Chapter 21 Flashcards
Partnership Definition
• An association of two or more persons to carry on a trade or business – Contribute money, property, labor – Expect to share in profit and losses • For tax purposes, includes: – Syndicate – Group – Pool – Joint venture, etc • Partners can be individuals, corporations, etc.
Entities Taxed as Partnerships (slide 1 of 4)
• General partnership
– Consists of at least 2 general partners
– Partners are jointly and severally liable
• Creditors can collect from both partnership and partners’ personal assets
• General partner’s assets are at risk for malpractice of other partners even if not personally involved in malpractice
Entities Taxed as Partnerships(slide 2 of 4)
• Limited liability company (LLC)
– Combines the corporate benefit of limited liability with benefits of partnership taxation
• Unlike corporations, income is subject to tax only once
• Special allocations of income, losses, and cash flow are available
– Owners are “members,” not partners, but if properly structured will receive partnership tax treatment
Entities Taxed as Partnerships (slide 3 of 4)
• Limited partnership
– Has at least one general partner
• One or more limited partners
– Only general partner(s) are personally liable to creditors
• Limited partners’ loss is limited to equity investment
Entities Taxed as Partnerships (slide 4 of 4)
• Limited liability partnership (LLP)
– Used primarily by service entities
– An LLP partner is not personally liable for malpractice committed by other partners
– Popular organizational form for large accounting firms
Key Concepts in Partnership Taxation (slide 1 of 3)
• Partnership is not a taxable entity
– Flow through entity
• Income taxed to owners, not entity
• Partners report their share of partnership income or loss on their own tax return
Key Concepts in Partnership Taxation (slide 2 of 3)
• Involves 2 legal concepts:
– Aggregate (or conduit) concept – Treats partnership as a channel with income, expense, gains, etc. flowing through to partners
• Concept is reflected by the imposition of tax on the partners, not the partnership
Key Concepts in Partnership Taxation (slide 3 of 3)
• Involves 2 legal concepts (cont’d):
– Entity concept – Treats partners and partnerships as separate and is reflected by:
• Partnership requirement to file its own information return
• Treating partners as separate from the partnership in certain transactions between the two
Partnership Taxation
• Generally, the calculation of partnership income is a 2-step approach
– Step 1: Net ordinary income and expenses related to the trade or business of the partnership
– Step 2: Segregate and report “separately stated items”
– If an item of income, expense, gain or loss might affect any 2 partners’ tax liabilities differently, it is separately stated
– e.g., Charitable contributions
Partner’s Ownership Interest
• Each owner normally has a:
– Capital interest
• Measured by capital sharing ratio
– Partner’s percentage ownership of capital
– Profits (loss) interest
• Partner’s % allocation of partnership ordinary income (loss) and separately stated items
• Certain items may be “specially allocated”
– Specified in the partnership agreement
Inside and Outside Bases
• Inside basis
– Refers to the partnership’s adjusted basis for each asset it owns
– Each partner “owns” a share of the partnership’s inside basis for all its assets
• Outside basis
– Represents each partner’s basis in the partnership interest
– All partners should maintain a record of their respective outside bases
Partnership Reporting(slide 1 of 2)
• Partnership files Form 1065, an information return
– No tax is calculated or paid with the return
• This return is due by the fifteenth day of the third month following the end of the tax year
• For calendar year partnerships, the return is due March 15 of the following year
Partnership Reporting(slide 2 of 2)
• Partnership files Form 1065, an information return
– On page 1 of Form 1065, partnership reports ordinary income or loss from its trade or business activities
– Schedule K accumulates information to be reported to partners
• Provides ordinary income (loss) and separately stated items in total
– Each partner (and the IRS) receives a Schedule K-1
• Reports each partner’s share of ordinary income (loss) and separately stated items
Tax Consequences of Partnership Formation (slide 1 of 2)
• Usually, no gain or loss is recognized by a partner or partnership on the contribution of money or property in exchange for a partnership interest
• Gain (loss) is deferred until taxable disposition of:
– Property by partnership, or
– Partnership interest by partner
Tax Consequences of Partnership Formation(slide 2 of 2)
• Partner’s basis in partnership interest = basis of contributed property
– If partner contributes capital assets and § 1231 assets, holding period of partnership interest includes holding period of assets contributed
– For other assets including cash, holding period begins on date partnership interest is acquired
– If multiple assets are contributed, partnership interest is apportioned and separate holding period applies to each portion
Exceptions to Tax-Free Treatment on Partnership Formation (slide 1 of 4)
• Transfers of appreciated stock to investment partnership
– Gain will be recognized by contributing partner
– Prevents multiple investors from diversifying their portfolios tax-free
Exceptions to Tax-Free Treatment on Partnership Formation (slide 2 of 4)
• If transaction is essentially a taxable exchange of properties, gain will be recognized
– e.g., Individual A contributes land and Individual B contributes equipment to a new partnership; shortly thereafter, the partnership distributes the land to B and the equipment to A; Partnership liquidates
– IRS will disregard transfer to partnership and treat as taxable exchange between A & B
Exceptions to Tax-Free Treatment on Partnership Formation (slide 3 of 4)
• Disguised Sale
– e.g., Partner contributes property to a partnership; Shortly thereafter, partner receives a distribution from the partnership
• Distribution may be viewed as a purchase of the property by the partnership
Exceptions to Tax-Free Treatment on Partnership Formation (slide 4 of 4)
•Receipt of fully vested interest in partnership capital in exchange for services is generally taxable to the partner
