REG - Notes Chapter 4

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Partnership Taxation
Formation
• No g/l is recognized on a contribution of property to a P/S in return for P/S interest
• Exceptions
- The value of P/S interest acquired for services is ordinary income to the partner
- Property contributed subject to excess liability, the excess amount is taxable boot as a gain to the
partner

Initial basis of contributing partners interest

• Cash – amount contributed
• Property – adjusted basis (NBV)
• <Liabilities> - put in by partner and is assumed by other partners which reduced their basis
• Services – FMV and taxable to partner
• Liabilities – other partner’s put in, and is assumed by incoming partner

A partner’s holding period for his P/S interest includes the holding period of the property contributed if the
property was a capital asset or section 1231 asset in the hands of the partner

When a partner contributes property, the built in gain or loss with respect to the contributed property when sold
must be allocated to the contributing partner

Partner basis formula

Beginning capital account [Cash + FMV services + NBV of assets]
+ % of all income
- % of all losses [Partner may take a P/S loss as a deduction up to their basis]
- Withdrawals [Property distribution reduce by NBV up to 0 in capital account]
= Ending capital account
+ % recourse liabilities [Your share of liabilities]
= Year end basis

Basis and capital account are different

Basis = Capital account + partners share of liabilities

When a P/S terminates

• Operations cease
• 50% or more of the total P/S interest in both capital and profits is sold or exchanges within any 1 yr period
• There are less than two partners

Transactions between the partner and the P/S

• Related party loss (WRaP) is not allowed
• Related party gain is ordinary income

A partner must include his distributive share of P/S income, even if not received, in his tax return for his
taxable year

Event Tax consequence Basis Impact

Income Taxable Increase
Withdrawals Non-taxable Decrease

Tax losses limited to basis (“at risk”), unused losses can be carryforward until basis becomes available

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Guaranteed Payments – like salary to partners
• For the P/S, it’s a tax deduction
• For the partner, its taxable as ordinary income (may also be included as part of self employment earnings)

Tax elections
• Most elections that affect the calculation of taxable income (depreciation, LIFO) are made by the P/S

Organizational expenditures and start-up costs

• Same as before
• Tax – expense $5,000, amortize excess over 180 months
• GAAP rule – expense all

Syndication cost, costs or raising capital are not deductible

When a P/S transfers capital or profits to a creditor to satisfy debts, the cancellation of debt is recognized as
income by the P/S

Individual partners report net income/loss on schedule E, and each partner get their own K-1

Non-liquidating distributions = withdrawals

• Generally non-taxable
• The distribution reduces basis, if property, by the NBV
• Reduction in basis is limited to P/S basis, can’t go below zero

Liquidating distributions – not sure what I need to know (R4-18)

Withdrawal Basis used Stopping point

Non-liquidating NBV asset taken Stop at Zero
Liquidating P/S interest Must “zero out” account

Sale of P/S interest (liquidation)

• G/l on transfer treated as capital g/l
• Exception: hot assets sold for cash are treated as ordinary income. Hot assets are:
- Unrealized receivables
- Appreciated inventory

Retirement or death of partner

• Payments for the interest in P/S assets result in capital gain/loss to the deceased partner

Estate, Trust and Gift Taxation

Unified estate and gift tax (transfer tax)
• Cumulative lifetime gifts – gifts under 12,000 per person per year are tax free
• Death time transfers – the credit for lifetime gifts ($345,800) exempts the first 1 million of lifetime transfers

Income taxation rules for estates and trusts

Distributable net income (DNI) formula
Estate/trust gross income [includes capital gains]
- estate/trust deductions
= adjusted total income [Form 1041, line 17]
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+ tax exempt income
- capital gains [attributable to corpus]
= Distributable Net Income (DNI)

Contributions to a charity are deductible (an unlimited charitable deduction is allowed if such contributions are
provided for in the will)

Income distributed to the beneficiaries retains the same character (tax exempt, portfolio, passive, etc) as it had
at the fiduciary level (which is the same as occurs in partnership taxation)

