WEEK 1 -9/1/16

I.

INTRODUCTION
A.

Materials

Fundamentals of Pshp Taxation

(9th ed) Foundation Press Schwartz & Lathrope

IRC and Regs regarding Subchapter K

Pshp Income Taxation - OPTIONAL

(5th ed) Foundation Press Lyons & Repetti

B.

Who I Am

C.

Format of the Class

D.

Lecture / Examples

Review homework - I will call on you as I expect you to have done the homework -

What it takes to Learn - Change from Have to - Want to

Syllabus
1.

Objectives of the Class

Recognize issues

Establish the facts

Apply the facts to the law

Conclusion

to read and understand primary and secondary sources of tax law and
interpretation of tax

Brief A Case
!
!
!
!
!
!

Name of Case [what court/year]

Facts
Issue
Procedure
Law [holding]
Rationale

2.

Tests

II.

Midterm
Final
Class Participation
I can and have thrown out Midterm grade if substantial improvement

OVERVIEW
A.

B.

C.

Forms of Business Organization

Sole Proprietorship - owned and operated by a sole individual and reports income
on schedule C of individual income tax return

Corporation - fictitious legal entity offers limited liability to its owners. File a
corporate tax returns and subject to corporate tax.

Partnership - Can either be GP or LP which consist of 2 or more individuals or

entities engaged in business for a profit. File a pshp tax return but income and
deductions flow through to partners

LLC - limited liability to its members. If no election to the contrary and more than
one member, filed as a partnership for tax purposes . If single member, and no
election to the contrary, filed as a Schedule C

Conceptual Taxation Models

Aggregate concept - treats assets of a business as owned directly by its owners who
are responsible for their share of the income, deductions, and liabilities

Entity concept - treats a business organization as a taxable entity that is separate and
apart from its owners

Hybrid Concepts - treating an organization as an entity for some purposes and an

aggregate for others

Overview of Taxing Regimes

Subchapter C
Entity approach by treating corporations as separate taxable entities and provide
rules governing transactions between corporations and their shareholders

Subchapter K
Applies a hybrid approach to partnerships and their partners. Pshps do not pay
taxes but pass through their income and deductions to the ptrs. A pshp is treated as

-2-

an accounting entity for purposes of determining its income and filing of returns.
However, some issues are passed through and determined at ptr level.

Subchapter S
Hybrid model governing the treatment of eligible corps that make an election. Pass
through entity that generally is not subject to tax.

D.

E.

Influential Policies

The Double Tax regime of Subchpt C increases the cost of operating a business as
a C Corp. And often provides an incentive for txprs to choose pshps or S Corps. For
business activities

Rate Structure - for most of our tax history, the maximum individual rate has
exceeded the corporate rate. Now, the max indiv rate is the same as the top corp.
rate. Many closely held bus. May prefer to operate as pshp, LLC, or S Corp to
avoid double tax.

Preferential Capital Gains Rate - whenever there is significant capital gains rate
preference, taxpayers are motivated to devise strategies to convert ordinary income
into capital gains such as bailing out C Corp. Profits [ 306). However, bailout
strategy has diminished, as most dividends are taxed at the same preferential rate
as capital gains.

Non-recognition - many corporate and pshp transactions qualify for non-recognition

treatment because they are regarded as mere changes in form which result in a
continuity of investment

Pervasive Judicial Doctrines

Substance Over Form - the Supreme Court has admonished that the tax
consequences of most transactions should be determined by economic substance
rather than the form. FOLLOW THE MONEY

Step Transaction - separate formal steps are combined into a single integrated
transaction for tax purposes. Huge disagreement, when to apply and how to apply.

Business Purpose - a transaction may be denied certain tax benefits, if it is not

motivated by a business purpose apart from tax avoidance. IN PLAY TODAY IN
THE CORP. SHELTER ARENA. Now codified.

Sham Transaction - a transaction that never actually occured or is devoid of

substance. Not respected for tax purposes.

-3-

III.

Pshp Balance Sheet

At inception, A contributes securities with basis of $40,000 and FMV of $60,000 to pshp ABC. B
contributes land to ABC w/ basis of $30,000 and FMV of $30,000. C contributes $10,000. Ptrs
share profits 60%, 30%, 10%, respectively.
The balance sheet looks as follows:
Assets
Cash
Securities
Land

AB
$10,000
$40,000
$30,000

BV
$ 10,000
$ 60,000
$ 30,000

$80,000

$100,000

Liab + Ptr Capital

AB
Liab A
$40,000
B
$30,000
C
$10,000
$80,000

BV
$ 60,000
$ 30,000
$ 10,000
$100,000

Year 1
Profit in year 1 is equal to $10,000. Profits allocated according to profits percentage and as A, B &
C will owe tax, it will increase each of their outside bases.
Assets
Cash
Securities
Land

AB
$20,000
$40,000
$30,000

BV
$ 20,000
$ 60,000
$ 30,000

$90,000

$110,000

Liab + Ptr Capital

AB
Liab A
$46,000
B
$33,000
C
$11,000
$90,000

BV
$ 66,000
$ 33,000
$ 11,000
$110,000

Also, in year 1 pshp sells land for $40,000 or a profit of $10,000 [$40,000 - $30,000]. Profits
allocated to profits % and again increasing their respective outside bases.
Assets
Cash
Securities

IV.

