Tax Saving Opportunities for Partnerships, Limited Liability Companies, and S Corporations
Partnerships
Regulations governing the allocation of partnership income and loss can sometimes lead to unanticipated results. The allocation of losses may be particularly sensitive to routine changes in partnership liabilities. Even if these changes do not affect allocations, they may trigger income to the partners in certain circumstances. Contributions, distributions, and interest transfers can also present income recognition issues. Many of these issues depend on the position of the partnership at the end of its taxable year. Therefore, unforeseen tax consequences can often be mitigated with year-end planning. For example, the implementation of loan guarantees or indemnification agreements can sometimes prevent tax problems related to partnership liabilities.
A partnership must generally file its federal income tax return by the 15th day of the fourth month following the end of its taxable year, but an automatic extension is available upon request. Until 2009, the due date for a partnership return could have been automatically extended for six months, so that a calendar-year partnership could file its return as late as October 15. For tax returns due after December 31, 2008, however, the Service will automatically grant partnerships an extension of only five months. As a result, the due date of a partnership return for the year ending December 31, 2010, can now be extended only until September 15, 2011. These changes also affect the due dates for the returns of estates and trusts.
The reason for the change was to ensure that partners will receive their Schedules K-1 in time to accurately report their share of partnership income by the extended due dates of their returns. Thus, while the change imposes a burden on partnerships that will have less time for gathering and processing year-end accounting information, it may also make it easier for partners to file complete and accurate returns on a timely basis.
Limited Liability Companies
Generally, the same federal tax rules that apply to a partnership also apply to a two-or-more member limited liability company (“LLC”) that is properly classified as a partnership, rather than a corporation, under applicable income tax regulations. Under these same regulations, a single-member LLC owned by an individual can choose to be classified either as a disregarded entity, i.e., sole proprietorship (Schedule C business), or as a corporation, and a single-member LLC owned by a corporation can choose to be classified as a disregarded entity, i.e., part of its corporate owner or a division, or as a separate corporate subsidiary.
S Corporations
With individual income tax rates equal to or close to corporate tax rates, now may be the time to consider making an S corporation election for your regular corporate business, if eligible. Shareholders of existing S corporations should consider the following year-end planning tips:
Shareholders must have basis in their stock or in loans to the corporation in order to take advantage of anticipated losses. Basis may be increased by additional capital contributions or direct shareholder loans to the corporation.
If the corporation has earnings and profits (“E&P”) on hand which were accumulated during the time it was a regular corporation, any additional investments in the corporation by the shareholders should be made as loans, rather than as capital contributions, to avoid taxable dividends if these investments are later returned to the shareholders. Shareholder loans should always be well documented.
After a shareholder’s basis in stock of an S corporation has been reduced to zero, the shareholder’s basis in a loan to the corporation is reduced by pass-through losses and increased by the pass-through of subsequent years’ income. Because loan repayments may produce taxable income for the shareholder, they should be timed, if possible, to result in the least amount of tax. Advances should be evidenced by a note to obtain favorable capital gain treatment if gain will result when the loan is repaid. Delaying loan repayments beyond 12 months (for long-term capital gain treatment) will allow any gain to be taxed at the lower (15 percent) capital gains tax rate.
Distributions to shareholders which exceed the corporation’s accumulated adjustments account (“AAA”) may result in inadvertent dividends if the corporation has E&P accumulated from the time it was a C corporation. Therefore, distributions should be delayed if the amount of the AAA balance at year-end is uncertain.
Until December 31, 2012, dividends received by non-corporate shareholders from domestic and qualified foreign corporations are taxed at a maximum 15-percent rate. (This expiration date was extended for two years by the 2010 Tax Relief Act.) Accordingly, S corporations with C corporation E&P may wish to consider making an actual or a deemed dividend distribution of this E&P, which would be taxed to its shareholders at the present maximum 15-percent dividend rate.
Consider making gifts of S corporation stock to shift income between family members. Gifts of nonvoting stock may be made to keep voting control, if desired.
Under certain conditions, an S corporation that sells appreciated property will be subject to tax on “built-in gains” (generally the property’s appreciation prior to the corporation becoming an S corporation). A built-in gain is determined as follows:
If an S corporation has sold property and recognized built-in gains, it should consider offsetting these gains by recognizing built-in losses. Alternatively, the built-in gains tax may be deferred or, in some circumstances, eliminated if the corporation’s taxable income can be eliminated.
Recent changes have temporarily suspended the application of the built-in gains tax for certain S corporations that converted from C corporation status several years ago. For taxable years beginning in 2009 or 2010, the tax will not be imposed if the S corporation has completed seven taxable years of its “recognition period” before the year of the sale or other disposition of the built-in gain asset. For the first taxable year beginning in 2011, the tax will not be imposed if the S corporation has completed five years (60 months) of the recognition period before the beginning of the 2011 taxable year.
Other changes have made more corporations eligible to become S corporations. For instance, financial institutions not using the reserve method of accounting can become S corporations; S corporations can have up to 100 shareholders and in determining the number of shareholders, extended family groups can be treated as a single shareholder; certain tax-exempt organizations can be shareholders; S corporations can hold controlling interests in other corporations; and wholly-owned domestic subsidiaries of S corporations can be disregarded as entities separate from their parent S corporations if an election is made by the S corporation.
In addition, income allocable to an employee stock ownership plan (“ESOP”) as a shareholder of an S corporation is not currently taxed, but rather is taxed to the ESOP beneficiary at the time of distribution.
Note: The American Jobs Creation Act of 2004 and the Small Business and Work Opportunity Tax Act of 2007 made several liberalizing changes with respect to S corporations. For more information, please refer to our November 2004 and May 2007 Washington Tax Reports available at www.bdo.com/publications/tax/wash/WashTaxReport11-04-6.pdf and www.bdo.com/publications/tax/wash/WTRSmallBus5-07-2.pdf.
Caution: Estimated taxes must be paid on net recognized built-in gains. (These estimates cannot be based on the preceding year’s tax, if any.)