1040 Part 2: Partnerships

Question 1

how do partnerships flow to form 1040?

Answer 1

partnerships are included in schedule E and flow to schedule 1 which is line 10 on the 1040 and the line is called “adjustments to income”

Question 2

what are the legal classification and nontax characteristics of business entities?

Answer 2

refer to the “legal classification and nontax characteristics of business entities” and “legal classification” exhibits

Question 3

what is the formula for ordinary business loss?

Answer 3

ordinary business loss = overall tax basis loss - (dividend income + short term gains)

Question 4

what is inside and outside basis?

Answer 4

refer to “inside and outside basis” exhibit

Question 5

how does a partnership flow to schedule 1 on form 1040?

Answer 5

FILE 1065 AND GIVE K-1 TO PARTNERS
LOSSES LIMITED TO BASIS-CARRIED FORWARD

BASIS
INITIAL
YRLY

ORDINARY BUSINESS INCOME(LOSS)
SEPARATELY STATED
LOSS LIMITS NOL ALLOWED TO PARTNERS

PROPERTY
G & L
LOSS LIMITS

DISTRIBUTIONS

Question 6

how is initial tax basis determined for a partnership?

Answer 6

NO GAINS OR LOSSES ON PROPERTY CONTRIBUTED TO THE
PARTNERSHIP.

IF CONTRIBUTED PROPERTY IS SUBJECT TO DEBT, THE
BASIS OF THE INDIVIDUALS CONTRIBUTION IS REDUCED BY THE PORTION
OF THE DEBT ASSUMED BY OTHER PARTNERS.

THE ASSUMPTION OF A PARTNERS DEBT BY OTHERS IS TREATED AS
A DISTRIBUTION OF MONEY (BASIS REDUCTION) TO THE PARTNER AND AS A CONTRIBUTION
OF MONEY TO THE PARTNERS ASSUMING THE DEBT.

RECOURSE
Outside basis, because partnership tax law treats them as each borrowing
their own proportionate shares of the partnership’s liabilities and then
contributing the borrowed cash to acquire their respective partnership
interests, paying the liability. Recourse liabilities are those for which at
least one partner has economic risk of loss—that is, they may have to
legally satisfy the liability with their own funds.

NON-RECOURSE
Nonrecourse liabilities such as mortgages are typically secured by real
property and only give lenders the right to obtain the secured property in
the event the partnership defaults on the liability. Because partners are
responsible for paying nonrecourse liabilities only to the extent the
partnership generates sufficient profits, such liabilities are generally
allocated according to partners’ profit-sharing ratios.

refer to “Nicole” exhibit

Question 7

how is the annual tax basis and annual tax basis adjustments in partnership interests?

Answer 7

Unlike the basis in a stock or other similar investment, which is usually
stable, the basis in a partnership interest is dynamic and must be adjusted
as the partnership generates income and losses, changes its liability
levels, and makes distributions to partners. These annual adjustments to a
partner’s tax basis are required to ensure partners don’t double-count
taxable income/gains and deductible expenses/losses, either when they
sell their partnership interests or when they receive partnership
distributions. They also ensure tax-exempt income and nondeductible
expenses are not ultimately taxed or deducted.

Partners make the following adjustments to the basis in their
partnership interests annually:

Increase for actual and deemed cash contributions to the partnership				
during the year.				
				
Increase for partner’s share of ordinary business income and separately				
stated income/gain items.				
				
Increase for partner’s share of tax-exempt income.				
				
				
DECREASE				
				
Decrease for actual and deemed cash distributions during the year.				
				
Decrease for partner’s share of nondeductible expenses not “properly				
chargeable to a capital account” (fines, penalties, etc.).				
				
Decrease for partner’s share of ordinary business loss and separately				
stated expense/loss items.				
				
Decrease for partner’s share of disallowed business interest expense.

Question 8

what are separately stated items for a partnership?

Answer 8

refer to “common separately stated items” exhibit

Partners first adjust their outside bases for items that increase basis, then for
distributions, then by nondeductible expenses, and then by deductible expenses and
losses to the extent any basis remains after prior adjustments.81 Basis adjustments
that decrease basis may never reduce a partner’s tax basis below zero.82

refer to “CCS investing” exhibit

Question 9

what are the loss limits for a partnership?

Answer 9

Partnership losses in excess of a partner’s tax basis are suspended and carried forward until additional basis is created.

Remaining partnership losses are further suspended by the at-risk rules to the extent a partner is allocated nonrecourse liabilities not secured by real property.