The income distribution deduction equals the lesser of:

• Actual distribution to beneficiary, or
• DNI less tax exempt income

Annual estate income tax (form 1041)

• Required when annual income exceeds $600
• Tax year – an estate may elect to have either a calendar or fiscal year
• An estate is exempt from making estimated tax payments for it first two tax years

Annual trust income tax (form 1041)

• All trusts must use a calendar year (except tax exempt trusts)
• Trust may deduct amounts distributed to beneficiaries up to DNI

So filing requirements for estates (calendar or fiscal) and trusts (calendar) differ

Simple trusts – can only make distributions out of current income, it cannot make distributions from the trust
corpus

Complex trusts – may accumulate current income, may distribute principal, can take charitable contribution
deduction

The estate tax (form 706)

• Filing requirements – gross estate exceeds 2 million
• Form 706 must be filed within 9 months after the decedent’s death, unless an extension is requested
Formula
FMV of assets
- Liabilities
= net worth
- transfers
= remainder
* tax rates
= estate tax
- Credits
- state tax
= Federal estate tax due

Gross estate – the value at the death of all the decedent’s worldwide property
• FMY of property owned
• Insurance proceeds
• Incomplete gifts
• Revocable transfers
• All property entitled to be received
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Timeline of Individual’s death

• 6 months to value the property
• 9 months to file tax form

Estates follow the same general rule for taxable events and basis as we learned in individual and P/S taxation
Taxpayer Event Taxed Basis
Estate taxable FMV FMV
Beneficiary non taxable None NBV

Estate deductions – the gross estate is reduced by deductions

Non-discretionary expenses
• Medical expenses = take it as an expense on the income tax return or liability estate tax return, but not both
• Administrative expenses = it as an expense on the income tax return or liability estate tax return, but not
both
• Outstanding debts of decedent
• Claims against the estate
• Funeral costs
• Certain taxes (state death taxes)
Discretionary expenses
• Unlimited charitable deduction
• Unlimited marital deduction

Credits that reduce the gross estate tax include

Unified credit
Foreign death taxes
Prior transfer taxes

The gift tax

Annual exclusion
• Gifts under 12,000 per person per year are tax free
Unlimited exclusion
• Payments made directly to an educational institution
• Payments made directly to a health care provider for medical care
• Charitable gifts
• Marital deduction (must be a terminable interest)

Gifts: present vs. future interest

• A present interest qualifies for the annual exclusion
• A future interest (or a present value without ascertainable value) does not qualify for the annual exclusion

Gifts: complete v. incomplete gifts

• Complete gifts qualify for the annual exclusions and not considered part of the gross estate at death
• Incomplete gifts are included ion the gross estate to calculate the estate tax
- Conditional gifts
- Revocable gifts

So, In order to apply the annual exclusion to a gift it must be:

• A present interest
• Complete
• Under $12,000/ MFJ $24,000 per donee (unless paid for medical or education expenses
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Generation skipping transfer tax – designed to prevent a rich individual from escaping an entire generation of
gift and estate tax.
• This is a separate tax that is imposed in addition to federal estate and gift tax.
• Tax applies when individuals transfer property to a person that is two or more generations younger than the
donor or transferor

Tax Return Preparer Issues

Preparer must provide a copy of the return to the taxpayer by or at the time the tax payer signs the original

The preparer must keep:

• A list of those for whom returns were filed, or
• Copies of the returns for three years

The preparer shall be subject to additional penalties for:

• Disclosure to enable third party to solicit business, or
• Knowing or reckless disclosure of information

The acceptable circumstances for disclosure

• Computer processing center
• Peer review
• Administrative order (court order)

A tax preparer should make reasonable inquires if the taxpayers information is incomplete

Sarbanes Oxley Act of 2002

SOX provides for a Public Company Accounting Oversight Board (PCAOB) which consists of 5 members
- 2 members must be CPA’s
- 3 members cannot be CPA’s