•When partner receives fully vested interest in partnership’s future profits in exchange for services rendered, the partner is not typically required to recognize any income at the time of receipt
•Partnership may deduct the amount included in the service partner’s income if the services are of a deductible nature
–If the services are not deductible by the partnership, they must be capitalized to an asset account
–Any deduction is allocated to the OTHER partners
Tax Issues Relative to Contributed Property (slide 1 of 4)
• Contributions of depreciable property and intangible assets
– Partnership “steps into shoes” of contributing partner
• Continues the same cost recovery and amortization calculations
• Cannot expense contributed depreciable property under § 179
Tax Issues Relative to Contributed Property (slide 2 of 4)
• Gain or loss is ordinary when partnership disposes of:
– Contributed unrealized receivables
– Contributed property that was inventory in contributor’s hands, if disposed of within 5 years of contribution
• Inventory includes all tangible property except capital assets and real or depreciable business assets
Tax Issues Relative to Contributed Property (slide 3 of 4)
• If contributed property is disposed of at a loss and the property had a ‘‘built-in’’ capital loss on the contribution date
– Loss is treated as a capital loss if disposed of within 5 years of the contribution
– Capital loss is limited to amount of ‘‘built-in’’ loss on date of contribution
Tax Issues Relative to Contributed Property (slide 4 of 4)
• Special allocations must be made relative to contributed property that is appreciated or depreciated
– The partnership’s income and losses must be allocated under § 704(c) to ensure that the inherent gain or loss is not shifted away from the contributing partner
– Discussed later in the chapter
Elections Made by Partnership(slide 1 of 2)
• Inventory method • Accounting method – Cash, accrual or hybrid • Depreciation method • Tax year • Organizational cost amortization • Start-up expense amortization
Elections Made by Partnership (slide 2 of 2)
- Optional basis adjustment (§754)
- § 179 deduction
- Research and development expense/credit
- NOTE: PARTNER determines treatment of foreign taxes (credit or deduction)
Organizational Costs (slide 1 of 2)
• Partnership may elect to deduct up to $5,000 of organization costs in year business begins
– Deductible amount must be reduced by organization costs that exceed $50,000
– Remaining amounts are amortizable over 180 months beginning with month the partnership begins business
Organizational Costs (slide 2 of 2)
•Organizational costs include costs:
–Incident to creation of the partnership, chargeable to a capital account, and of a character that, if incident to the creation of a partnership with an ascertainable life, would be amortized over that life
• Includes accounting fees and legal fees connected with the partnership’s formation
•Costs incurred for the following items are not organization costs:
–Acquiring and transferring assets to the partnership
–Admitting and removing partners, other than at formation
–Negotiating operating contracts
–Syndication costs
Start-up Costs (slide 1 of 2)
• Start-up costs – Include operating costs incurred after entity is formed but before it begins business including:
– Marketing surveys prior to conducting business
– Pre-operating advertising expenses
– Costs of establishing an accounting system
– Costs incurred to train employees before business begins
– Salaries paid to executives and employees before the start of business
Start-up Costs (slide 2 of 2)
• Partnership may elect to deduct up to $5,000 of start-up costs in the year it begins business
– Deductible amount must be reduced by start-up costs in excess of $50,000
– Costs that are not deductible under this provision are amortizable over 180 months beginning with the month in which the partnership begins business
Method of Accounting (slide 1 of 2)
• New partnership may adopt cash, accrual or hybrid method
– If partnership uses the accrual method of accounting
• Its income must be reported no later than the date that income would be reported on the partnership’s “applicable financial statement”
• e.g., An audited financial statement or other similar financial statement
• Cash method cannot be adopted if partnership:
– Has one or more C corporation partners
– Is a tax shelter
Method of Accounting (slide 2 of 2)
•C Corp partner does not preclude use of cash method if:
–Partnership meets the $25 million gross receipts test (below)
–C corp. partner(s) is a qualified personal service corp., or
–Partnership is engaged in farming business
•A partnership meets the $25 million gross receipts test if it has not received average annual gross receipts of more than $25 million for all tax years
–“Average annual gross receipts” is the average of gross receipts for the three tax years ending with the tax period prior to the tax year in question
Alternative Tax Years
• Other alternatives may be available if:
– Establish to IRS’s satisfaction that a business purpose exists for another tax year
• e.g., Natural business year at end of peak season
– Choose tax year with no more than 3 month deferral
• Partnership must maintain with the IRS a prepaid, non-interest-bearing deposit of estimated deferred taxes
– • Elect a 52- to 53-week taxable year
Measuring Income of Partnership
• Calculation of partnership income is a 2-step approach:
– Step 1: Net ordinary income and expenses related to the trade or business of the partnership
– Step 2: Segregate and report “separately stated items” and other information the partners need to complete their returns
Separately Stated Items (slide 1 of 2)
• If an item of income, expense, gain or loss might affect any 2 partners’ tax liabilities differently, it is separately stated
Separately Stated Items (slide 2 of 2)
• Separately stated items fall under the “aggregate” concept
– Each partner owns a specific share of each item of partnership income, gain, loss or deduction
• Character is determined at partnership level
• Taxation is determined at partner level
Examples of Separately Stated Items (slide 1 of 2)
- Net short and long-term capital gains and losses
- § 1231 gains and losses
- Charitable contributions
- Interest income and other portfolio income
- Expenses related to portfolio income
- Personalty expensed under § 179
Examples of Separately Stated Items (slide 2 of 2)
• Special allocations of income or expense
