CH. 20 - Partnerships

Question 1

Flow-through entities

Answer 1

legal entities, like partnerships, limited liability companies, and S corporations, that do not pay income tax. Income and losses from flow-through entities are allocated to their owners.

Question 2

True or false: owners of flow-through entities are taxed on the share of entity level income allocated to them

Answer 2

true!

Question 3

C corporations

Answer 3

a corporate taxpaying entity with income subject to taxation. Such a corporation is termed a “C” corporation because the corporation and its shareholders are subject to the provisions of Subchapter C of the Internal Revenue Code.

Question 4

General partnership (GP)

Answer 4

a partnership with partners who all have unlimited liability with respect to the liabilities of the entity.

Question 5

Limited partnership (LP)

Answer 5

a partnership with at least one general partner with unlimited liability for the entity’s debts and at least one limited partner with liability limited to the limited partner’s investment in the partnership.

Question 6

Limited liability company (LLC)

Answer 6

a type of flow-through entity for federal income tax purposes. By state law, the owners of the LLC have limited liability with respect to the entity’s debts or liabilities. Limited liability companies are generally taxed as partnerships for federal income tax ­purposes.

Question 7

Subchapter K

Answer 7

the portion of the Internal Revenue Code dealing with partnerships tax law.

Question 8

Subchapter S

Answer 8

the portion of the Internal Revenue Code containing tax rules for S corporations and their shareholders.

Question 9

S corporation

Answer 9

a corporation under state law that has elected to be taxed under the rules provided in Subchapter S of the Internal ­Revenue Code. Under Subchapter S, an S corporation is taxed as a ­flow-through entity.

Question 10

Entity approach

Answer 10

a theory of taxing partnerships that treats partnerships as entities separate from partners.

Question 11

Aggregate approach

Answer 11

a theory of taxing partnerships that ignores partnerships as entities and taxes partners as if they directly owned partnership net assets.

Question 12

True or false: partnerships pay income taxes

Answer 12

False–as flow through entities, they do not.

Question 13

Partnership interest

Answer 13

an intangible asset reflecting the economic rights a partner has with respect to a partnership, including the right to receive assets in liquidation of the partnership (called a capital interest) and the right to be allocated profits and losses (called a profits interest).

Question 14

Capital interest

Answer 14

an economic right attached to a partnership interest giving a partner the right to receive cash or property in the event the partnership liquidates. A capital interest is synonymous with the liquidation value of a partnership interest.

Question 15

Profits interest

Answer 15

an interest in a partnership giving a partner the right to share in future profits but not the right to share in the current value of a partnership’s assets. Profits interests are generally not taxable in the year they are received.

Question 16

What are the key facts of property contributions when forming a partnership?

Answer 16

-Partners generally don’t recognize gain or loss when they contribute property to partnerships
-Initial tax basis for partners contributing property: basis of contributed property – liability securing contributed property + partnership liabilities
-Contributing partner’s holding period in a partnership interest depends on the type of property contributed

Question 17

When forming a partnership, realized gains and losses from the exchange of contributed property for partnership interests are _________________ for tax purposes, depending on the specifics of the transaction.

Answer 17

either fully or partially deferred for tax purposes

Question 18

True or false; partners in a partnership (or the partnership itself) recognize gain or loss when they contribute property to partnerships

Answer 18

False; as a general rule, they do not

Question 19

Built-in gain

Answer 19

the difference between the fair market value and tax basis of property owned by an entity when the fair market value exceeds the tax basis.

Question 20

Built-in losses

Answer 20

the difference between the fair market value and tax basis of property owned by an entity when the tax basis exceeds the fair market value

Question 21

Outside basis

Answer 21

an investor’s tax basis in the stock of a corporation or the interest in a partnership or LLC.

Question 22

Inside basis

Answer 22

the tax basis of an entity’s assets and liabilities.

Question 23

What steps must be taken to determine each partners tax basis in their respective partnership interests when the partnership has liabilities?

Answer 23

1. All partners must include their shares of the partnership’s liabilities in calculating their own outside basis’s because partnership law treats them as each borrowing their own proportionate shares of the partnerships liabilities and then contributing the borrowed cash to acquire their own respective partnership interests.
2. Contributing partners must treat their own liability relief as deemed cash distributions from the partnership that reduce their individual outside basis.

Question 24

recourse liabilities

Answer 24

Those for which at least one partner has economic risk of loss–aka, they may have to legally satisfy the liability with their own funds.

Example: unsecured liabilities of general partnerships, such as payables, are recourse liabilities because general partners are legally responsible for the liabilities of the partnership.

