A major difference between partnerships and S corporations involves the treatment of distributions of appreciated property. With respect to the timing of gain recognition from such distributions, the rules applicable to partnerships (unlike those applicable to S corporations) generally permit gain deferral. This article demonstrates how to ensure that such distributions do not cause unexpected tax results.
As a result of the fact that the maximum corporate tax rate exceeds the maximum individual rate for the first time in seventy-three years, there is renewed interest in “pass- through” entities (i.e., S corporations and partnerships) as tax-favored ways of conducting a business. In addition to taking advantage of the lower rates for individuals, the pass-through entity eliminates double taxation associated with the payment of dividends from C corporations.
Although both S corporations and partnerships are now tax-favored entities, there are differences between the two. S corporations typically are more expensive to organize and require greater attention to the maintenance of corporate formalities than is required with partnerships. However, the corporate form usually provides owners with a greater degree of insulation from business liabilities than does the partnership form. There are subtle (and some not so subtle) differences between the two entities from a tax perspective as well. One significant difference exists with respect to distributions of appreciated property. Current distributions of appreciated property from S corporations produce gain at the entity level whereas distributions of such property from partnerships generally permit a deferral of taxable gain.
*Stephen T. Byrd is associated with the law firm of Petree Stockton & Robinson in Raleigh, North Carolina. Mr. Byrd is also a CPA. This article previously appeared in the Tax Assessment newsletter, published by the North Carolina Bar Association, and is reprinted with permission.
S Corporation Distributions
Section 1363(d) requires an S corporation to recognize gain on the distribution of appreciated property to its shareholders. No deferral of gain at the time of the distribution is available. The amount of gain is determined as if the S corporation had sold the property to the distributee at its fair market value. The distributee shareholder receives basis in the property distributed equal to its fair market value under Section 301(d)(1). Section 311(b)(2) mandates that the fair market value of the property for determination of gain recognition by the corporation is not less than the amount of any corporate liability assumed by the distributee in connection with the distribution.
Gain Characterization and Basis Implications
The character of the S corporation`s gain passes through to its shareholders under Section 1366(b). Although there has been much fanfare about capital gains being taxed at the same rate as ordinary income under the Tax Reform Act of 1986 (TRA `86), Congress retained the statutory structure to allow reinstatement of the long term capital gains deduction in the future and thereby reestablish the effective rate differential.
If the requirements of Section 1231 are met, the S corporation`s gain on distributions of appreciated property will be taxed as long term capital gain to the shareholder. However, Section 1231 excludes from capital gain treatment any inventory or property held primarily for sale in the ordinary course of the corporation`s trade or business. In addition, Sections 1245 and 1250 require that any depreciation recapture inherent in the gain be reclassified as ordinary income. Further, if appreciated depreciable property is distributed to a shareholder owning 50 percent or more of the S corporation`s stock, Section 1239 requires that the portion of the corporate gain attributable to the distribution received by such shareholder be reclassified as ordinary income.
As with partnerships, an S corporation`s taxable gains usually pass through to its owners and avoid double taxation. However, Section 1374 may impose a corporate-level tax on “built-in gains” on property dispositions by corporations that convert from C to S status after 1986 (unless the exception for certain small corporations converting to S status before 1989 applies). Section 1375 may impose a corporate-level tax on passive investment income, which includes gains on some distributed appreciated property, if the corporation has accumulated earnings and profits.
Basis adjustments to shareholders` stock are determined under Section 1367(a). The gain recognized by the S corporation passes through to the shareholders and increases the bases of their corporate stock. Except as provided under Section 1368 (see the following discussion), the distribution will reduce the distributees` bases by the amount of any money plus the fair market value of any other property distributed.`
If the S corporation has no accumulated earnings and profits, Section 1368(b) provides that a distributee shareholder will have no gain with respect to the distribution itself to the extent that the amount of the distribution does not exceed the adjusted basis of his stock. However, the shareholder recognizes gain (as from the sale or exchange of the stock) on the amount of the distribution in excess of the stock basis. In addition, under Section 1368(c), if the S corporation has accumulated earnings and profits, the distribution is a tax free return against the shareholder`s stock basis only to the extent of the corporation`s “accumulated adjustments account” (i.e., oversimplifying, the accumulation of the net taxable income generated by the entity reduced, but not below zero, by distributions to shareholders during the period covered by the S election under Section 1368(e)).