• Other information the partner needs:
– AMT preference and adjustment items
– Passive activity items
– Self-employment income
– Foreign taxes paid and related information
– Other tax credits
– Distributions and other information the partner needs to calculate basis
Partnership Allocations (slide 1 of 4)
• Partnership agreement can provide that partners share capital, profits, and losses in different ratios
– e.g., Partnership agreement may provide that a partner has a 25% capital sharing ratio, yet be allocated 30% of the profits and 20% of the losses
– Such special allocations are permissible if certain rules are followed
• e.g., Economic effect test, Substantiality
Partnership Allocations (slide 2 of 4)
• The economic effect test requires three things:
– An allocation must be reflected in a partner’s capital account
– When partner’s interest is liquidated, partner must receive assets with FMV = the positive balance in the capital account
– A partner with a negative capital account must restore that account upon liquidation
• This can best be envisioned as a contribution of cash to the partnership equal to the negative balance
Partnership Allocations (slide 3 of 4)
• Substantiality
– Partnership allocations must also have “substantial” effect
• In general, an allocation does not meet the “substantial” test unless it has economic consequences in addition to tax consequences that might benefit a subset of the partners
Partnership Allocations (slide 4 of 4)
• Precontribution gain or loss
– Must be allocated to partners taking into account the difference between basis and FMV of property on date of contribution
• For nondepreciable property this means any built-in gain or loss must be allocated to the contributing partner when disposed of by partnership in taxable transaction
• For depreciable property, allocations related to the built-in loss can be made only to the contributing partner
– For allocations to other partners, the partnership’s basis in the loss property is treated as being the fair market value of the property at the contribution date
Deduction for Qualified Business Income(slide 1 of 4)
•Beginning in 2018, an individual is allowed a 20% deduction for “Qualified Business Income” (QBI) from a sole proprietorship, partnership, or S corporation
–The deduction is calculated at the partner or S corporation shareholder level
–The entity must report, on Sch. K–1, any information the owners need to complete their tax return
•In general, the deduction for QBI is the lesser of 20% of:
–Qualified business income, or
–Modified taxable income (taxable income before the QBI deduction, reduced by any net capital gain)
Deduction for Qualified Business Income(slide 2 of 4)
•If taxable income before the QBI deduction is more than certain threshold amounts, the QBI deduction cannot exceed the greater of:
– 50% of the W–2 wages relating to the qualified trade or business, or
– The sum of:
• 25% of W–2 wages relating to the qualified trade or business, and
• 2.5% of the unadjusted basis (immediately after acquisition) of all qualified property
Deduction for Qualified Business Income(slide 3 of 4)
•QBI is the ordinary income less ordinary deductions from a “qualified trade or business”
–QBI does not include wages, capital gains and losses, dividend income, and interest income
•QBI is calculated separately for each business
– “Combined QBI” is the sum of these separate QBI amounts
• QBI does not include
–Guaranteed payments received for services provided to the partnership, or
–Income from certain service professions
Deduction for Qualified Business Income(slide 4 of 4)
•The service professions excluded from the definition of a qualified trade or business include the fields of – Health – Law – Accounting – Consulting – Investment advising, or – Brokerage Services •For taxpayers with taxable income less than certain threshold amounts, the deduction is permitted for income earned even in those specified fields
Basis of Partnership Interest (slide 1 of 3)
• For new partnerships, partner’s basis usually equals:
– Adjusted basis of property contributed (cost basis or basis of property received by gift or as inheritance), plus
– FMV of any services performed by partner in exchange for partnership interest (i.e., amount reported as ordinary income from services)
Basis of Partnership Interest (Bonus content - slide 2 of 3)
• For existing partnerships, basis depends on how interest was acquired
– If purchased from another partner, basis = amount paid for the interest
– If acquired by gift, basis = donor’s basis plus, in certain cases, a portion of the gift tax paid on the transfer
– If acquired through inheritance, basis = FMV on date of death (or alternate valuation date)
Basis of Partnership Interest (slide 3 of 3)
• A partner’s basis in partnership interest is adjusted to reflect partnership activity
– This prevents double taxation of partnership income
Adjustments to Basis (In Order)
• Initial Basis \+ Partner’s subsequent contributions to partnership,including increases in share of debt \+ Partner’s share of partnership: Taxable income items Exempt income items – Distributions and withdrawals from partnership,including decreases in share of partnership debt – Partner’s share of partnership: Nondeductible expenses Separately stated deductions Losses
Basis Limitation
•A partner’s basis in the partnership interest can never be negative
Partnership Liabilities
• Included in partner’s adjusted basis
– Increase in partner’s share of liabilities
• Treated as a cash contribution to the partnership
• Increases partner’s adjusted basis
– Decrease in partner’s share of liabilities
• Treated as a cash distribution to the partner
• Decreases partner’s adjusted basis
Allocation of Partnership Liabilities
• Two types of partnership debt
– Recourse debt – The partnership or at least one partner is personally liable
• Allocated according to partners’ “economic risk of loss”
• Regulations prescribe a “Constructive Liquidation Scenario”
• If all allocations are proportionate, allocation is based on loss-sharing ratios
– Nonrecourse debt – No partner is personally liable
• Subset: Qualified nonrecourse financing (relevant for Schedules K-1 and at risk limitations)
• Allocate to partners using a three-tiered allocation; first two tiers beyond scope
• Third tier: profit-sharing ratios
Constructive Liquidation Scenario (Bonus content)
1.Partnership assets deemed to be worthless.
