and meets the following requirements:
Present for 31 consecutive days in the current year;
Present 75 percent of the days in the current year (beginning day 1 of the 31 consecutive
days); and
Meets substantial presence test for the succeeding year.
The election is made by filing an extension for the first year or by filing an amended return for
the first year.

6 Expatriation U.S. (out) Foreign country (in)
6.1 Mark-to-Market Regime for Individuals

The mark-to-market tax regime is imposed on"covered expatriates "who renounce their
U.S. citizenship and satisfy one of the following three tests:
1. Tax Liability Test: Average annual net income tax liability for five preceding taxable years
Meet exceeds indexed threshold ($190,000 for 2023).
1 2. Net Worth Test: Net worth of $2 million or more on date of expatriation.
test 3. Compliance Test: The individual failed to comply with U.S. federal tax obligations for five
preceding taxable years.
6.1.1 Calculation of Tax

All property of the "covered expatriate" is treated as sold on the day before the expatriation
date with any gain arising from the deemed sale taken into account in the taxable year of
the deemed sale.
A $821,000 exclusion (2023) is allowed.
A taxpayer may elect to defer payment of tax attributable to property deemed sold
[Section 877A(b)].
Example 6 Exit Tax
Facts: Cathleen is a U.S. citizen who has lived in the United States her entire life. She is the
founder of Cupcakes Inc., a U.S. company. Her stock in the company is worth $7 million and
her basis in the stock is $250,000. In 2023, Cathleen renounces her citizenship and moves
to Bermuda. Assume that the gain exclusion for 2023 is $821,000.
Required: Determine Cathleen's U.S. tax consequences of this action.
Solution: Cathleen qualifies as a"covered expatriate "because her net worth
exceeds $2 million. She will be treated as if she sold her stock at fair market value
the day before her expatriation. Cathleen's long-term capital gain is $5,929,000
($7,000,000 FMV − $250,000 stock basis − $821,000 exclusion).
6.2 Expatriated Entity Rules for Corporations

When a U.S. company decides to reorganize its operations under a foreign parent to reduce its
U.S. tax obligations, it is considered an"expatriated entity."
Expatriated entities fall into one of two categories for U.S. tax purposes:
1. Continue to be treated as U.S. corporations if former U.S. shareholders own 80 percent or
more of interests in the new foreign parent; or
1 met
2. Denied certain tax attributes such as net operating losses and foreign tax credits to offset
"inversion gain" if former U.S. shareholders own 60 percent but less than 80 percent of
interests in the new foreign parent.

The TCJA also includes provisions to reduce a U.S. company's incentive to expatriate:
Dividends received by a U.S. corporation from a surrogate foreign corporation are not
eligible for the 100 percent dividends-received deduction.
Any individual shareholder who receives a dividend from a corporation that is a surrogate
foreign corporation is not entitled to the lower rates on qualified dividends.
7 Tax Treaties
Tax treaties are bilateral income tax conventions entered into by the United States and a
foreign country.
Tax treaties carry the same weight as domestic law and often modify otherwise applicable
U.S. tax rules.
Tax treaties modify the rules for investment-type income by reducing the withholding rate
below 30 percent.
Tax treaties also modify statutory rules related to business income, residency, and source-
of-income rules.
The U.S. treaty network includes income tax conventions with approximately 60 countries.
Most of these countries have a comprehensive income tax system in place.
Alpert Corp. (a U.S. corporation) manufactures dental equipment in Arizona. It makes sales
of dental equipment during the year to the following customers:
I. Rupert Corp. (a foreign corporation) for use in its dental centers in Texas
II. Janis Corp. (a foreign corporation) for use in its dental centers in Canada
III. Rogers Corp. (a foreign corporation and related party) for use in its dental centers
in Mexico
IV. Commodore Corp. (a U.S. corporation) for use in its dental centers in Canada
Which transactions increase Alpert Corp.'s foreign-derived intangible income?

a. I and II
b. II only
c. I, II, and III
d. II and IV

Which of the following payments to a foreign person is not subject to U.S. withholding tax
requirements?
a. An interest payment from a savings account at a U.S. bank
b. A dividend payment from a U.S. corporation
c. A customer payment for the sale of inventory within the U.S.
d. A payment to a foreign financial institution that does not provide information
about U.S. persons


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REG

5 Multi-jurisdictional Tax Issues 49

6 International Tax Issues 63

R5–2 © Becker Professional Education Corporation. All rights reserved.

- 1120-S due on March 15

Small, closely held corporations, if eligible, may elect to be taxed as an S corporation,

1.2 Property Contributions to an S Corporation

© Becker Professional Education Corporation. All rights reserved. Module 1 R5–3

Example 1 Contributions to S Corporations

To qualify as an S corporation, the following requirements must be met:

2. Eligible Shareholders USA

100 U.S. yy An individual shareholder may not be a nonresident alien.

4. One Class of Stock Common stock

R5–4 Module 1 © Becker Professional Education Corporation. All rightsSreserved.

3 Electing S Corporation Status

3.1 When Election Takes Effect By March 15 (retroactive to beg. of year)

3.2 New Shareholders

4 Effect of S Corporation Election on Corporation

4.1 S Corporation Tax Year General Rule: Dec. 31 is required year-end

4.3 Certain Corporation-Level Taxes

4.3.1 LIFO Recapture Tax

4.3.2 Built-in Gains Tax

© Becker Professional Education Corporation. All rights reserved. Module 1 R5–5

4.3.3 Tax on Passive Investment Income

5 Effect of S Corporation Election on Shareholders

5.1 Pass-Through of Income and/or Losses (to Shareholder/K-1)

R5–6 Module 1 © Becker Professional Education Corporation. All rightsSreserved.

Example 2 Allocation on Per-Share, Per-Day Basis

5.1.2 Separately Stated Items : on a K-1 to each shareholder

© Becker Professional Education Corporation. All rights reserved. Module 1 R5–7

Example 3 Ordinary Business Income and Separately Stated Items

5.2 Fringe Benefits

5.2.2 Nondeductible Fringe Benefits Include in that

Similar to a partnership, shareholders in an S corporation must include on their individual

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5.3 Shareholder Basis in S Corporation Stock

Note B Initial stock basis (contributions)

(at-risk) basis S − Distributions to shareholders

E = Ending basis in S corporation stock

5.4.1 Tax Basis Limitation

5.4.2 At-Risk Limitation

An S corporation shareholder is permitted to pass through for deduction on the

Illustration 1 Stock Basis and At-Risk Amount

Gearty is a shareholder in an S corporation. He contributed $12,000 in cash and land with

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Example 4 S Corporation Tax Basis Limitation

Prior S corp income

5.5.1 Increases to AAA

5.5.2 Decreases to AAA

5.5.3 Other Adjustments Account

5.6 Distributions to Shareholders

S Corporation With No C Corporation E&P

Illustration 2 Taxability of Distributions With No C Corporation E&P

1st distribution deemed from S corp. earnings/already taxed to shareholder on K-1

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Illustration 3 Taxability of Distributions With C Corporation E&P

6.1 Terminating Event

6.3 Short Tax Years

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A + % All Income Separately stated

Ordinary business loss

Cash Like a bank account