Any amount of the distribution in excess of the lesser of (1) the accumulated adjustments account or (2) the adjusted basis of the stockholder`s stock is taxed to the shareholder as a dividend up to the amount of the earnings and profits of the corporation. Any amount of the distribution remaining after exhaustion of the earnings and profits is applied (as in the case of a corporation having no earnings and profits), first against the shareholder`s remaining basis, and then as gain from the sale or exchange of the stock. Distributions from earnings and profits do not reduce the stock basis. 2
` See I.R.C. § 301(b)(1)(A).
2 See I.R.C. § 1367(a)(2)(A).
Example. X, an S corporation, has earnings and profits of $100,000 and an accumulated adjustments account of $10,000. If X distributes undivided interests in appreciated property worth $50,000 (with a basis of $10,000) pro rata to its four 25 percent shareholders. X recognizes $40,000 of capital gain. The four shareholders each receive a basis in the distributed property of $12,500. Assuming no other gain or loss recognition by X for the year, its accumulated adjustments account is increased from $10,000 to $50,000 and decreased by the $50,000 distribution to net out at $0 at year-end. Because the distribution did not exceed the accumulated adjustments account, the shareholders recognize no gain on the distribution. The basis of each shareholder`s stock, assumed to be $10,000, would be increased by the $10,000 gain passed through to that shareholder and decreased by the $12,500 distribution to arrive at an ending basis of $7,500. On the other hand, if the beginning accumulated adjustments account had been $0, the distribution in excess of such account is $10,000, which would produce dividend income to each shareholder of $2,500. In this event, the decrease to each shareholder`s stock basis resulting from the distribution would be only $10,000, so that the shareholder`s ending basis would be $10,000. Under Section 1366(f), if corporate-level taxes are imposed by Section 1374 or 1375, the $40,000 gain (and accompanying basis adjustment) is reduced by any such taxes.
The Section 1363(d) treatment of a distribution of appreciated Section 38 property effects an early disposition (triggering investment tax credit (ITC) recapture) if it occurs prior to the expiration of the estimated life used in computing the ITC. However, this recapture occurs at the shareholder level only if the Section 38 property was acquired while the corporation was operating under the S election. Section 1371(d)(2) states that the S corporation is liable for the ITC recapture if the Section 38 property was acquired while the corporation was a C corporation. Any ITC recapture occurring at the S corporation level will reduce its accumulated earnings and profits pursuant to Section 1371(d)(3).
Disproportionate distributions to the shareholders also cause concern. Such distributions may indicate that more than one class of stock is involved, which could invalidate the corporation`s S election. Although regulations have not been proposed with respect to the single class of stock requirement, a pattern of discriminatory disproportionate distributions indicates that the corporation has more than one class of stock and each class has different rights with respect to the corporation`s profits and assets.
Section 1363(e) provides that a distribution of appreciated property from an S corporation may be accomplished without gain if it is pursuant to a tax-free spin-off, split-up, or split-off (all divisive reorganizations). However, all requirements related to Section 355 (including the 80 percent control requirement, the five-year active business requirement, the device test, requisite business purpose, and continuity of interest) must be met in order for the transaction to be tax free.
If the transaction is completely tax free, depreciation recapture will not result. Although ITC recapture does not result from a spin-off by an S corporation, recapture is triggered in split-offs and split-ups for shareholders whose interests in Section 38 property are terminated. The IRS has ruled in Revenue Ruling 72-3203 that the momentary control of another corporation by an S corporation pursuant to a divisive reorganization should not terminate the S election in connection with the affiliated group prohibition of Section 1361(b)(2)(A).4
Unlike S corporations, distributions of appreciated property from partnerships typically permit gain deferral with respect to the property. Under Section 731(b), the partnership generally does not recognize gain or loss on a distribution of property (however, Section 751(b) may cause gain recognition for the partnership, as will be discussed later). Furthermore, Section 731(a)(1) provides that gain is recognized by a distributee partner only to the extent that any money distributed exceeds the basis of the partner`s partnership interest.