2.Assets deemed sold at $0; losses determined
3.Losses allocated to partners under partnership agreement
4.Partners with negative capital accounts deemed to contribute cash to restore negative balance to 0
5.Deemed contributed cash would repay partnership debt
6.Partnership deemed to liquidate
7.Partner’s share of recourse debt = Cash contribution
–used to repay debt (Step 5)
Nonrecourse Debt Allocation(Bonus content)
• Three step allocation:
1.“Minimum Gain” allocated under regulations
– Minimum gain is basically gain which would arise on foreclosure of property
2.Liability = precontribution gain allocated to contributing partner
3.Remaining debt commonly allocated by profit sharing ratios (other allocation methods could be used)
Loss Limitations(slide 1 of 2)
• Partnership losses flow through to partners for use on their tax returns
– Amount and nature of losses that may be used by partners may be limited
– Three different loss limitations apply
• Only losses that make it through all three limits are deductible by a partner
Loss Limitations (slide 2 of 2)
Section Description
704(d) Basis in partnership interest
465 At-risk limitation
469 Passive loss limitation
• Limitations are applied successively to amounts which are deductible at all prior levels
Guaranteed Payments
• Payment from partnership to partner for use of capital or for services provided to partnership
– May not be determined by reference to partnership income
– Usually expressed as a fixed dollar amount or as a% of capital
Treatment of Guaranteed Payments (slide 1 of 2)
• Partnership level: Deducted or capitalized,depending on the nature of the payment
– Deductible by partnership if meets “ordinary and necessary business expense” test
– May create partnership loss
Treatment of Guaranteed Payments (slide 2 of 2)
• Partner level: Included in partner’s income at time partnership deducts
– Treated as if received on last day of partnership tax year
– Character is ordinary income to recipient partner
Other Transactions Between Partner and Partnership (slide 1 of 2)
• Payment to partner may be treated as if between unrelated parties, for example:
– Services unrelated to position as partner (e.g., cleaning services if partnership operates a retail store)
– Loan transactions
– Rental payments
– Sales of property
Other Transactions Between Partner and Partnership (slide 2 of 2)
• Timing of deduction for payment by an accrual basis partnership to a cash basis partner depends on whether payment is:
– Guaranteed payment
• Included in partner’s income on last day of partnership year when accrued (even if not paid until the next year)
– Payment to partner treated as an outsider
• Deduction cannot be claimed until partner includes the amount in income
Sales of Property
• No loss is recognized on the sale of property between a partnership and a partner who owns > 50% of partnership capital or profits
– If property is subsequently sold at a gain, the disallowed loss reduces gain recognized
Partners as Employees
• A partner is not treated as an employee for tax purposes, resulting in the following tax consequences:
– A partner receiving guaranteed payments from the partnership is not subject to tax withholding
– The partnership cannot deduct payments for a partner’s fringe benefits
– A general partner’s distributive share of ordinary partnership income and guaranteed payments for services are generally subject to the Federal self-employment tax
Distributions from a Partnership(slide 1 of 4)
• A payment from a partnership to a partner is not necessarily treated as a distribution
– e.g., Partnership may pay interest or rent to a partner, make a guaranteed payment, or purchase property from a partner
• If a payment is treated as a distribution, it will fall into one of two categories:
– Liquidating distributions
– Nonliquidating distributions
• Depends on whether the partner remains a partner in the partnership after the distribution
Distributions from a Partnership (slide 2 of 4)
• A liquidating distribution occurs when either:
– Partnership itself liquidates and distributes all its property to the partners, or
– Ongoing partnership redeems interest of one of its partners
• e.g., Partner retires
Distributions from a Partnership (slide 3 of 4)
• A current (or nonliquidating) distribution is any other distribution from a continuing partnership to a continuing partner
– Essentially, any distribution that is not a liquidating distribution
Distributions from a Partnership(slide 4 of 4)
• Current or liquidating distributions from a partnership may be either:
– Proportionate – Partner receives his or her share of certain ordinary income-producing assets
– Disproportionate – Partner’s share of certain ordinary income-producing assets increases or decreases
• Most distributions in chapter are “proportionate”
Proportionate Current Distributions (slide 1 of 3)
• In general, neither partner nor partnership recognizes gain or loss on proportionate nonliquidating distributions
– Partner usually takes a carryover basis in assets distributed
– Basis in partnership interest is reduced by amount of cash and basis of property distributed
Proportionate Current Distributions (slide 2 of 3)
– Partner recognizes gain to extent cash received exceeds partner’s adjusted basis (outside basis) in partnership interest
• Reduction in partner’s share of partnership debt is treated as a distribution of cash
– First reduces partner’s basis in partnership
– Any reduction in excess of partner’s basis in partnership results in taxable gain to the partner
– Partner cannot recognize loss on a proportionate nonliquidating distribution
Proportionate Current Distributions (slide 3 of 3)
• Property distributions
– In general, no gain recognized on a property distribution
.• If inside basis of property distributed exceeds partner’s outside basis in partnership interest, distributed asset takes substituted basis