In limited partnerships, generally allocated only o general partners because limited partners are legally protected from an LLCs recourse creditors.

Question 25

Nonrecourse liabilities

Answer 25

They do not provide creditors the same level of legal recourse against partners as recourse liabilities do. Partners are responsible for paying nonrecourse liabilities on to the extent the partnership generates sufficient profits.

Question 26

How are recourse and nonrecourse liabilities allocated partners?

Answer 26

Recourse liabilities: allocated to partners with ultimate responsibility for pay the liability
Nonrecourse liabilities: allocated according to partners profit sharing ratios

Question 27

What is an important exception to the general rule that partners typically don’t recognize gain on property contributions that may apply when property secured by a liability is contributed to a partnership?

Answer 27

In these situations, the contributing partner recognizes gain only if the cash deemed to have been received from a partnership distribution exceeds the contributing partner’s tax basis in the partnership interest prior to the deemed distribution. Any gain recognized is generally treated as capital gain.

Question 28

A partnership interest is a _________ asset

Answer 28

capital asset

Question 29

To ensure built-in gains and losses on contributed property are ultimately recognized if partnerships sell contributed property, partnerships generally take a tax basis in the property….

Answer 29

To ensure built-in gains and losses on contributed property are ultimately recognized if partnerships sell contributed property, partnerships generally take a tax basis in the property equal to the contributing partner’s tax basis in the property at the time of the contribution

Question 30

When computing a partnership’s inside basis, whether gains or losses on dispositions of contributed property are capital or ordinary usually depends on….

Answer 30

When computing a partnership’s inside basis, whether gains or losses on dispositions of contributed property are capital or ordinary usually depends on the manner in which the partnership uses contributed property

Question 31

Capital account

Answer 31

an account reflecting a partner’s share of the equity in a partnership. Capital accounts are maintained using tax accounting methods or other methods of accounting, including GAAP, at the ­discretion of the partnership.

Question 32

GAAP capital accounts

Answer 32

partners’ capital accounts maintained using generally accepted accounting principles (GAAP).

Question 33

Tax capital accounts

Answer 33

partners’ capital accounts initially determined using the tax basis of contributed property and maintained using tax ­accounting income and expense recognition principles.

Question 34

§704(b) capital accounts

Answer 34

partners’ capital accounts maintained using the accounting rules prescribed in the Section 704(b) regulations. Under these rules, capital accounts reflect the fair market value of property contributed to and distributed property from partnerships.

Question 35

True or false: partners must contribute property in order to receive a partnership interest

Answer 35

False–they can also contribute services in lieu of property

Question 36

Liquidation value

Answer 36

the amount a partner would receive if the partnership were to sell all its assets, pay its debts, and distribute its remaining assets to the partners in exchange for their partnership interests.

Question 37

What’s a Capital Interest?

Answer 37

A capital interest means if the partnership were to liquidate immediately after granting the capital interest, the holder would receive his or her proportionate share of the partnership’s assets in the liquidation

Treated as ordinary income at the time the partner receives their interest

Question 38

Service partner

Answer 38

a partner who receives a partnership interest by contributing services rather than cash or property.

Question 39

Nonservice partner

Answer 39

a partner who receives a partnership interest in exchange for property rather than services.

Question 40

What is the fundamental difference between capital interests and profit interests>

Answer 40

The only economic benefit profit interests provide is the right to share in the future profits of the partnership. Unlike capital interests, profits interests have no liquidation value at the time they are received.

Question 41

Organizational expenditures

Answer 41

expenses that are (1) connected directly to the creation of a corporation or partnership, (2) chargeable to a capital account, and (3) generally amortized over 180 months (limited immediate expensing may be available).

Ex: attorney and accountant fees

Question 42

Syndication costs

Answer 42

costs partnerships incur to promote the sale of partnership interests to the public. Syndication expenses must be capitalized and are not amortizable.

Question 43

Start-up costs

Answer 43

expenses that would be classified as business expenses except that the expenses are incurred before the business begins. These costs are generally capitalized and amortized over 180 months, but ­limited immediate expensing may be available.

Question 44

What are the key facts of acquisitions of partnership interersts after formation?

Answer 44

-Contributing partner’s tax basis and holding period in contributing property carry over to the partnership
-If service partners report ordinary income, the partnership either expenses or capitalizes the amount depending on the nature of the services provided
-The tax basis of a purchased partnership interest = purchase price + partnership liability allocated to partner, and the holding period begins on the purchase date

Question 45

What are some examples of tax elections at the time the partnership forms?