Accordingly, partners have tax planning opportunities that are unavailable in the S corporation context because partners can defer gain recognition on a distribution of appreciated property. For example, assume the basis in a partnership interest is $10,000 and a distribution of appreciated property valued at $25,000 is made. The distributee defers the gain until subsequent disposition of the property and takes a carryover basis in the property from the partnership (if such basis does not exceed the $10,000 basis of his partnership interest). On the other hand, if $25,000 of cash is distributed to the partner, a gain of $15,000 is recognized by that partner.
3 1972-1 C. B. 270.
4 However, in Haley Bros. Constr. Corp. v. Comm`r, 87 T.C. 498 (1986), the Tax Court cast some doubt on this ruling.
Regulations Section 1.761-1(d) categorizes two types of partnership distributions. A current distribution is any distribution that does not completely liquidate a partner`s interest. A liquidating distribution, on the other hand, is any distribution or a series of distributions that terminates a partner`s entire interest in a partnership. Basis implications vary depending on whether the distribution is a current or a liquidating distribution.
Gain and Basis Implications
In general, any gain recognized by a partner on a distribution under Section 731(a)(1) is capital gain from the sale or exchange of such partner`s partnership interest. However, Section 751(b), discussed later, generally precludes escape from ordinary income treatment on a distribution with respect to the partner`s share of the partnership`s ordinary income assets. Section 735(a) preserves the ordinary income nature of certain unrealized receivables and inventory items on dispositions by a partner after distributions of such property. Also, Section 732(c) prevents tax avoidance with respect to the amount of ordinary income by ensuring that a distributee partner`s basis in these items after a distribution does not exceed the partnership`s basis therein. Under Section 735(b), the distributee partner tacks the partnership`s holding period with respect to any distributed property. Although some commentators have mentioned that the new equivalency of capital gain and ordinary income rates has largely emasculated the need for these provisions, Congress need only reinstate the long-term capital gain deduction to reestablish the importance of the provisions.
In addition, Sections 1245(a)(2) and 1245(d)(6) ensure that, on a subsequent disposition of distributed appreciated property, the distributee will recognize the depreciation recapture accruing during the time that both the partnership and the partner held such property. However, if for some reason the “outside” bases are greater than the “inside” bases of a partnership, depreciation recapture on distributed property may be avoided permanently in liquidating distributions. In this regard, the basis of distributed partnership property, other than unrealized receivables as defined in Sections 751(c)(1) and 751(c)(2) and inventory items defined in Section 751(d)(2), will be increased if the distributee`s basis in the partnership (outside basis) exceeds the partnership`s basis in the distributed property (inside basis). If the basis of the property to the distributee (see discussion under “Distributee`s Basis” later in this article) equals or exceeds its fair market value, the distributee`s disposition of the property at such fair market value will result in either no gain or a loss, thereby avoiding depreciation recapture.5 The operation of this provision is illustrated in Example 2 of the appendix at the end of this article.
Gain recognition on distributions of appreciated property may occur in unforeseen ways. For example, a partner`s basis is adjusted to include a pro rata share of partnership liabilities; and, under Section 752(b), a decrease in a partner`s share of partnership liabilities is considered to be a distribution of money to that partner. Accordingly, a partner may recognize taxable gain on this deemed distribution of money if the allocation of partnership cumulative net taxable loss has reduced the partnership interest basis below the partner`s share of partnership liabilities. In this event, a reduction in the partner`s share of partnership liabilities (e.g., by a distribution of partnership property subject to all partnership liabilities to another partner) constitutes a deemed distribution of money to the first partner. This deemed distribution may be in excess of the partner`s basis and may generate recognizable gain to such partner under Section 731(a)(1). For example, partnership AB distributes a building subject to a $100,000 mortgage to B. If 50 percent partner A`s basis in his partnership interest had been $40,000, A has a $10,000 gain on a $50,000 deemed cash distribution.