• Assets are deemed distributed and basis applied in a certain order
Ordering Rules
• When multiple assets are distributed from a partnership, they are deemed distributed in the following order
:1. Cash
2. Unrealized receivables and inventory
3. All other assets
• Basis is allocated to assets within a category based on adjusted basis to partnership
Proportionate Liquidating Distributions
• In general:
– No gain or loss is recognized by partnership
– Partner reduces basis in partnership interest by basis in property received at each level using Ordering Rules
– Partner’s entire basis in interest will be absorbed by distributed assets
Exceptions to Liquidating Distribution Rules (slide 1 of 2)
• Gain is recognized if:
– Cash distributed exceeds partner’s basis
– Precontribution gain exceptions
– Disproportionate distribution
Exceptions to Liquidating Distribution Rules (slide 2 of 2)
• Loss is recognized only if:
– Assets received include only cash, unrealized receivables and inventory, and
– Outside basis exceeds partnership’s inside basis in distributed property
Sale of Partnership Interest (slide 1 of 4)
• Generally, results in gain or loss recognition by selling partner
– Gain (loss) = amount realized less partner’s basis in partnership interest
– Partnership liabilities assumed by purchasing partner are treated as part of consideration paid for the partnership interest
Sale of Partnership Interest (slide 2 of 4)
• Partnership tax year closes for selling partner on sale date
– Partner’s share of income through sale date is calculated
• Can prorate annual income or use interim closing of the books
– Taxed to selling partner and increases basis in partnership interest
Sale of Partnership Interest (slide 3 of 4)
• Effect of hot assets
– Hot assets include
:• Unrealized receivables (same as for disproportionate distributions)
• Inventory
– Includes all partnership property except money, capital assets, and §1231 assets
Sale of Partnership Interest (slide 4 of 4)
• Effect of hot assets (cont’d)
– Must allocate sales price of partnership interest between “hot” (ordinary income) assets and “nonhot” (capital gain) components
– Selling partner’s gain is classified as a capital gain or loss portion and an ordinary income or loss amount related to the hot assets
Limited Liability Companies
• A LLC with 2 or more owners is taxed as a partnership
– LLC members are not personally liable for debts of the entity
• Effectively treated as a limited partnership with no general partners
• Results in unusual application of partnership taxation rules in areas such as
– Allocation of liabilities to the LLC members,
– Inclusion or exclusion of debt for at-risk purposes,
– Passive or active status of a member for passive loss purposes
– Determination of a member’s liability for self-employment tax
Limited Liability Partnerships
- Partners are not personally liable for the malpractice and torts of their partners
- Taxable as a partnership
- Conversion of a general partnership into a LLP is not taxable if all of the general partners become LLP partners and hold the same proportionate interest
One advantage of a partnership is:
a. Losses and credits generally pass through to the partners.
b. Income is taxed to the partnership.
c. The liability of the general partners is limited.
d. Taxation is based on distributions, not earnings.
e. None of these choices are correct.
A
A partnership is a flow-through or pass-through entity, because the entity’s income, gains, losses, deductions, credits, and general tax information flow through and are taxed or attributed to the owners.
A partnership can have partners who are individuals, corporations, trusts, associations, or even other partnerships.
True
False
True
A partnership can have partners who are individuals, corporations, trusts, associations, or even other partnerships.
A partner’s profits (loss) interest must be the same as their capital sharing ratio.
True
False
False
Each partner’s profit-, loss-, and capital-sharing ratios are reported on that partner’s Schedule K–1. In many cases, the three ratios are the same. However, if the partnership agreement provides for special allocations or if capital contributions or distributions differed at some point from the profit- or loss-sharing percent, these ratios may differ for a given partner.
In the current year, the GHI Partnership received revenues of $200,000 and paid the following amounts: $50,000 in rent and utilities and $20,000 as a distribution to partner Hanna. In addition, the partnership earned $6,000 of long-term capital gains during the year. Partner Igor owns a 50 percent interest in the partnership. How much income must Igor report for the tax year?
a. $78,000 ordinary income.
b. $75,000 ordinary income; $3,000 of long-term capital gains.
c. $68,000 ordinary income.
d. $65,000 ordinary income; $3,000 of long-term capital gains.
e. None of these choices are correct.
B
The partnership’s ordinary income is calculated as follows:
Revenues $200,000
Less: rent and utilities (50,000)
Ordinary income $150,000
The distribution to Hanna is not deductible. Igor’s share of GHI’s ordinary income is $75,000. The $6,000 of long-term capital gains is a separately stated item, of which Igor’s share is $3,000.
Regarding partnership reporting:
a. An automatic two month extension can be requested.
b. Form 1120 must be filed with the IRS.
c. For a calendar year partnership, the due date is March 15.
d. The partners make most of the elections regarding the treatment of partnership items.
e. For a calendar year partnership, each partner must be given their K–1 by January 31.
C
The partnership return is due by the fifteenth day of the third month following the end of the tax year. For a calendar year partnership, this deadline is March 15.
