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The split purchase option for small businesses.

Since an S corporation is "related" to all its shareholders the following split purchases may be considered:

1. The S corporation may acquire a term interest in property with a third party investor purchasing the remainder. The amortization deduction is allowed as long as the remainderman is neither a shareholder nor related to one. If the property is depreciable both cost recovery and amortization deductions will pass through to the shareholders.

2. The S corporation stock itself may be acquired in a split purchase. This, however, is only possible by placing the stock in a qualified subchapter S trust (QSST). In addition the income beneficiary and remainderman in the QSST must be unrelated.

3. For ultimate acceleration of deductions, both 1. and 2. take place simultaneously.

Split Purchases of Nondepreciable Property by an S Corporation

When an S corporation purchases a term interest in nondepreciable property, the amortization deduction is available and passes through to the shareholders as long as the remainderman is not a direct or indirect shareholder.

Example 16: S, Inc., owned by two equal shareholders, A and B, purchases a 10-year term interest in a $100,000 rental property for $60,000, while two unrelated investors, C and D, acquire the remainder interest for $40,000, as tenants in common. The tax consequences are:

1. S collects rental income on the full $100,000 for 10 years.

2. The rental income flows through, as such, to its shareholders, A and B.

3. A and B's bases in their stock is increased by the rental income under Section 1367(a)(1)(A).

4. S deducts $6,000 of amortization each year which flows through to A and B who, because of number 3, above are more likely to be able to utilize the deduction currently.

5 . After 10 years C and D own the real estate with a basis of $40,000.

6. Upon sale C and D will recognize a Section 1231 gain or a long-term capital gain of $60,000, plus/minus any value change. Thus current ordinary deductions have been converted into long-term gain later. To the extent C and/or D keep the property for life the gain escapes income tax permanently since the basis of a successor in interest equals the estate tax value under Section 1014(a).

7. If A and B materially participate in S, Inc.'s business, the deductions are currently deductible despite the passive loss rules in Section 469. In any event, $25,000 of losses are available annually if A and B actively participate in the business under Section 469(i).

8. The 2% floor on miscellaneous itemized deductions under Section 67 does not apply to rental expenses from an S corporation.

Simultaneous Amortization and Cost Recovery

As discussed above, where the property subject to a split purchase is depreciable, all depreciation or cost recovery is generally claimed by the holder of the term interest under Section 167(h). Thus, where the parties to the split purchase are unrelated, both cost recovery of the property itself and amortization deductions of the basis in the term interest are allowable simultaneously. This has the effect of making accelerated depreciation available, even on buildings which can only be written off straight-line, if placed in service after 1986. However, the sum of cost recovery and amortization can never exceed to total cost basis. In the examples below, the cost of land is disregarded for illustrative purposes.

Example 17.- Cost Recovery. S, Inc., buys a 10-year term interest in an apartment building for $60,000 and C and D, two unrelated investors, the remainder for $40,000. S will deduct cost recovery on $100,000 based on a 27.5 year life, straight-line, nd pass the deductions through A and B, in addition to amortization.

Example 18: Cost Recovery Plus Amortization. Same as Example 17, but both cost recovery and amortization are claimed since S, Inc., is unrelated to C and D. Each year S claims cost recovery of $100,000/ 27.5, or $3,636. Sixty percent of the deduction would reduce its basis in the term interest by $2,182, and 40%, or $1,455, would reduce A and B's basis in the remainder. S, Inc's amortization deduction the first year would be $15,782, ($60,000 $2,182)/10. Thus, A and B will deduct $9,418 the first year, rather than just $5,782 if S had simply purchased the building outright. After 10 years, S has no property and no basis, while C and D will recover their reduced basis in the remainder ($25,450), which is then their basis in the building, straight line, over the 17.5 year of its remaining tax life.

Amortizing a Term Interest in S Corporation Stock

By setting up a qualified subchapter S trust (QSST) the ownership of S stock may be divided into a life estate and a remainder.(13) If these interest are purchased by unrelated taxpayers, the basis in the life estate (the income interest in the QSST) may be amortized over the life expectancy of the holder of the present interest. A term interest should not be purchased since a QSST requires that a termination of the trust during the life of the income beneficiary must result in the distribution of the trust assets to such income beneficiary.(14)

Example 19: A 50% shareholder in S, Inc., sells his stock to a QSST for $100,000. E, age 67, life expectancy 15 years, purchases the life estate in the trust for its actuarial value of 75,000, and N, E's niece, purchases the remainder for $25,000. E will amortize his basis and deduct $5,000 a year for 15 years. After 15 years E has recovered his initial basis in the stock, but if he is still living he will retain his interest in the QSST for life. The trustee's basis is adjusted for distributive shares of income, gain, loss and deductions, as well as E's amortization deductions. Upon E's death the trustee's adjusted basis in the S stock will carry over to N under Section 643(e).

Combining Shareholder and S Corporation Amortization Deductions

By combining the purchase of life estates in QSSTs with a split purchase between the S corporations and an independent investor, the income beneficiaries in the QSSTs can amortize their basis in the QSSTs while simultaneously deducting their distributive shares of S's amortization deductions with respect to the corporate term interests. In addition, if the underlying property is depreciable, S can deduct and pass through a combination of cost recovery and amortization.