AB
$ 60,000
$ 40,000

BV
$ 60,000
$ 60,000

$100,000

$120,000

Liab + Ptr Capital

AB
Liab A
$ 52,000
B
$ 36,000
C
$ 12,000
$100,000

CLASSIFICATION OF ENTITY
A.

Impact of Classification

C Corporations subject to double taxation / return filed

-4-

BV
$ 72,000
$ 36,000
$ 12,000
$120,000

B.

C.

V.

Pshp passed through to ptrs / return still filed w/ tax elections

Normally, IRS respects entity

Role of State Law

classification for tax purposes is a matter of federal law [Supremacy Clause]

Thus, classification under state law will not control

Principal Classification Issues

Determining whether a separate entity exists for tax purposes, and

determining whether an entity with more than one owner should be classified as a
corporation or pshp, or whether a single owner entity should be disregarded for
federal tax purposes

EXISTENCE OF A SEPARATE ENTITY

A.

B.

In General

In general, regulations provide a contractual arrangement may create a separate

entity for federal tax purposes if the participants carry on a trade, business, financial
operation, or venture and divide the profits therefrom. 301.7701-1(a)(2)

The regulations definition of a separate entity for federal tax purposes is derived
from 761(a) and case law.

The Supreme Court held that a critical factor in determining whether a partnership
exists is whether the parties in good faith and acting with a business purpose
intended to join together in the present to conduct an enterprise. Commr v.
Culbertson, 337 U.S. 733, 742 (1949)

The critical factor is whether the parties have a joint profit motive

Joint Profit Motive

Sometimes difficult to determine

Allison v. Comm., 35 T.C.M. 1069 (1976)

FACTS:

Acceptance [A], a licenced property loan broker, agreed to

arrange for a loan with Sierra National bank and separately loan
$53,000 to aid in the purchase and subdivision of real property
known as Goose Lake Property. In exchange for those services, A
received 75 of the subdivided lots free and clear of any

-5-

encumbrances, which it sold in the subsequent year. The

arrangement between A and the developer was labeled as a joint
venture and A took the position that the lots were a tax-free
partnership distribution.
PROC:

IRS audited and issued a SNOD claiming A incurred ordinary

income for financial services rendered. A filed a Tax Court
Petition.

ISSUE:

Was there a joint venture [combination of 2 or more to join to

make a profit and not a pshp designation], thus, a partnership for
tax purposes?

HOLDING:

No, deficiency upheld as respondent was correct. The Agreement

appears to be 75 lots for services rendered and not an agreement to
share profits.

RATIONALE: Although an agreement entitled Joint Venture Agreement, there

was not a joint profit motive as parties did not contemplate
subsequent joint sale of lots or a procedure of dividing the
possible profits. Also, partnership books were not kept and
partnership returns not filed which is an admission against
interest.

C.

Separate Entity v. Co-ownership

1.

In General

The regulations provide that mere co-ownership of property which is

maintained, kept in repair, and rented or leased does not constitute a
separate entity for tax purposes 301.7701-1(a)(2). HOWEVER, if they
purchase the parcel to subdivide and develop the parcel with the intention
of selling lots, a separate entity does exist because they are actively
carrying on a business and dividing a joint profit.

Podell v. Comm, 53 TC 429 (1970)

FACTS:

Podell entered into an oral agreement w/ Young for the

purchase, renovation, and sale of certain real estate.
Profits and losses to be shared equally and was shared
equally.

PROC:

Podell reported sales as sale and exchange of capital

assets. IRS audited and issued a SNOD claiming sales
were ordinary as not sale & exchange of capital asset as
parties established a partnership for the purposes of
purchasing, renovating, and selling real estate in the

-6-

ordinary course of business.

ISSUE:

Whether a partnership was created, and as such, was the

sale from an asset other than a capital asset?

HOLDING:

Yes, held for Respondent as agreement gave rise to a joint

venture.

RATIONALE: The agreement gave rise to a joint venture, and as such a

partnership under 761. The elements are: (i) A contract
disclosing a business venture [express or implied]; (ii) an
agreement for joint control and proprietorship; (iii) a
contribution of $ or property, or services; and (iv) a
sharing of profits. It did not matter that Podell did not
exercise as much managerial control over day-to-day
activities.
NOTE:

2.