Sally and Roberto formed the RT Partnership four years ago. Because they decided the company needed some expertise in multimedia presentations, they offered Katie a 1/3 interest in partnership capital if she would come to work for the partnership. She will also receive a 25 percent interest in future partnership profits. On July 1 of the current year, the unrestricted partnership capital interest (fair market value of $25,000) was transferred to Katie. How should Katie treat the receipt of the partnership interest in the current year?
a. $25,000 ordinary income.
b. $25,000 long-term capital gain.
c. Nontaxable.
d. $25,000 short-term capital gain.
e. None of these choices are correct.
A
A person who receives an unrestricted partnership capital interest for services rendered recognizes ordinary income when the interest is received. The amount of income recognized is the fair market value of the partnership interest on the date it is received.
Section 721 provides that, in general, gain but not loss is recognized by the partnership or the partner on contribution of appreciated or depreciated property to a partnership in exchange for an interest in the partnership.
True
False
False
Section 721 provides for nonrecognition of either gain or loss on a contribution of property to the partnership.
Kit and Min form the KM partnership, with each receiving a 50% interest in the capital and profits of the partnership. Kit contributes land with a basis of $30,000 (fair market value of $50,000 and cash of $20,000 for a 50% interest in the partnership. Min contributes services worth $70,000 to the partnership. Which of the following reflects the results of these transactions?
a. Kit recognizes a gain of $20,000.
b. Kit has a basis of $50,000 in his partnership interest.
c. Min has a capital gain equal to $70,000.
d. Min’s basis in the partnership interest is zero.
e. The partnership’s holding period for the land begins on the date of the transfer.
B
Kit has a basis of $50,000 in his partnership interest ($30,000 adjusted basis of the land plus the $20,000 of cash contributed). Services are not considered property that can be transferred to a partnership on a tax-free basis.
Syndication costs arise when partnership interests are being marketed to investors. These costs are deducted on the partnership’s first tax return.
True
False
False
Under § 709, these costs are neither amortizable nor deductible.
Tempe LLC was organized on June 1 and began business on August 1 of 2018. Tempe has adopted a calendar year and incurred the following costs during 18:
Legal fees for drafting the operating agreement $18,000
Syndication costs $19,000
Preopening advertising expenses $20,000
Accounting fees for tax advice of an organizational nature $15,000
Training costs for new employees before opening the business $12,000
The maximum amount Tempe can deduct as startup costs on its tax return for 2018 is:
a. $5,000.
b. $6,800.
c. $2,133.
d. $5,750.
e. None of these choices are correct.
D
Startup costs include the preopening advertising expenses and the training costs for new employees before opening the business ($20,000 + $12,000 = $32,000). The partnership may deduct up to $5,000 of startup costs in the year in which it begins business. This amount must be reduced, however, by startup costs that exceed $50,000. Excess expenditures are amortizable over 180 months, beginning with the month in which the partnership begins business.
Permitted deduction $5,000
Amortization ($32,000 – $5,000)/180 months × 5 months 750
Total deduction $5,750
Stork Partnership incurred $15,000 of organizational costs and $75,000 of startup costs in 2017. Stork may deduct $5,000 each of organizational and startup costs, and the remaining costs ($10,000 of organizational costs and $70,000 of startup costs) may be amortized over 180 months.
True
False
False
For organizational and startup costs, the first $5,000 may be deducted, provided total expenses in that category do not exceed $50,000. If costs in the category exceed the base amount, the deduction is phased out, dollar for dollar. When costs exceed the phaseout amount in that category, no portion of the current deduction is permitted. Any amount that may not be deducted is amortized over 180 months.
Which of the following statements is false regarding accounting methods available to a partnership?
a. If a partnership is a tax shelter, it can use the cash method of accounting.
b. If a partnership has a partner that is a C corporation, it cannot use the cash method.
c. If a partnership has a partner that is a personal service corporation, it cannot use the cash method.
d. None of these choices are correct.
e. All of these choices are correct.
E
“If a partnership is a tax shelter, it can use the cash method of accounting” is false because a partnership must use the accrual method if it is considered to be a tax shelter. A partnership must often use the accrual method if it has a partner that is a C corporation (“If a partnership has a partner that is a C corporation, it cannot use the cash method” is false). However, the partnership can use the cash method if (1) the C partner is a personal service corporation (“If a partnership has a partner that is a personal service corporation, it cannot use the cash method” is false) or (2) the partnership has average annual gross receipts of $25 million or less for all prior three-year tax periods.
A partnership must use the accrual method of accounting if one of the partners is a C corporation.
True
False
False
The cash method may not be adopted by a partnership that has one or more C corporation partners. However, a partnership may be able to use the cash method of accounting if the partnership has never had “average annual gross receipts” in excess of $25 million in any prior three-year period, if the C corporation partner is a qualified personal service corporation, or if the partnership is engaged in the farming business.
Three principal partners do not have the same year-end. Therefore, the least aggregate deferral method must be used to determine the partnership’s year-end.
True
False
True
Three principal partners do not have the same year-end. Therefore, the least aggregate deferral method must be used to determine the partnership’s year-end.
Partnership taxable income (and any separately stated items) will not flow through to each partner at the end of the partnership’s taxable year.
True
False
False
Partnership taxable income (and any separately stated items) flows through to each partner at the end of the partnership’s taxable year.