Example: Four unrelated taxpayers: A, her niece, C, U and his nephew N, form S, Inc. There are two shareholders, [QSST.sub.1] and [QSST.sub.2]. In [QSST.sub.1]A holds the income interest for life, purchased for $75,000, and C holds the remainder, purchased for $25,000. In [QSST.sub.2] U purchased the life estate for $75,000 and N the remainder for $25,000. The funds, $100,000 from each trust, are transferred to S, Inc., in exchange for 50% of the S stock. S purchases a 20-year term interest in a building for $200,000 and two independent investors the remainder in their individual capacity for $50,000 as tenants in common for $25,000 each. S will simultaneously amortize its basis in its term interest and claim cost recovery on the building (as illustrated previously), passing through all the deductions to [QSST.sub1] and [QSST.sub.2] which in turn passes the deductions through to A and U. In addition, A and U will separately amortize their basis in their life estates in [QSST.sub.1]and [QSST.sub.2]over their respective life expectancies.

Even though the shareholders are related to the corporation, the S corporation s amortization deductions are allowed because the remainder is held by unrelated parties. In addition, the income beneficiaries in the QSSTs are able to amortize their bases in such income interest as long as the remainderman in each is unrelated to the income beneficiary.

Partnership/Partner Split Purchases

The following split purchase opportunities may be considered by partnerships and partners:

1. The partnership may purchase a term interest in property with a third party investor acquiring the remainder. Since the partnership is related to all its partners, the remainderman cannot be a partner nor related to any partner if the amortization deduction is to be allowed. If the property is depreciable, a combination of cost recovery and amortization will flow through to the partners.

2. The partnership interest itself may be the subject of a split purchase. As long as the holders of the present and future interests are unrelated, the income beneficiary may amortize the basis in the beneficial interest in the trust holding the partnership interest.

3. For ultimate acceleration of deductions, both of the above scenarios take place simultaneously. Unlike in the S corporation case discussed above, there are no special restrictions on the trust ownership interest in the entity.

Split Purchases of Nondepreciable Property by a Partnership

In the simplest scenario, the partnership merely purchases a term interest in nondepreciable property.

Example 20: T and R are 50% partners in P. P and a third party investor, 1, engage in a split purchase of an empty lot for $100,000 needed for parking in P's business. I is unrelated to T and R, e.g., T's uncle and P's father-in-law, and pays $40,000 for the remainder while P pays $60,000 for a 10-year term interest. The tax consequences are:

1. T and R's bases in their partnership interests are unaffected by P's purchase. However, to the extent either partner contributed cash to P or PIP incurred liabilities to facilitate the purchase, each partner would increase the basis in his or her partnership accordingly under Section 722 and 752(a).

2. I's basis in the remainder is frozen at $40,000.

3. I recognizes no income over time as the actuarial value of the future interest automatically increases, nor on the termination of the present interest, nor on the distribution of the lot.

4. P will amortize its basis in the term interest at the rate of $6,000 a year for 10 years. The deduction is allowed since I is not related to T or R and thus unrelated to P.

5. Each year $6,000 of amortization deductions flow through to T and R. In the absence of special allocations. T and R will deduct $ 3,000 each. If the partnership agreement calls for it and the requirements of the Regulations under Section 704(b) are met, the deduction may be allocated in any proportion desired.

6. The deduction may be suspended if T and/or R do not have sufficient basis in their partnership interest under Section 704(d) because they do not have sufficient "at risk" basis under Section 465 or because they do not materially participate" in the partnership's business under the passive loss rules in Section 469.

7. T and R's bases in their partnership interests are reduced each year by their distributive shares of the amortization deduction under Section 705.

8. After 10 years P has neither an interest nor a basis in the land.

9. Upon receipt of the land after 10 years, I has a basis of $40,000 in it and, most likely, a substantial built-in gain, having recognized no income during the existence of P's present interest.

Split Purchases of Partnership Interests

Like any other property, real or personal, tangible or intangible, a partnership interest may itself be the subject of a split purchase. To separate the present from the future interest the partnership interest must be held in trust. The trustee is the legal partner, and only the trustee has basis in the partnership interest as such, including its share of partnership liabilities, for the duration of the trust. The bases of the beneficiaries are their cost bases. The tax consequences to the parties are explored below.

Tax Consequences to the Term Holder

During the period that the term holder owns a present interest in the trust/partner tax consequences are as follows:

1 . The trustee's entire distributive share of partnership income, gain, loss, deduction or credit flow through to the term holder. Exceptions are made for items allocable to corpus, typically capital gains and losses, which would be taxed to the trust.

2. The trustee's overall basis in the partnership interest is adjusted upwards for income and gain, and downward for deductions, losses and distribution, but is not adjusted for credits.

3. The present income beneficiary's basis is not adjusted for distributive share items or distribution.

4. Deductions claimed by the term holder for the amortization of the cost basis in the beneficial interest must reduce both the basis in such interest and the trustee's overall basis in the partnership interest to avoid a double tax benefit.