Answer 45

-The election of overall accounting method (accrual vs cash)
-the election to expense a portion of organizational expenditures and start-ups costs
-the election to expense tangible personal property

The partnership itself is responsible for these tax elections

Question 46

What are the key facts for tax elections, accounting periods, and methods for partnerships?

Answer 46

-Partnerships are responsible for making most tax elections
-A partnership’s taxable year is the majority interest taxable year, the common taxable year of the principal partners, or the taxable year providing the least aggregate deferrals to the partners
-Partnerships are generally eligible to use the cash method for 2022 unless they have corporate partners and average gross receipts over the three prior years of greater than $27 million

Question 47

Majority interest taxable year

Answer 47

the common tax year of a group of partners who jointly hold greater than 50 percent of the profits and capital interests in the partnership.

Question 48

Principal partner

Answer 48

a partner having a 5 percent or more interest in partnership capital or profits

Question 49

Least aggregate deferral

Answer 49

an approach to determine a partnership’s ­required year-end if a majority of the partners don’t have the same year-end and if the principal partners don’t have the same year-end. As the name implies, this approach minimizes the combined tax deferral of the partners.

Question 50

What are the key facts of reporting the results of partnership operations?

Answer 50

-Partnerships file annual information returns reporting their ordinary business income/loss and separately stated items
-Ordinary business income/loss = partnership overall income or loss exclusive of separately stated items
-Separately stated items change partners’ tax liabilities according to each partner’s unique situation

Question 51

Ordinary business income (loss)

Answer 51

a partnership’s or S corporation’s remaining income or loss after separately stated items are removed. It is also referred to as nonseparately stated income (loss).

Question 52

Separately stated items

Answer 52

income, expenses, gains, losses, credits, and other items that are excluded from a partnership’s or S corporation’s ­operating income (loss) and disclosed to partners in a partnership or shareholders of an S corporation separately because their tax effects may be different for each partner or shareholder.

Question 53

What are some examples of common separately stated items?

Answer 53

-Short-term capital gains or losses
-Long-term capital gains or losses
-1231 gains and losses
-charitable contributions
-dividends
-interest income
-guaranteed payments
-net earnings/loss from self-employment
-tax-exempt income
-net rental real estate income
-investment interest expense
-royalties
-179 deduction

Question 54

Guaranteed payments

Answer 54

payments made to partners or LLC members that are guaranteed because they are not contingent on partnership ­profits or losses. They are economically similar to shareholder salary payments. They are typically deducted in computing a partnerships ordinary income or loss for the year.

Similar to cash salary payments made to partners for services provided

Question 55

What are the key facts of guaranteed payments and self-employment income?

Answer 55

-guaranteed payments are separately stated items, are treated as ordinary income by partners receiving them, and are either capitalized or expenses by partnerships.
-guaranteed payments for services are always treated as self-employment income
-Shares of ordinary business income/loss are always treated as self-employment income income/loss by general partners and never treated as self-employment income income/loss by limited partners
-Shares of ordinary business income/loss may or may not be treated by LLC members as self-employment income/loss, depending on the extent of their involvement with the LLC.

Question 56

Self-employment taxes

Answer 56

Social Security and Medicare taxes paid by the self-employed on a taxpayer’s net earnings from self-employment. For self-employed taxpayers, the terms “self-employment tax” and “FICA tax” are synonymous.

Question 57

The degree to which partners are responsible for self-employment taxes depends on….

Answer 57

The degree to which partners are responsible for self-employment taxes depends on their legal status as general partners, limited partners, or LLC members and their business

Question 58

The degree to which partners are responsible for self-employment taxes depends on….

Answer 58

The degree to which partners are responsible for self-employment taxes depends on their legal status as general partners, limited partners, or LLC members and their business activities.

Question 59

The deduction for business interest expense is limited to the sum of……

Answer 59

The deduction for business interest expense is limited to the sum of:
(1): business interest income
and
(2) 30% of the adjusted taxable income of the taxpayer for the taxable year

Question 60

True or false: in a partnership setting, QBI would typically include a partnership’s ordinary business income from most service-related businesses as well as a partnership’s investment income such as capital gains, dividends, and investment interest income

Answer 60

False–it would not

Question 61

Are guaranteed payments received by partners for services provided to the partnership considered QBI?

Answer 61

No

Question 62

An individual partners pare of gross income from interest, dividends, annuities, royalties, or rents is/is not included in the partner’s net investment income when calculating the net investment income tax

Answer 62

Is included

Question 63

Special allocations

Answer 63

allocations of income, gain, expense, loss, etc., that are allocated to the owners of an entity in a manner out of proportion with the owners’ interests in the entity. Special allocations can be made by entities treated as partnerships for federal income tax purposes.