If a partner is not a material participant or the partnership is involved in rental activities, losses remaining after application of the tax-basis and at-risk limitations may be used only against other passive income or when the partnership interest is sold.

Losses remaining after applying the tax basis, at-risk, and passive activity loss limitations are only deductible to the extent they do not add to or create an excess business loss at the partner level.

Question 10

what is the tax basis limitation for a partnership?

Answer 10

As a result, partners may not utilize partnership losses in excess of their investment or outside basis in their partnership interests. Any losses allocated in excess of their basis must be suspended and carried forward indefinitely until they have sufficient basis to utilize the losses.85 Any suspended losses remaining when partners sell or otherwise dispose of their interests are lost forever.
Partnership losses in excess of a partner’s tax basis are suspended and carried forward until additional basis is created.

Question 11

what is the at risk amount limitation for a partnership?

Answer 11

The at-risk rules in §465 were adopted to limit the ability of partners to use nonrecourse liabilities as a means of creating tax basis to use losses from tax shelter partnerships expressly designed to generate losses for the partners. The at-risk rules limit partners’ losses to their amount “at risk” in the partnership—their at-risk amount. Generally, a partner’s at-risk amount is the same as the partner’s tax basis except that, with one exception, the partner’s share of certain nonrecourse liabilities is not included in the at-risk amount. Specifically, the only nonrecourse liabilities considered to be at risk are nonrecourse real estate mortgages from commercial lenders that are unrelated to borrowers.

Partners apply the at-risk limitation after the tax-basis limitation. Any partnership losses that would otherwise have been allowed under the tax-basis limitation are further limited to the extent they exceed a partner’s at-risk amount. Losses limited under the at-risk rules are carried forward indefinitely until the partner generates additional at-risk amounts to utilize the losses, or until they are applied to reduce any gain from selling the partnership interest.

Question 12

what is the passive active loss limitation for a partnership?

Answer 12

the PAL rules limit the ability of partners in rental real estate partnerships and other partnerships they don’t actively manage (passive activities) from using their ordinary losses from these activities (remaining after the application of the tax-basis and at-risk limitations) to reduce other sources of taxable income.

Question 13

how is passive activity defined for a partnership?

Answer 13

The passive activity rules define a passive activity as “any activity which involves the conduct of a trade or business,88 and in which the taxpayer does not materially participate.”

Question 14

what are the tests for material participation for partnership passive activity?

Answer 14

The individual participates in the activity more than 500 hours during the year.

The individual’s activity constitutes substantially all the participation in such activity by individuals.

The individual participates more than 100 hours during the year and the individual’s participation is not less than any other individual’s participation in the activity.

The activity qualifies as a “significant participation activity” (individual participates for more than 100 hours during the year) and the aggregate of all other “significant participation activities” is greater than 500 hours for the year.

The individual materially participated in the activity for any 5 of the preceding 10 taxable years.

The activity involves personal services in health, law, accounting, architecture, and so on, and the individual materially participated for any three preceding years.

Taking into account all the facts and circumstances, the individual participates on a regular, continuous, and substantial basis during the year.

Question 15

what are the income and loss brackets for partnership passive activity?

Answer 15

In effect, passive activity losses are suspended and remain in the passive income or loss basket until the taxpayer generates current-year passive income, either from the passive activity producing the loss or from some other passive activity, or until the taxpayer sells the activity that generated the passive loss.

Question 16

what are the basics of partnership distributions?

Answer 16

Operating Distributions of Money Only.

The general rule for operating distributions states that a partnership does not recognize gain or loss on the distribution of property or money.21,22 Nor do the general tax rules require a partner to recognize gain or loss when receiving distributed property or money.23 The partner simply reduces the outside basis in the partnership interest by the amount of cash distributed and the inside basis of any property distributed. In general, the partnership’s basis in its remaining assets remains unchanged.24

Operating Distributions That Include Property Other Than Money

If a partnership makes a distribution that includes property other than money, the partners face the problem of determining how much outside basis in their interests to allocate to the distributed property.27 Under the general rule, the partner takes a basis in the distributed property equal to the partnership’s basis in the property. This is called a carryover basis.28 The tax rules define the order in which to allocate outside basis in a partnership interest to the bases of distributed assets. First, the partner allocates the outside basis in their interest to any money received and then to other property as a carryover basis. The remainder is the partner’s outside basis in the partnership interest after the distribution.