PQR Partners reported the following items:
Sales revenue $720,000 Interest income 5,000 Long-term capital gain 8,000 Cost of goods sold 200,000 Wages paid to employees 100,000 Cash distributions to partners 20,000 Other operating expenses 30,000
How much will PQR report as ordinary business income?
a. $403,000.
b. $383,000.
c. $390,000.
d. $733,000.
e. $720,000.
C
The partnership’s ordinary business income is $390,000 ($720,000 sales revenue – $200,000 cost of goods sold – $100,000 wages paid to employees – $30,000 other operating expenses).
Book income is reconciled to taxable income on Schedule:
a. K–2.
b. L.
c. M–1.
d. M–2.
e. None of these choices are correct.
C
Book income is reconciled to taxable income on either Schedule M–1 or Schedule M–3. Schedule M–1 is found on page 5 of Form 1065. Schedule M–3 is a separate three-page form and is often required (in lieu of Schedule M–1) for larger partnerships.
Any disallowed business interest expense is passed through to the partners.
True
False
True
Any disallowed business interest expense is passed through to the partners (reducing their basis in the partnership interest) and can be used to offset the partnership’s “excess taxable income” in future years.
A partnership’s allocations of income and deductions to the partners are required to be proportionate to the partners’ percentage ownership of partnership profits in order to meet the substantial economic effect tests.
True
False
False
A partnership may allocate items of partnership income, gain, loss, deduction, or credit in any manner agreed upon by the partners, provided the allocation meets the three substantial economic effect tests or certain alternate tests for economic performance.
A partnership may allocate items of partnership income, gain, loss, deduction, or credit in any manner agreed upon by the partners, provided the allocation meets the three substantial economic effect tests or certain alternate tests for economic performance.
True
False
True
A partnership may allocate items of partnership income, gain, loss, deduction, or credit in any manner agreed upon by the partners, provided the allocation meets the three substantial economic effect tests or certain alternate tests for economic performance.
Miguel and Ann formed a partnership. Miguel received a 40 percent interest in partnership capital and profits in exchange for land with a basis of $100,000 and a fair market value of $140,000. Ann received a 60 percent interest in partnership capital and profits in exchange for $210,000 of cash. Three years after the contribution date, the land contributed by Miguel is sold by the partnership to a third party for $160,000. How much taxable gain will Miguel recognize from the sale?
a. $48,000.
b. $0.
c. $35,000.
d. $110,000.
e. $68,000.
A
Section 704(c)(1)(A) requires that any precontribution gain must be allocated entirely to Miguel. The total gain is $60,000 ($160,000 selling price less the $100,000 basis). Miguel’s precontribution gain is $40,000 ($140,000 fair market value less $100,000 basis). The $40,000 precontribution (“built-in”) gain is allocated all to Miguel plus 40 percent ($8,000) of the $20,000 postcontribution gain.
A partner’s basis is reported on the Schedule K–1.
True
False
False
A partner’s basis is not reflected anywhere on the Schedule K–1. Instead, each partner should maintain a personal record of the basis in the partnership interest..
Julia purchased her partnership interest from Christina on the first day of the current year for $40,000 cash. She received a $10,000 cash distribution from the partnership during the year, and her share of partnership income is $15,000. If her share of partnership liabilities on the last day of the partnership year is $20,000, her outside basis for her partnership interest at the end of the year is $65,000.
True
False
True
Julia’s adjusted basis at the end of the year is $65,000, determined as follows: $40,000 cash (paid to acquire interest) + $15,000 (share of income) + $20,000 (share of partnership liabilities) – $10,000 (cash distribution).
A partner’s adjusted basis in a newly formed partnership usually equals (1) the fair market value of any property (or cash) the partner contributed to the partnership plus (2) the fair market value of any services the partner performed for the partnership.
True
False
False
For property (or cash) contributed to the partnership, the adjusted basis is used, not the fair market value.
Recourse debt is partnership debt for which the partnership or at least one of the partners is personally liable.
True
False
True
Recourse debt is partnership debt for which the partnership or at least one of the partners is personally liable.
Marina and Nolan formed the MN Partnership. Marina contributed $20,000 of cash in exchange for her 50 percent interest in the partnership capital and profits. During the first year of partnership operations, the following events occurred: the partnership had a net taxable income of $10,000; Marina received a distribution of $8,000 cash from the partnership; and Marina had a 50 percent share in the partnership’s $16,000 of recourse liabilities on the last day of the partnership year. Marina’s adjusted basis for her partnership interest at year-end is:
a. $25,000.
b. $17,000.
c. $20,000.
d. $38,000.
e. $33,000.
A
Marina’s adjusted basis consists of her $20,000 cash contribution, plus her $5,000 share of partnership income, minus the $8,000 cash distribution, plus her $8,000 share of partnership liabilities.
An increase in a partner’s share of partnership debt is treated as a cash contribution by the partner to the partnership.
True
False
True
An increase in a partner’s share of partnership debt is treated as a cash contribution by the partner to the partnership and increases the partner’s basis.
Meredith and Katie form an equal partnership during the current year. Meredith contributes cash of $160,000, and Katie contributes property (adjusted basis of $90,000, fair market value of $260,000) subject to a nonrecourse liability of $100,000. As a result of these transactions, Katie has a basis in her partnership interest of $40,000.