With respect to current distributions, Section 732(a)(1) provides that a partner`s basis in distributed property is equal to the partnership`s basis in such property prior to the distribution (hence a carryover, or transferred, basis rule). However, under Section 732(a)(2), the basis of distributed property to the distributee cannot exceed his basis in his partnership interest reduced by any money distributed to him in the same transaction (an exchange, or substituted, basis rule, i.e., basis determined with respect to the distributee`s basis rather than with respect to the distributor`s basis).
5 This results from the fact that, although depreciation recapture is an unrealized receivable under I.R.C. § 751(c) for most purposes, it is not an unrealized receivable for purposes of basis allocation under I.R.C. § 732.
With respect to liquidating distributions, Section 732(b) provides that a distributee partner`s basis in distributed property is equal to his basis in his partnership interest reduced by any money distributed in the transaction (again, a substituted or exchange basis rule). Under Section 733, a distributee partner`s basis in his partnership interest is reduced in both types of distributions by the amount of any money distributed and the amount of the basis in his hands of distributed property other than money.
Example. If the building in the previous example had a $100,000 basis to the partnership, the building`s basis would be $100,000 in 50 percent partner B`s hands if received in a current distribution (assuming B`s partnership-interest basis prior to the distribution was $100,000). The basis of B`s partnership interest is increased pursuant to Section 752(a) from $100,000 to $200,000 by assumption of partnership liabilities and reduced under Section 733 by (1) $50,000 (the reduction in B`s share of partnership liabilities) pursuant to Section 752(b) and (2) the $100,000 basis of the building distributed to B. Thus, the remaining basis in B`s partnership interest is $50,000. If a liquidating distribution of the building subject to the liability were made to B, the building takes a substituted basis of $150,000 in B`s hands under Section 732(b) (i.e., $200,000 basis in partnership interest after adjustment for liabilities assumed less $50,000 deemed distribution of money).
ITC Recapture Implications
Although a detailed inquiry into this issue is not possible here, a distribution of Section 38 property likely will cause ITC recapture to some if not all partners. ITC is computed at the partner (not the partnership) level, and regulations under Section 47 provide that a partner will recapture ITC to the extent of the reduction of his interest in the qualified investment of Section 38 property. Such recapture will occur upon a reduction of his interest below 662/3 percent of what it was when the ITC was taken. Thus, all nondistributee partners must recapture ITC when Section 38 property is distributed before the five-year vesting period has passed. In addition, the distributee partner will have ITC recapture on the Section 38 property if his basis therein is determined under a substituted basis rule because Regulations Section 1.47-3(f)(1)(ii) regarding the “mere change in form” exception to ITC recapture requires a carryover basis in this context.6
6 See Siller Bros. v. Comm`r, 89 T.C. 256 (1987).
Section 734(b) Implications
Although it is beyond the scope of this article, practitioners should be aware of the often complex effects of a Section 754 election, which may be made by a partnership for any taxable year on its tax return filed for such year. Once made, the election is effective for all subsequent taxable years until it is terminated.
If the election is in effect, Section 734(b) provides that, on any distribution of property to a partner, the partnership`s basis in remaining property is increased by (1) gain recognized by the distributee and (2) any excess of the partnership`s basis in the distributed property over its basis to the distributee, and is decreased by (3) any loss recognized by the distributee and (4) any excess of the distributee`s basis in the distributed property over its basis to the partnership prior to the distribution. A simple application of this provision is illustrated in Example 2 of the appendix at the end of this article.
Section 751(b) Implications
Section 751 (b) provides that a distribution of “Section 751 property” to a partner in exchange for any part of his interest in the partnership`s non-Section 751 property or a distribution of non Section 751 property in exchange for any part of a partner`s interest in the partnership`s “Section 751 property” is treated as a sale of exchange of such property between the partnership and the partner. “Section 751 property” consists of “unrealized receivables” and “substantially appreciated inventory” of the partnership.
