S Corporation

A program is arranged so that each investor is treated as owning an undivided interest in the underlying property directly, reporting the income and deductions on his own return rather than receiving an allocated share from an entity. Which entity is described?

1. A.A limited partnershipWrong. A partnership files an informational return and allocates items out to its partners.
2. B.A grantor trustCorrect. The beneficial owner is treated as owning the underlying assets directly.
3. C.An S corporationWrong. Its shareholders own stock and receive allocated items, not the assets themselves.
4. D.A joint ventureWrong. It is an association formed for a single undertaking and is generally taxed as a partnership.

Why: A grantor trust is disregarded for tax purposes, so the beneficial owner is treated as owning the trust assets themselves. That is a different mechanism from entities that file an informational return and allocate items out to their owners, even though the practical result of no entity-level tax looks similar. The distinction matters because direct ownership of the underlying property is what a like-kind exchange structure requires. An entity that merely passes allocated shares through to its owners would not produce that treatment.

A program is organized as an S corporation. Four prospective buyers seek to purchase stock: an individual investor, a tax-exempt organization, the estate of a deceased shareholder, and another partnership. Which of them presents an eligibility problem?

1. A.The individual investorWrong. Individuals are the core of the permitted ownership category.
2. B.The tax-exempt organizationWrong. Certain tax-exempt organizations are expressly permitted holders.
3. C.The estate of the deceased shareholderWrong. Certain estates are permitted to hold the stock.
4. D.The other partnershipCorrect. A partnership is not among the classes of holder an S corporation may have.

Why: S corporation eligibility is restricted in several ways at once: a limited number of shareholders, a domestic corporation, and ownership confined to individuals and certain estates, trusts and tax-exempt organizations. A partnership is not among the permitted classes of holder, so its purchase is the one that creates a problem. The other three buyers each fall inside the permitted categories. If the individual partners of that partnership bought in their own names instead, and the shareholder count stayed within the limit, each of them could hold the stock directly.

A limited partner holding 15 percent of the units receives a Schedule K-1 showing 15 percent of the cash distributions for the year but a materially larger share of the taxable loss. He asks whether the sponsor has made an error. What should the representative explain?

1. A.That cash distributions and tax allocations must match, so a corrected schedule should be requestedWrong. Nothing obliges the two figures to track one another in a partnership.
2. B.That the compensation of the general partner has been charged against his share of the lossWrong. That compensation is an expense borne by the partnership, not a charge against a single partner.
3. C.That the partnership agreement fixes each allocation separately, so the two shares need not agreeCorrect. Loss allocations and cash distributions are independent terms of the governing agreement.
4. D.That an S corporation would report the same divergence, so the result is unremarkableWrong. That is the one entity here that could not produce this result, since it may not allocate disproportionately.

Why: The agreement of limited partnership sets the allocation of income, loss, capital gain and cash distributions, and it sets each of those separately. Nothing requires the share of taxable loss allocated to a partner to track the share of cash he receives, and programs are commonly drafted so the two diverge. A loss percentage that exceeds a distribution percentage is therefore a design feature of the agreement rather than a mistake in preparing the schedule. Had the program been organized as an S corporation, every item would have had to follow stock ownership and the two figures could not have differed.

A sponsor wants a structure in which it takes 10 percent of the equity but is allocated 30 percent of the losses in the early years, with the sharing reversing after investors recover their capital. Which entity cannot accommodate that arrangement?

1. A.An S corporation, because it permits no disproportionate allocation among its shareholdersCorrect. Every item must follow stock ownership, which the shifting split described here would violate.
2. B.A limited partnership, because allocations must follow the capital each partner contributedWrong. Partnership allocations are set by the agreement and need not track contributed capital.
3. C.An LLC, because its members must all be treated alike in every allocationWrong. An LLC carries the allocation flexibility of a partnership rather than a uniform-treatment requirement.
4. D.None of them, because all three are pass-through entities and pass items through alikeWrong. Pass-through status settles where items land, not the proportions in which they are divided.

Why: All three of these entities pass items through to their owners without tax at the entity level, so pass-through status does not separate them. What separates them is proportionality. An S corporation must allocate income, loss, deduction and credit in proportion to stock ownership and permits no disproportionate allocation. A limited partnership and an LLC allocate as the governing agreement provides, which is exactly what a shifting sharing arrangement of this kind requires. Were the sponsor content with a straight 10 percent of every item, the S corporation would serve.