Question 64

What is the form partnerships file annually with the IRS to report partnership ordinary income (loss) and separately stated items for the year?

Answer 64

Form 1065 (US Return of Partnership Income)

Question 65

What is the form C corporations, partnerships, and S corporations file to receive an automatic extension to file their annual tax return?

Answer 65

Form 7004

Question 66

Schedule K

Answer 66

a schedule filed with a partnership’s annual tax return ­listing its ordinary income (loss) and its separately stated items.

Question 67

What are the adjustments to a partner’s basis in a partnership that are made every year?

Answer 67

-Increase for actual and deemed cash contributions to the partnership during the year
-Increase for partner’s share of ordinary business income and separately state income/gain items
-Increase for partner’s share of tax-exempt income
-Decrease for actual and deemed cash distributions during the year
-Decrease for partner’s share of nondeductible expenses (fines, penalties, etc)
-Decrease for partners’ share of ordinary business loss and separately states expense/loss items
-Decrease for partner’s share of disallowed business interest expense

Question 68

In what order do partners adjust their basis in partnerships annually?

Answer 68

1. Adjust their outside bases for items that increase basis
2. Adjust for distributions
3. Adjust for nondeductible expenses
4. Adjust for deductible expenses and losses to the extent any basis remains after prior adjustments

Question 69

What are the key facts in a partner’s basis adjustments?

Answer 69

-A partner will increase he tax basis in her partnership interest for:
-contributions
-share of ordinary business income
-separately stated income/gain items
-tax-exempt income
-A partner will decrease the tax basis in her partnership interest for:
-cash distributions
-share of nondedutible expenses
-share of ordinary business loss
-separately stated expense/loss items
-share of disallowed business interest expense
*A partners tax basis may not be negative

Question 70

Partners are taxed on income as the partnership earns/distributes it

Answer 70

Earns it

Question 71

True or false: ordinary losses (not capital losses) from partnerships are deductible against any type of capital income

Answer 71

True!
However, they are deductible on the partner’s tax return only when they clear four separate hurdles:
1. Tax-basis
2. At-risk amount
3. Passive activity
4. Partners are not allowed to deduct excess business losses.

Question 72

What are the key facts on loss limitations?

Answer 72

-Partnership losses in excess of a partner’s tax basis are suspended and carried forward until the 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 or create business loss at the partner level.

Question 73

At-risk rules

Answer 73

tax rules limiting the losses flowing through to partners or S corporation shareholders to their amount “at risk” in the partnership.

Question 74

At-risk amount

Answer 74

an investor’s risk of loss in a worst-case scenario. In a partnership, an amount generally equal to a partner’s tax basis exclusive of the partner’s share of nonrecourse debt.

Question 75

Qualified nonrecourse financing

Answer 75

nonrecourse debt secured by real property from a commercial lender unrelated to the borrower.

Question 76

Partners apply the at-risk limitation (before/after) the tax basis limitation

Answer 76

After

Question 77

Passive activity loss (PAL) rules

Answer 77

tax rules designed to limit taxpayers’ ability to deduct losses from activities in which they don’t materially participate against income from other sources.

Question 78

What are the 7 tests for material participation in a business?

Answer 78

1. The individual participates in the activity more than 500 hours a year.
2. The individual’s activity constitutes substantially all the participation in such activity by individuals
3. 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.
4. The activity qualifies as a “significant participation activity” (individual participates more than 100 hours during the year) and the aggregate of all other “significant participation activities” is greater than 500 hours for the year.
5. The individual materially participates in the activity for any of the 5 preceding 10 taxable years.
6. The activity involves personal services in health, law, accounting, architecture, and so on, and the individual materially participated for any three preceding years.
7. Taking into account all the facts and circumstances, the individual participates on a regular, continuous, and substantial basis during the year.

An individual, other than a limited partner, can be classified as a material participant in activities, other than rental activities, by meeting any ONE of the criteria listed above/

Question 79

What are the income and loss “baskets”?

Answer 79

1. Passive activity income or loss: income or loss from an activity, including partnerships, in which the taxpayer is not a material participant
2. Portfolio income: income from investments, including capital gains and losses, dividends, interest, annuities, and royalties
3. Active business income: income from sources, including partnerships, in which the taxpayer is a material participant. For individuals, this includes salary and self-employment income

Note: losses from the passive basket are not allowed to offset income from the other baskets.

Question 80

Excess business loss

Answer 80

excess of aggregate business deductions for the year over aggregate business gross income or gain of an individual ­taxpayer plus a threshold amount depending on filing status.