Section 751(c) defines “unrealized receivables” to include (1) any rights to payment (to the extent not previously includable in taxable income) for services rendered or goods delivered (to the extent that income therefrom would be ordinary) and (2) for the limited purposes of partnership distributions and sales or exchanges of partnership interests, potential depreciation recapture income under Sections 1245 and 1250, among other items. Section 751(d) defines “substantially appreciated inventory” as inventory having a fair market value (1) exceeding 120 percent of the partnership`s basis therein and (2) exceeding 10 percent of the fair market value of all partnership property other than money. Regulations Section 1.7511(e) defines “other property” as all non-Section 751 property. Thus, the provision divides all partnership property into two classes: Section 751 property and other property.
Section 751(b) is based on an aggregate theory that each partner has an undivided interest in the value of all Section 751 property and in the value of all other property.7 A distribution must change the proportionate interest of the distributee partner in the value of Section 751(b) property in order to cause sale or exchange treatment.
Regulations Section 1.751-1(b)(1)(iii) provides that any distribution invoking Section 751(b) is analyzed in two parts: (1) the part treated as a sale or exchange of Section 751 property and (2) the part not treated as such sale or exchange, in which case the normal rules governing partnership distributions (Sections 731 through 736) apply. In addition, Section 751(b) covers two types of distributions: (1) those where the distributee receives greater than his share of the partnership`s Section 751 property in exchange for any part of his interest in the partnership`s other property and (2) distributions where the distributee receives greater than his share of the partnership`s other property in exchange for any part of his interest in the partnership`s Section 751 property.8
Both the distributee partner and the partnership can recognize taxable gain or loss in these distributions. The partnership will recognize gain or loss if its property involved in the deemed exchange of Section 751 property has unrealized appreciation or depreciation. The examples in the appendix at the end of this article illustrate these points.
Although the illustrations in the appendix at the end of this article may seem involved, a review of the examples in Regulations Section 1.751-1(g), which contain facts only slightly more complex than those in the appendix, indicates that Section 751(b) is exceedingly complicated and fraught with pitfalls. Even the regulations` examples are oversimplified relative to real life scenarios. For example, in some cases a deemed distribution of money resulting from a reduction in a partner`s share of partnership liabilities under Section 752 might cause tax problems under Section 751(b).9
Further, if several assets are involved in a partnership having Section 751(b) transactions, a written agreement may be necessary between the parties to specify the details of the deemed exchanges in order to give certainty to the amount and character of taxable gains and losses.
7 See Reg. § 1.751-1(b)(1)(iii).
8 See Reg. §§ 1.751-1(b)(2), 1.751-1(b)(3).
9 See Rev. Rul. 84-102, 1984-2 C.B. 119.
Some tax planning opportunities are available with respect to Section 751(b). The section does not cause taxable income on a distribution of a partner`s pro rata share of the value of Section 751 property. Accordingly, income may be shifted by distributing to a partner low basis Section 751 property with high gain potential.
A distribution of Section 751 property to the partner who originally contributed such property to the partnership, even if the distribution is disproportionate, is exempt from Section 751(b). If the partnership and a retiring distributee contract that the payments made in liquidation of the distributee`s partnership interest are taxed as ordinary income under Section 736(a), then Section 751(b) is inapplicable. Moreover, Regulations Section 1.751-1(b)(1)(ii) provides that Section 751(b) does not apply if the distribution is a mere advance against a partner`s share of partnership income, a gift, or a payment for services or for the use of capital. In these cases, the distributee partner`s share of Section 751 property is unaffected.
TRA `86 has ushered in a new era with respect to the choice of entity for business enterprises. Among the advantages and disadvantages considered when selecting between the S corporation and the partnership form, practitioners must give careful attention to the subtle and often complex tax differences between the entities. With respect to one such tax difference, the timing of gain recognition on distributions of appreciated property, the partnership form generally permits gain deferral while the S corporation form does not. Nevertheless, circumspect analysis of partnership distributions is necessary to assure that Section 751(b) does not cause unexpected tax results for clients.