4.

In the area of property rental, a separate entity exists if co-owners lease

space and in addition provide non-customary tenant services to the tenants
[utilities, maintenance, unattended parking, trash removal are deemed
customary services and attendant parking, cabanas, other utilities are
deemed non-customary services]. Rev. Rul 75-374.

Fractional Interests in Rental Real Property

3.

Even if the Court had concluded there was not a

partnership, it would appear that the sales were still
ordinary income because real estate constituted property
primarily for sale to customers under 1221(a)(1)

IRS has specified the conditions under which it will rule on whether an
undivided fractional interest in rental real property is or is not an interest
in a business entity. Rev. Proc 2002-22. The decision may have
significance if the disposition is intended to qualify as a 1031 exchange as
prop held as TIC qualify while exchanges of pshp interests do not.

Section 761(a) Election

permits an unincorporated organization to elect to be excluded from

Subchptr K if it is availed of (1) for investment purposes only [not active
business], (2) for the joint production of income but no selling of services
or products, (3) by dealers in securities for the purpose of selling or
distributing securities.

in each case, participants must be able to adequately compute their income

Separate Entity v. Expense Sharing

-7-

VI.

as entity depends on joint profit motive, regulations provide expense

sharing is not a pshp. 301.7701-1(a)(2)

Ex. CPA #1 and CPA#2 agree to share office and support expenses but
each will retain her own clients, there is no partnership

CLASSIFICATION OF BUSINESS ENTITIES

A.

B.

Introduction

defines corporation as including associations, joint stock companies, and insurance

companies 7701(a)(3).

associations have been defined in terms of their corporate characteristics such as (1)
continuity of life, (2) centralization of management, (3) limited liability of
investors, and (4) free transferability of interests see Morrisey v. Comm, 296 U.S.
344 (1935)

history includes professionals were not allowed corporate status under state law, yet
wanted corporate tax benefits [qualified fringe benefits and retirement plans]

also, in late 1970s, taxpayers wanted partnership status with respect to tax shelter
investments because of pass through of losses

The pre-1997 regulations set forth 6 characteristics of a corporation: (1) associates,

(2) objective to carry on business and divide profits, (3) continuity of life, (4)
centralization of management, (5) limited liability to corporate assets, and (6) free
transferability of interests

In 1996, the Treasury concluded that state law developments [LLCs, LLPs] had
blurred the classic distinctions between corporations and unincorporated entities,
thus the check-the-box regulations

Check-The-Box Regs

incorporated entities are automatically corporations for tax purposes 301.77011(b)(1)

entity taxable as a corporation under other provision of the IRC [e.g. publicly traded
corp.] classified as corporation for tax purposes 301.7701-2(b)(7)

entity with 2 or more members that is not classified as corporation, is classified as

a pshp unless an election is made to be classified as corporation. 301.7701-2(c)(1)

entity with only 1 owner that is not automatically classified as a corporation, is

disregarded for tax purposes unless an election is made to be classified as a
corporation for tax purposes [i.e. sole proprietorship]. 301.7701-2(a)

-8-

C.

D.

VI.

entity that is solely owned by husband and wife as community property may be
treated by the owners as disregarded entity or pshp unless elects to be treated as
corporation. Rev. Rul. 2002-69

Election effective up to 75 days before or 12 months after it is filed. 301.77013(c)(1)(iii). Election must be signed by each member of the entity or an officer
authorized to make the election.

Once election made, cannot change for 60 months unless IRS permits and 50% of
entitys ownership are owned by persons who did not own any interests when first
election was made. 301.7701-3(b)(3)(i)

Publicly Trade Pshps

pshp whose interests are traded on an established securities market or are readily
tradeable on a secondary market 7704(a). Treated as corporation for tax purposes

Exception if 90% or more of gross income consists of passive investment income

7704(c)

Trusts

arrangements created by will or inter vivos declaration under which trustee takes
title to property in order to protect or conserve it for beneficiaries - ORDINARY
TRUST

arrangements to carry on a profit-making business rather than the protection and

conservation of property - BUSINESS TRUSTS

If business objective is present, it will be classified as a partnership for tax purposes

unless an election to treat as corporation. 301.7701-4(b)

CHOICE OF ENTITY CONSIDERATIONS

currently, the highest marginal individual rate is a bit higher that the top corporate rate
[39.6% v 35% as of 1/1/13]. In any case, there remains an incentive for a tax regime with
a single level of tax [Subchptr K or S]

However, S corporations are subject to various restrictions as to ownership [no more than
100 shareholders and 1 class of stock] and not very flexible

While Subchptr K is more flexible [thus, generally preferred], but liability exposure

LLCs with more than one member will be taxed as a partnership unless election. As limited
liability, they are very popular [best of both worlds]

-9-

However, some states [not Illinois], LLCs are taxed as corporations, or maybe because
owner wants to minimize employment taxes including investment tax, may make an S
corporation more desirable

VII. REVIEW HYPOS

(A)

X and Y agree to build an irrigation system to drain surface water from their properties. Are
X and Y partners?
Answer:

(B)

If A and B form a limited liability company or limited partnership to conduct their joint
venture, how will the entity be classified for federal tax purposes? What if A forms a single
member LLC to operate a business?
Answer:

(C)

301.7701-1(a)(3) states that a joint undertaking merely to share expenses

does not create a separate entity for tax purposes. This is consistent with
Allison v. Comm.