5. The passive loss rules will, most likely, apply in the following manner: a) A distributive share of partnership loss will be suspended unless the present holder materially participates In the partnership business with the usual exceptions for working interests in oil and gas ventures and active-participation real estate). At the time the term interest expires any such losses still suspended will presumably be added to the trustee's basis and carry over to the remainderman. b) The term holder's deductions resulting from the amortization the term interest itself may also be suspended. If so, they should be deductible to the holder in full upon expiration of the beneficial interest under Section 469(g) since such expiration should constitute a disposition of the entire interest in a passive activity.

The Remainderman's Basis Considerations

For the duration of the present interest the remainderman's basis in the purchased future interest in the trust is generally frozen at cost. This is because no income is recognized despite the continuous increase in the actuarial value of the interest. However, if the remainderman is related to the term holder, the basis in the remainder is increased by the term holder's disallowed amortization deductions under Section 167(r). In this situation the trustee's basis in the partnership interest is unaffected by the amortization of the term interest. Furthermore, the trustee's basis is adjusted for additional investments, distributions, changes in liabilities of the partnership, and distributive shares of income, loss, gain or deductions, as well as amortization deductions allowed the term holder. When the term interest ceases, the trust terminates and distributes the partnership interest to the remainderman, making the latter a partner outright. The following determines the new partner's basis:

1 . The trustee's basis in the partnership interest carries over to the distributee under Section 643(e)(1), including the appropriate share of partnership 11abilities under Section 752(a).

2. The basis in the interest should be increased by losses suspended under the at-risk rules and/or the passive loss rules at the trust level, but not by amortization deduction, if any, suspended by the passive loss rules at the term holder level. No authority exists for adding losses suspended under Section 704(d) to the basis of a subsequent holder.

Combining Two Split Purchases

When the partnership purchases a term interest in depreciable property and one or all partnership interests are the subject of a split purchase as well the result is two sets of amortization deductions in addition to cost recovery.

Example 21: One of the P partnership's assets is a 10-year term interest, purchased for $60,000 in depreciable property with a 20-year useful life for tax purposes. An independent investor, 1, paid $40,000 for the remainder. P has liabilities of $200,000. T and R engaged in a split purchase of a 50% general partnership interest in P held in trust with T paying $ 30,000 for a 10-year term interest and R paying $20,000 for the remainder. The tax consequences are, among others:

1. P deducts $5,000 a year in cost recovery under Section 167(h) which passes through to the partners.

2 .The cost recovery deduction reduces P's basis in its term interest by $3,000 while $2,000 is allocable to I's remainder.

3. One-half of $5,000, or $2,500, flows through to the trust partner and reduces its basis in the partnership interest, originally $150,000 ($50,000 plus one-half of P's liabilities).

4. The cost recovery deduction ($2,500) passes through to T who does not reduce his basis in the present interest in the trust.

5 .P amortizes its basis in its term interest over 10 years, one-tenth the first year, one-ninth the record, etc., as reduced by $3,000 a year in cost recovery and previously claimed amortization deductions.

6. P's amortization deductions pass through to the partners who reduce their bases in their partnership interests. A trust partner then passes the deductions through to its partners.

7. Half of P's amortization deduction flows through to the trust partner which reduces its basis in the partnership interest by it and passes it through to T who does not adjust his basis is the beneficial interest in the trust.

8. T amortizes his basis in his term interest at the rate of $3,000 a year. The deduction reduces both his basis in the present interest and the trust's basis in the partnership interest.

9. After 10 years. a) P has no interest in the depreciable property and has recovered its $60,000 basis through a combination of cost recovery and amortization b) 1, the independent investor, owns the property outright with a basis of $40,000. c) T has no interest in the trust and has deducted $60,000 in cost recovery over a 10-year period, one-half of P's combined cost recovery and amortization deductions, plus his own $30,000 basis in the term interest in the trust. d) R becomes a 50,70 partner. His basis in the partnership (disregarding other adjustments) equals the trust's basis, i.e., the original basis of $150,000, less half of P's amortization and cost recovery deduction and T's amortization deductions, or $90,000.

Conclusion

A term interest acquired by purchase may be amortized for tax purposes when the underlying property is held for investment or for use in a trade or business and the remainder is held by an unrelated taxpayer. The built-in gain resulting from current deductions may be deferred indefinitely. The split purchase technique has a myriad of applications. Of special interest to small business, split purchases may be employed to avoid double taxation on the liquidation of C corporations, as a dividend alternative, and to provide accelerated deductions to owners of conduit entities, such as S corporations and partnerships. The most aggressive uses of split purchases result in the combination of cost recovery and amortization deductions and the expensing of the cost of stock in C and S corporations and partnership interests.

Footnotes

(13) Section 1361(d).

(14) Section 1361(d)(3)(A)(iv).
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:part 2
Author:Auster, Rolf
Publication:The National Public Accountant
Date:Jul 1, 1991
Words:3174
Previous Article:Minimizing the self-employment tax bite.
Next Article:Income shifting through gifts and trusts.
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