The board is subject to oversight by the SEC and has the duty to:
• Register public accounting firms that prepare audit reports for issuers
• Establish rules relating to the preparation of audit reports for issuers
• Conduct inspections, investigations and disciplinary proceedings concerning registered public acctg firms

Only a registered public accounting firm with the PCAOB may prepare audit reports for an SEC issuer

Registered public accounting firms must:

• Maintain audit papers and supporting documentation for 7 years
• Provide a concurring or second partner review for each audit report, and
• Describe in audit reports the scope of the testing of the issuers internal control structure and procedures

Firm cannot provide additional services that may hinder independence

Tax services are permissible if pre-approved by the audit committee

The lead audit and reviewing partner must rotate off the audit every 5 years

The audit committee is appointed by the board

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CEO and CFO must sign 10-K and 10Q certifying that:
• The report is true and does not contain material deficiencies and is fairly stated
• The signing officers are responsible for establishing internal controls

The SEC requires each issuer to disclose in form 10K and 10Q whether or not they have a code of ethics for
senior financial officers. If they do not have a code, they must state why

There is a criminal penalty for the destruction of corporate records

There is whistle blower protection – employees discharged because they lawfully provided information about
the firms conduct may sue their employer

Ethics and Professional Responsibilities

State board can revoke your license
AICPA’s code of professional conduct governs any services that a member performs
The code is applicable to all member of the AICPA
Members should exercise sensitive professional and moral judgement in all their activities

Objectivity applies all services rendered

Independence applies to attestation services only (audits, special reports i.e financial forecasts, and reviews)

Members should have:

• Adequate internal quality control measures to ensure quality work
• Determine if conflicts of interest arise due to the scope and nature of other services

Rule 101: Maintain independence in fact and appearance

Independence is not impaired in a financial institution client if items occur in ordinary course of business:
• Fully collaterized car loans with a financial institution
• Cash advance or credit card balances not exceeding $5,000
• A bank account that is fully insurable by the government
• A passbook loan

Independence is not impaired by an immediate family members employment with a client, as long as that the
family member is not:
• In a key position at the client
• An internal auditor

Independence is impaired when the client is over 1 year overdue in payment of professional fees. Because now
you are a creditor. Fees from the previous year must be paid before the issuance of the next report.

Rule 201: General standards – members must comply with in all engagements:
• Professional competence – undertake only services that the member can reasonable expect to complete
• Due professional care – possess the same degree of skill commonly possessed by others in the field
• Planning and supervision
• Obtain sufficient relevant data

Rule 202: Compliance with standards – a benchmark that measure the quality of the performance

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Rule 203: Accounting principles – GAAP should be followed
• A member shall not express an opinion or state affirmatively or negatively that F/S are presented in
conformity with GAAP if there is any departure from an accounting principle that has material effect on the F/S

A member may disclose client work papers without the clients consent when:
• Subpoenaed
• Quality review

Contingent fees are specifically prohibited for audits and reviews (they are permitted in tax and bankruptcy)

A member cannot receive a commission for recommending or referring a client any product or service when
that member performs for the client either an audit, review, compilation, examination

Can not use misleading firm names – if it’s a sole proprietorship can’t have name that implies a P/S

Can use the CPA designation to sign a report intended for internal use, not external use (signing CPA implies
independence)

Types of consulting services – CPA SIT

• Consultations
• Product services
• Advisory services
• Staff and other support
• Implementation services
• Transaction services

Tax preparation
• The tax preparer cannot wilfully aid in understanding tax liability, and has no affirmative duty to check the
facts presented by the client, unless the facts seem implausible
• Endorsing and negotiating a clients refund check is forbidden

Personal financial planning (PFP) engagements do not include:

• Implementation engagements
• Monitoring engagements
• Updating engagements
Unless these services were specifically agreed upon

PFP engagements do not include services limited to compiling personal F/S or those limited to tax areas