Like shareholders receiving corporate dividend distributions, partners often receive distributions of the partnership profits, known as operating distributions. Recall that owners of flow-through entities are taxed currently on their business income regardless of whether the business distributes it. As a result, partners may require cash distributions in order to make quarterly estimated tax payments on their shares of business income. Usually, the general partners (or managing members of LLCs) determine the amount and timing of distributions; however, the partnership (operating) agreement may stipulate some distributions.

Question 17

what are operating distributions for partnerships?

Answer 17

Gain or loss recognition: Partners generally do not recognize gain or loss. One exception occurs when the partnership distributes money only and the amount is greater than the partner’s outside basis in their interest.

Basis of distributed assets: Partners generally take a carryover basis in distributed assets. If the partnership distribution includes property and the combined inside basis of the distributed property is greater than the partner’s outside basis in their interest, the bases of the distributed property will be reduced.

Remaining outside basis: In general, partners reduce outside basis by the amount of money distributed and the inside basis of distributed property.

A distribution from a partnership is an operating distribution when the partners continue their interests afterwards. Operating distributions are usually made to distribute the business profits to the partners but can also reduce a partner’s capital interest. The partnership may distribute cash or other assets. Let’s look at the tax consequences of distributions of money, and then at the tax consequences of distributing property other than money.

Question 18

what are operating distributions of money only for partnerships?

Answer 18

The general rule for operating distributions states that a partnership does not recognize gain or loss on the distribution of property or money.21,22 Nor do the general tax rules require a partner to recognize gain or loss when receiving distributed property or money.23 The partner simply reduces the outside basis in the partnership interest by the amount of cash distributed and the inside basis of any property distributed. In general, the partnership’s basis in its remaining assets remains unchanged.24

What if: Suppose CCS makes its first distribution to the owners on December 31, 2023: $250,000 each to Nicole and Greg and $333,333 to Sarah. After taking into account their distributive shares of CCS’s income for the year, the owners have the following predistribution bases in their CCS interests:
Owner
Nicole
Sarah
Greg

What are the tax consequences (gain or loss and basis in CCS interest) of the distribution to Sarah?

Answer: Sarah does not recognize any gain or loss on the distribution. She reduces her outside basis in her interest from $420,000 to $86,667 ($420,000 − $333,333) after the distribution.

PREDISTRIBUTION BASIS
$205,000
$420,000
$334,000

POST DISRIBUTION
$86,667 =420000-333333

The general rule of no gain is impractical when the partner receives a greater amount of money than their outside basis in their partnership interest. They cannot defer gain to the extent of the excess amount because the outside basis is insufficient for a full reduction. Therefore, the partner reduces their outside basis in their interest to zero25 and recognizes gain (generally capital) to the extent the amount of money distributed is greater than their outside basis.26 A partner never recognizes a loss from an operating distribution.

What if: Suppose that in the December 31, 2023, distribution Nicole’s distribution consists of $250,000 cash. Her outside basis in her CCS interest is $205,000 before the distribution. What are Nicole’s gain or loss and basis in her CCS interest after the distribution?

Owner
Nicole
Sarah
Greg

Answer: Nicole has $45,000 capital gain and $0 basis in CCS. Because she receives only money in the distribution, she decreases her outside basis to $0 and must recognize a $45,000 capital gain ($250,000 distribution − $205,000 basis). She recognizes gain because she receives a cash distribution in excess of her outside basis in her CCS interest.

PREDISTRIBUTION BASIS
$205,000
$420,000
$334,000

                 POST DISRIBUTION		
	                                    BASIS =205000-250000		              $0 

REMAINING TREATMENT
CAPITAL GAIN
$45,000

Question 19

what are operating distributions that include property other than money for partnerships?

Answer 19

If a partnership makes a distribution that includes property other than money, the partners face the problem of determining how much outside basis in their interests to allocate to the distributed property.27 Under the general rule, the partner takes a basis in the distributed property equal to the partnership’s basis in the property. This is called a carryover basis.28 The tax rules define the order in which to allocate outside basis in a partnership interest to the bases of distributed assets. First, the partner allocates the outside basis in their interest to any money received and then to other property as a carryover basis. The remainder is the partner’s outside basis in the partnership interest after the distribution.

What if: Suppose CCS’s December 31, 2023, distribution to Sarah consists of $133,333 cash and investments (other than marketable securities) with a fair market value of $200,000 and an adjusted basis of $115,000. Sarah has a predistribution outside basis in her CCS interest of $420,000. What are the tax consequences (Sarah’s gain or loss, basis of distributed assets, outside basis of CCS interest, and CCS’s gain or loss) of the distribution?