Assume a partnership with the following tax balance sheet:
Cash $ 60,000 $ 60,000
Section 1245 property 60,000 90,000
A $ 40,000 $ 50,000
B 40,000 50,000
C 40,000 50,000
The “recomputed basis” (i.e., existing basis plus prior depreciation deductions) of the Section 1245 property is at least $90,000, so that the unrealized appreciation of such property is potential depreciation recapture income. Accordingly, the partnership is treated as having Section 751 property of $30,000 with a basis of $0.
Example 1. In complete liquidation of his partnership interest, partner C receives a distribution of appreciated Section 1245 property worth $50,000 with a basis to the partnership of $20,000. The distribution consists of two parts: first, the part treated as a sale or exchange of Section 751 property (i.e., the $20,000 in value of Section 751 property in excess of C`s one-third share), and second, the part not treated as a sale or exchange.
With respect to the first part of the distribution, C is deemed to receive his share ($20,000) of the partnership`s cash, with which he purchases the $20,000 of Section 751 property (i.e., unrealized appreciation of property representing depreciation recapture potential) that he actually receives in excess of his one-third share thereof. The $20,000 deemed cash distribution reduces the basis of C`s partnership interest from $40,000 to $20,000, which becomes C`s basis in the $30,000 of other property distributed under the exchange basis rule of Section 732(b).
Accordingly, after the dust settles, C`s basis in the $50,000 of Section 1245 property received is $40,000, resulting from the $20,000 basis obtained in the deemed acquisition (see Section 1012) and the $20,000 basis resulting under Section 732(b). C retains the remaining $10,000 depreciation recapture potential in the unrealized appreciation of the distributed Section 1245 property (see Regulations Section 1.1245-4(f)(3), Example 2).
The partnership realizes $20,000 ordinary income as a result of the Section 751 property deemed sold to C for his share of $20,000 cash retained by the partnership. The ordinary income is allocated only to A and B.
Example 2. Assume the same facts as in Example 1 except the partnership has $60,000 of land (with a basis of $30,000) instead of $60,000 cash. Assume also that C`s basis in the partnership is still $40,000. The tax consequences are as follows. With respect to the first part of the distribution, C is deemed to receive in a current distribution his share of the partnership`s land, valued at $20,000 with a basis of $10,000. C is deemed to exchange such land with the partnership for the $20,000 Section 751 property actually received.
C recognizes $10,000 of capital gain from the exchange of the capital asset (or Section 1231 property, depending on its character) (see Regulations Section 1.751-1(b)(2)(iii)) and obtains a basis of $20,000 in the Section 1245 property deemed purchased. C`s $40,000 basis is reduced to $30,000 by the $10,000 basis in the land deemed distributed. The $30,000 of other property ($20,000 basis to the partnership) distributed to C receives a basis allocation in his hands of $30,000 under the substituted basis rule of Section 732(b). Therefore, C permanently avoids his share of the $10,000 depreciation recapture potential inherent in such property because outside bases were greater than the partnership`s inside bases.
As in Example 1, the partnership has $20,000 ordinary income on the deemed exchange of Section 751 property. The partnership receives a $10,000 increase in the basis of the land deemed acquired in such exchange. As noted in Regulations Section 1.751-1(g), Example 2(e)(1), this basis adjustment occurs under Section 1012 and not by virtue of a partnership Section 754 election.
Because of C`s $10,000 basis increase in other property in the part of the distribution not treated as a deemed exchange, Section 734(b)(2)(B) requires the partnership to reduce the basis of its remaining Section 1245 property if the Section 754 election is in effect. Nevertheless, this basis reduction cannot be made at the time of the distribution because the complex basis allocation rules of Section 755 and regulations thereunder do not permit it. The partnership cannot make the basis reduction until it obtains capital assets or depreciable property with a tax basis greater than its fair market value (see Regulations Sections 1.755-1(a)(1)(iii), 1.755-1(b)(3), and 1.755-1(b)(4)). If the Section 754 election is not in effect, no basis adjustment by the partnership is made.