Shifting Income and Maximizing Basis Recovery

24.3 Shifting Income and Maximizing Basis Recovery

In the realm of S corporations and partnerships, one of the most nuanced topics in tax planning involves shifting income among owners while maximizing basis recovery. By properly leveraging guaranteed payments, special allocations, and changes in entity ownership, practitioners can optimize tax outcomes and ensure that each owner or partner makes the best use of available basis. However, these strategies must be approached with caution: intricate Internal Revenue Code (IRC) and Treasury Regulation rules apply to special allocations, guaranteed payments, and adjusted bases. This section provides a comprehensive overview of these mechanisms and the key considerations for effectively implementing them.

Shifting income and maximizing basis recovery applies to both partnerships and S corporations, albeit in different ways. Partnerships rely on provisions such as IRC §704(b) (which governs special allocations) and IRC §707(c) (which addresses guaranteed payments). S corporations use a different structure: income is allocated pro rata based on stock ownership, but unique possibilities arise when altering shareholder ownership and effectively adjusting basis for distributions and losses.

The topics covered include: • Key benefits and pitfalls of guaranteed payments
• Designing special allocations to shift income effectively
• Changing ownership percentages to reallocate future tax items
• Basic and advanced strategies to maximize basis recovery

This guidance builds on prior discussions about flow-through entities (see Chapter 20 for S corporations and Chapter 21 for partnerships) and refers to related concepts such as debt allocations, recourse vs. nonrecourse liabilities, and at-risk rules (see Chapter 16).

Shifting Income Among Owners: An Overview

Shifting income refers to modifying an entity’s income allocations, distributions, or ownership structure in a manner that allows certain owners to recognize more or less taxable income in a given period. The ultimate goal is often to place income with those owners who stand to benefit from lower marginal tax rates, to accelerate or defer income based on individual preferences, or to optimize the usage of deductions and credits.

Several methods can facilitate income shifting:
• Guaranteed payments in partnerships
• Special allocations within partnerships
• Changing ownership structure or stock ownership in S corporations
• Adjusting debt allocations or capital account balances (applicable primarily to partnerships)

However, the IRS and state tax authorities rigorously scrutinize these strategies. The allocations must have “substantial economic effect” (a key standard for partnership allocations), or otherwise be carried out strictly according to the relevant governing documents in the case of S corporations. Failing to comply can lead to recharacterization of allocations and potential tax penalties.

Guaranteed Payments: A Direct Way to Shift Income in Partnerships

Guaranteed payments (IRC §707(c)) are compensation to a partner for services rendered or for the use of capital, made without regard to the partner’s proportionate share of the partnership’s income. These payments effectively shift income directly to the partner receiving the payment, while reducing the partnership’s ordinary income.

Below is a basic flow illustrating how a partnership might use guaranteed payments:

    graph LR
	A["Partnership"] --> B["Guaranteed Payment"]
	B --> C["Partner (Service Provider)"]
	A --> D["Reduced Amount of Ordinary Income"]

1. The partnership pays a fixed amount to a partner for services.
2. This guaranteed payment is ordinary income to the partner receiving it.
3. The partnership deducts the payment, reducing the total income available for allocation to the other partners.

Tax Implications for Guaranteed Payments

• For the recipient partner: The payment is typically reported as ordinary income on the partner’s tax return and may be subject to self-employment tax.
• For the partnership: Guaranteed payments are off the top of the partnership’s income, reducing net ordinary business income.

Shifting Income Using Guaranteed Payments

Guaranteed payments can be used to strategically compensate a partner who may be in a lower tax bracket or who has a tax attribute (like substantial net operating losses (NOLs)) that can be used to offset that income. However, to be respected for tax purposes, the payment must reflect a bona fide compensation arrangement—excessive or contrived payments can trigger IRS scrutiny under the test of economic reality.

Special Allocations in Partnerships

Partnerships can provide special allocations to allocate specific items of income, gain, loss, deduction, or credit to particular partners in a way that deviates from the partners’ ownership percentages. These allocations must have “substantial economic effect” under IRC §704(b).

Understanding Substantial Economic Effect

The IRS requires that allocations meet two main tests to qualify as having substantial economic effect:

1. The allocation must be reflected accurately in the partners’ capital accounts.
2. The final distribution of proceeds upon liquidation must follow those capital accounts.

In other words, the special allocation must reflect true economic arrangements among the partners. If the allocation is purely tax-motivated (i.e., there is no parallel economic arrangement in the real world), the IRS may disallow it.