Would the answer to (C) change if A and B filed partnership returns?

Answer:

(E)

The entity will be classified as a Pshp unless elect otherwise. If LLC, it

will be a disregarded entity (Schedule C) unless elect otherwise.

A and B both drive taxi cabs in Chicago during off season to supplement their baseball
salaries. Several years ago they decided to jointly rent a car and a medallion. They each
drive for 12 hours [A from noon to midnight and B from midnight to noon] and assume 50%
of all expenses with the car. They each take home their respective gross earnings and do not
commingle funds. They report for tax purposes their separate income and deductions. Is
this an eligible entity?
Answer:

(D)

No a joint undertaking merely to share expenses is not a separate entity for

federal tax purposes and X and Y will not be partners. 301.7701-1(a)(2)

It would give more support. However, the mere filing of partnership returns
would not preclude the IRS from asserting the arrangement does not
constitute an entity. See Demkowicz v. Comm, 34 TCM 1201 (1975).
Thus, this arrangement probably still does not qualify.

What if A and B deposit their earning in a joint account from which the business expenses
are paid and after expenses, divide profits 50-50?
Answer:

Now ok as carrying on a business with a joint profit motive. Other factors

would be a sharing of losses, ownership of capital, participation in
management, performance of substantial services, use of joint names in
conduct of business, maintenance of separate books, existence of written
agreement, and filing of pshp returns. See Luna v. Comm, 42 TC 1067
(1964)

-10-

(F)

Quintana [Q] and Sale [S] want to buy a race car. S races cars in his spare time and Q
accounts for the prize money and time records. They negotiated a fixed price of $1M with
a dealer for a quality racing machine. Under the contract, the amount and timing of the
principal payments are based upon Ss prize earnings. S and Q agree to pay the dealer 10%
of the profits S earns from racing after reduction for car maintenance each year for 10 years
or until principal is paid, whichever is sooner. All of the principal is due in the 10th year if
not already paid and unpaid principal bears adequate interest. Is this an entity with the
dealer?
Answer:

(G)

Would the answer to (F) change if instead of a $1M purchase price, the parties agree that
S and Q will pay the dealer 10% of the profits for 10 years and after 10 years, S and Q get
title free and clear?
Answer:

(H)

This distinguishes between a lender-borrower and entity separate from its

owners. Probably P treated as a lender because $1M is payable in all
events and unpaid principal bears interest.

Does the answer to (H) change if S and Q agree to pay P $100,000 a year for 10 years and
instead of agreeing to a fixed interest rate, they agree to pay P .05% of the gross earnings
every year for 10 years?
Answer:

(J)

Now, there is no fixed price for car. Because the dealers share is
determined after taking costs into account, dealer is subject to
contingencies with respect to revenues and expenses. Thus, probably an
entity. Alternatively, could be viewed as an installment sale.

What if S and Q borrow the $1M from Paulie [P] to buy the race car from the dealer and
parties agree that P is entitled to 10% of Ss prize money after costs for 10 years or until
$1M principal is paid, whichever is sooner. Assume unpaid principal bears interest and at
the end of the 10th year, S and Q remain liable for any unpaid principal. Now, is this an
entity?
Answer:

(I)

This distinguishes between purchaser-seller relshp and entity separate from

its owners. Probably not an entity separate from its owners, as S and Q, no
matter what, must pay dealer the principal and interest. Thus, there is no
joint profit motive and the only contingency is the timing of the payments,
not the amount.

Close call but probably be treated as lender-borrower as no other

indications the parties intended to create a separate entity. However,
interest is based solely on Ss prize winnings. In the end, because based on
gross earnings as opposed to net earnings, probably not a separate entity.

Assume that S and Q purchase the car with cash and agree to pay Abreau [A], a star
mechanic from California, 10% of gross earnings in exchange for As mechanical services.
Is this an a separate entity?

-11-

Answer:

Generally an employee/independent contractor is not treated as a member

of an entity merely because compensation based upon entitys gross profits.
No participation in management, no capital interest are probably fatal. See
Friednash v. Comm., 209 F.2d 601 (9th Cir. 1954)

-12-