Answer: Sarah recognizes no gain or loss on the distribution. To determine her bases in the distributed assets, she first allocates $133,333 to the cash and then takes a carryover basis in the investments, so her basis in the investments is $115,000. Sarah reduces her outside basis in CCS by $248,333 ($133,333 cash + $115,000 basis of investments). Her outside basis in CCS after the distribution is $171,667 ($420,000 − $248,333). CCS does not recognize any gain or loss on the distribution.

Because a partner’s outside basis in a partnership interest includes their share of the partnership liabilities, the outside basis in a partnership interest must reflect any changes in a partner’s share of partnership liabilities resulting from a distribution. In essence, a partner treats a reduction of their share of liabilities as a distribution of cash.32 If the partner increases their share of liabilities, the increase is treated as a cash contribution to the partnership.

What if: Suppose Greg receives land held for investment with a fair market value of $250,000 (inside basis is $140,000) as his distribution from CCS on December 31, 2023. He agrees to assume the $120,000 mortgage on the land after the distribution. His outside basis in his CCS interest is $334,000 before considering the distribution. What are the tax consequences (gain or loss, basis of distributed assets, and outside basis in his CCS interest) of the distribution to Greg?

Answer: Greg does not recognize any gain or loss on the distribution. His basis in the land is $140,000 and his post-distribution outside basis in CCS is $278,000, determined as follows:
Table Summary: Table summarizes computation for Greg’s post-distribution outside basis in CCS. The third column, explanation, is blank for data rows numbered 1 and 2. In row 7 Greg’s post-distribution outside basis in CCS and 278,000 dollars are in bold.

Greg must first consider the effects of changes in debt before determining the effects of the distribution. The tax rules treat him as making a net contribution of $84,000 cash to the partnership, the difference between the full mortgage he assumes and his predistribution share of the debt. Greg then allocates $140,000 of his outside basis in his CCS interest to the land and reduces his outside basis in CCS accordingly.

Question 20

what is the summary of key differences of inside basis and outside basis for a partnership?

Answer 20

refer to “summary of key differences of inside basis and outside basis” exhibit

Question 21

what are liquidating distributions for a partnership?

Answer 21

Partners may also receive liquidating distributions. Because the market for partnership interests is much smaller than for publicly traded stock, partners may have a difficult time finding buyers for their interests. Partnership agreements also often limit purchasers of an interest to the current partner group, to avoid adding an unwanted partner. If the current partner group either cannot or does not want to purchase the interest, the partnership can instead distribute assets to terminate a partner’s interest. These liquidating distributions are similar in form to corporate redemptions of a shareholder’s stock. They can also terminate the partnership. We first explore the tax consequences of operating distributions and then examine the tax treatment for liquidating distributions.

In contrast to an operating distribution in which the partners retain a continuing interest in the partnership after the distribution, a liquidating distribution terminates a partner’s interest in the partnership. Like operating distributions, a liquidating distribution can be made to just one partner or to multiple partners simultaneously. For example, if outside investors or current partners do not have sufficient cash or inclination to purchase a partner’s interest, the partnership agreement often allows a partner wishing to cash out to receive a liquidating distribution from the partnership in lieu of selling the interest. On the other end of the spectrum, all the partners may agree at some point to end the partnership because they have lost interest in continuing it or because it has not been profitable. In such cases, the partnership may distribute all its assets to the partners in a complete liquidation of the partnership. Once a partnership has been terminated in this manner, it must file a final return covering the period from the beginning of its tax year through the date of termination. Subsequently, it no longer has any tax filing obligations. A partnership termination is analogous to a complete corporate liquidation (discussed in the Corporate Formation, Reorganization, and Liquidation chapter).

The tax issues related to partnership liquidating distributions are basically twofold: (1) to determine whether the partner receiving the distribution recognizes gain or loss and (2) to allocate the partner’s outside basis in their interest to the assets received in the liquidating distribution. The rationale behind the rules for liquidating distributions is simply to have the partner’s outside basis in their interest carry over to the assets received by the partner. In some instances, the partner receiving the distribution will not recognize gain or loss on the distribution, and the tax basis in the distributed assets will be the same in the partner’s hands as they were inside the partnership. Unfortunately, this simple outcome rarely occurs. Thus, the rules in this area stipulate when gain or loss must be recognized by partners receiving such distributions and describe how they must allocate their outside basis in their interests to the distributed assets received.