Examples of Special Allocations

• Allocating depreciation deductions primarily to one partner who has significant passive activity income that can absorb those deductions.
• Allocating capital gains to a partner who has capital losses carried forward.
• Allocating ordinary business income away from a partner who is already in a high tax bracket toward a partner in a lower bracket.

Caution with Special Allocations

Under IRC §704(c), the partnership must account for built-in gains or losses on contributed property. If a partner contributes property with a built-in gain or loss, the partnership generally must allocate that gain or loss back to that contributing partner upon disposition. Attempting to circumvent this with special allocations can trigger anti-abuse rules.

    graph LR
	A["Partner 1 (High-Tax Bracket)"] -. Special Allocation .-> B["Capital Gains"]
	C["Partner 2 (Low-Tax Bracket)"] -. Special Allocation .-> D["Depreciation"]
	B --> E["Partnership Capital Account Tracking"]
	D --> E

In the diagram above, Partner 1 may receive an allocation of capital gains, while Partner 2 gets a higher allocation of depreciation. Each partner’s capital account must accurately reflect these allocations, reflecting the true economics of the deal.

Changing Ownership to Shift Income: Partnerships and S Corporations

Partnerships

Partners can also shift income by changing ownership percentages. For instance, a family partnership may add children or other relatives as limited partners if they are in lower tax brackets. However, the partnership must operate in a manner that respects partnership formalities:
• The new partner must have a genuine ownership interest.
• The capital account balances must be recorded accurately.
• The partner’s share of liabilities (if any) must be appropriately allocated.

When the partnership interests are reallocated, existing partners may recognize gain or have other tax implications if the changes result in a deemed distribution or contribution of assets. Thus, reevaluating the partnership’s potential built-in gains and each partner’s capital account is crucial.

S Corporations

An S corporation must allocate items of income, loss, deduction, and credit strictly on a pro rata, per-day basis. This means that if a shareholder sells or transfers stock halfway through the year, the S corporation typically splits the allocations between the old and new shareholders based on the time period of ownership (unless a “closing of the books” election is made).

Nevertheless, shifting income within an S corporation can occur by changing each shareholder’s ownership percentage. If new shares are sold to (or old shares redeemed from) a shareholder in a lower tax bracket, subsequent distributions of S corporation income will accrue to that new owner.

Limitations for S Corporations

1. Single class of stock requirement: S corporations can only have one class of stock, though voting and nonvoting shares are permissible.
2. Per-day allocation rule: If a shareholder changes over mid-year, the allocations of income and loss are generally prorated across the days of ownership unless the corporation elects to treat the change as occurring at the end of a day.
3. Basis adjustments: S corporation shareholders adjust their stock basis annually for income, losses, credits, and distributions. Unlike partnerships, S corporation shareholders cannot generally increase basis by increasing personal liability (except in certain cases of shareholder loans made directly to the S corporation).

Maximizing Basis Recovery

While shifting income focuses on short-term tax rate advantages, maximizing basis recovery is crucial for long-term tax planning. Higher basis can allow owners to deduct larger shares of current or future losses. Additionally, basis impacts the tax treatment of distributions, and it reduces taxable gain upon disposition.

Basis Recovery in Partnerships

A partner’s basis in a partnership starts with the capital they contribute (cash or property) plus any share of the partnership’s liabilities for which they are at-risk. This basis increases for allocated income and additional contributions and decreases for distributed losses, deductions, and cash distributions.

Strategies for Maximizing Partnership Basis

• Debt Allocation: Because a partner’s basis is increased by their share of partnership liabilities, structuring debt as recourse vs. nonrecourse may enhance basis for specific partners.
• Guaranteed Payments vs. Distributions: In some circumstances, substituting guaranteed payments with a partner’s share of net income can prevent “basis stripping.”
• Timing of Contributions: A well-timed infusion of capital before year-end can increase basis, thereby allowing the partner to deduct losses that would otherwise be suspended.

Basis Recovery in S Corporations

Unlike in partnerships, S corporation shareholders can only increase their basis through direct loans made to the corporation or capital contributions, not by guaranteeing the corporation’s debt to third parties. The key is to structure transactions so that the shareholder can increase stock or debt basis when needed.

Example: Shareholder Debt

If a shareholder loans the corporation $50,000 directly, that loan typically increases the shareholder’s debt basis, allowing them potentially to deduct more of the S corporation’s losses (subject to at-risk and passive activity limitations).

Practical Scenarios Illustrating Income Shifting and Basis Recovery

Case Study 1: Partnership Using Guaranteed Payments and Basis Timing

Ash and Morgan form a 50-50 partnership. Ash has substantial net operating losses from a prior venture, while Morgan is in a higher tax bracket. Mid-year, the partnership sees an opportunity to accelerate business income.

• They decide to provide Morgan with a guaranteed payment to ensure Morgan receives a steady stream of income. This reduces the partnership’s overall taxable income, which means the remaining income flows to Ash—who can use NOLs to offset the income.
• Ash also anticipates future losses, so Ash contributes an additional $20,000 just before year-end, boosting basis to absorb upcoming losses.

By combining guaranteed payments and a late-year capital contribution, the partnership effectively shifts income to the partner who can best offset it, while simultaneously maximizing basis for the partner expecting future losses.

Case Study 2: S Corporation Ownership Adjustment

XYZ, Inc. is an S corporation owned equally by two siblings, Jill and Sam. Jill is in a higher tax bracket, and Sam has suspended passive losses from other investments. Mid-year, Jill sells half of her shares to Sam, shifting more of XYZ’s future income to Sam, who can offset that flow-through income with passive losses.

• Allocations for the portion of the year before the ownership change are made 50-50.
• For the portion of the year after the change, Sam holds 75% ownership, while Jill holds 25%.
• The increased flow of income to Sam provides a synergy with Sam’s passive losses from other activities.

This strategy helps the siblings reduce overall family taxation, provided the sale is a bona fide transaction that meets all S corporation requirements.

Common Pitfalls and Compliance Risks

• Economic Substance Requirements: Any arrangement lacking a non-tax business rationale risks recharacterization by the IRS.
• Overreliance on Special Allocations: If the allocation pattern is inconsistent with the partners’ capital balances or economic realities, it may be disallowed.
• Improper Basis Adjustments: Partners sometimes fail to properly account for their share of recourse vs. nonrecourse debt, leading to miscalculations on deductions. In S corporations, incorrectly assuming that personally guaranteeing corporate debt increases basis can trigger disallowed losses.
• Family Partnership Scrutiny: Allocations to minor children or other family members are heavily examined for economic substance and compliance with the assignment of income doctrines.

Best Practices and Planning Tips

• Draft Operating Agreements or Shareholder Agreements Carefully: Agreements should explicitly outline allocation methodologies, provisions for future partner/shareholder changes, and basis tracking.
• Monitor Capital Accounts and Basis: Keep accurate, consistent records of each partner’s or shareholder’s basis, including contributions, distributions, and allocated items.
• Communicate with Tax Professionals: Especially when designing intricate special allocations or guaranteed payments, consult seasoned tax advisors to avoid pitfalls.
• Plan Ahead for Exit Strategies: If an owner plans to exit or reduce their ownership stake, consider timing and potential recapture of depreciation, built-in gains, or recourse liabilities.
• Stay Vigilant on Legislative Changes: Tax laws regarding pass-through entities evolve. Keep informed about updates that might affect special allocations, basis calculations, or allowed deductions.

Diagram: Overview of Key Mechanisms to Shift Income While Preserving Basis

    graph LR
	A["Partnership or S Corporation"] --> B["Guaranteed Payments (Partnership)"]
	A --> C["Special Allocations (Partnership)"]
	A --> D["Ownership Changes (Both)"]
	B --> E["Income Shift to Low-Bracket Partner"]
	C --> E
	D --> E
	E --> F["Potential Basis Adjustments <br/>via Capital Contributions or Debt"]

Explanation of Diagram:
• Partnerships can use guaranteed payments or special allocations to direct income to certain partners.
• Both entity types can shift income by altering ownership.
• Partners or shareholders can further boost basis via direct capital contributions (or shareholder loans in S corporations) to enable expanded loss deductions.

References for Further Exploration
• IRC §704(b) and §704(c) guidance for special allocations
• IRC §707(c) rules on guaranteed payments
• Treasury Regulations §§1.704-1 – 1.704-4 on substantial economic effect
• IRS Publication 541 on Partnerships
• IRS Instructions for Schedules K-1 (Form 1065 and Form 1120S)

Consider also reviewing Chapters 19, 20, and 21 of this guide for more on C corporations, S corporations, and partnerships, respectively. For additional insights on loss limitations and how they interrelate with basis, revisit Chapter 16.

Quiz: Shifting Income and Maximizing Basis Recovery

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