True
False
False
Katie is allocated the first $10,000 of debt ($100,000 debt – $90,000 basis), plus one-half of the remaining debt. She has an adjusted basis for her partnership interest of $45,000, calculated as follows:
Basis, property transferred $90,000
Less: liability assumed by partnership (100,000)
Plus: § 704(c) allocation of debt 10,000
Basis before remaining allocation $–0–
Remaining allocation of debt ($90,000 × 50%) 45,000
Katie’s basis $45,000
The partner’s basis is shown on Schedule K–1.
True
False
False
The partner’s basis is not shown on Schedule K–1 or anywhere else on the tax return.
The sum of the partner’s ending basis on Schedule K–1 equals the total of the partner’s ending capital account on Schedule L.
True
False
False
The partner’s basis is not shown on Schedule K–1 or anywhere else on the tax return. The partner’s capital account is shown on Schedule K–1, but it does not generally equal the partner’s basis. The amounts are not equal for various reasons, one being that the partner’s share of partnership debt is not included in the capital account.
If a partnership allocates losses to the partners, the partners must first apply the at-risk limitations, then the basis limitation, and finally the passive loss limitations. If all three hurdles are met, the partner may deduct the loss.
True
False
False
The overall limitation of § 704(d) must first be met. This means the allocated loss cannot exceed the partners’ basis in the partnership interest. Any loss that meets the overall limitation must be tested under the at-risk rules of § 465. Any losses that pass the at-risk rules are evaluated. If the loss is a passive loss under § 469, it is combined with passive income and losses from other sources to determine whether or not it may be deducted. If a loss passes these three limitations, a noncorporate taxpayer must consider whether the excess business loss limitation might apply.
If a partner contributes a capital asset to the partnership, the partner’s holding period in the partnership interest begins on the date of the transfer.
True
False
False
If a partner contributes a capital asset, the partner’s holding period in the partnership interest is the same as that partner’s holding period for the capital asset.
Section 721 provides that, in general, gain but not loss is recognized by the partnership or the partner on contribution of appreciated or depreciated property to a partnership in exchange for an interest in the partnership.
True
False
False
Section 721 provides for nonrecognition of either gain or loss on a contribution of property to the partnership.
Kit and Min form the KM partnership, with each receiving a 50% interest in the capital and profits of the partnership. Kit contributes land with a basis of $30,000 (fair market value of $50,000 and cash of $20,000 for a 50% interest in the partnership. Min contributes services worth $70,000 to the partnership. Which of the following reflects the results of these transactions?
a. Kit recognizes a gain of $20,000.
b. Kit has a basis of $50,000 in his partnership interest.
c. Min has a capital gain equal to $70,000.
d. Min’s basis in the partnership interest is zero.
e. The partnership’s holding period for the land begins on the date of the transfer.
B
Kit has a basis of $50,000 in his partnership interest ($30,000 adjusted basis of the land plus the $20,000 of cash contributed). Services are not considered property that can be transferred to a partnership on a tax-free basis.
Sally and Roberto formed the RT Partnership four years ago. Because they decided the company needed some expertise in multimedia presentations, they offered Katie a 1/3 interest in partnership capital if she would come to work for the partnership. She will also receive a 25 percent interest in future partnership profits. On July 1 of the current year, the unrestricted partnership capital interest (fair market value of $25,000) was transferred to Katie. How should Katie treat the receipt of the partnership interest in the current year?
a. $25,000 short-term capital gain.
b. $25,000 long-term capital gain.
c. Nontaxable.
d. $25,000 ordinary income.
e. None of these choices are correct.
D
A person who receives an unrestricted partnership capital interest for services rendered recognizes ordinary income when the interest is received. The amount of income recognized is the fair market value of the partnership interest on the date it is received.
Artie, Willy, and Thomas contributed assets to form the equal AWT Partnership. Artie contributed cash of $40,000 and land with a basis of $80,000 (fair market value of $60,000). Willy contributed cash of $60,000 and land with a basis of $50,000 (fair market value of $40,000). Thomas contributed cash of $60,000 and a fully depreciated property ($0 basis) valued at $40,000. Which of the following tax treatments is not correct?
a. Thomas realizes a gain of $40,000 but recognizes $0 gain.
b. AWT has a basis of $80,000, $50,000, and $0 in the land and property (excluding cash) contributed by Artie, Willy, and Thomas, respectively.
c. Artie’s basis in his partnership interest is $120,000.
d. Willy realizes and recognizes a loss of $10,000.
e. All of these choices are correct.
D
Willy’s basis in the partnership interest equals the $60,000 cash plus his $50,000 basis in the property contributed. He cannot recognize his $10,000 realized loss. The other three statements are correct. Artie’s basis equals the cash contribution plus the $80,000 basis in the land. Thomas’s basis equals the $60,000 cash contribution since he had no basis in the property he contributed; he does not recognize his $60,000 realized gain. The partnership takes a carryover basis in the three contributed properties.
Syndication costs include brokerage fees, legal fees, and registration fees incurred in connection with marketing interests in partnerships.
True
False
True
Syndication costs include brokerage fees, legal fees, and registration fees incurred in connection with marketing interests in partnerships. Under § 709, these costs are neither amortizable nor deductible.
Stork Partnership incurred $15,000 of organizational costs and $75,000 of startup costs in 2017. Stork may deduct $5,000 each of organizational and startup costs, and the remaining costs ($10,000 of organizational costs and $70,000 of startup costs) may be amortized over 180 months.
True
False
False
For organizational and startup costs, the first $5,000 may be deducted, provided total expenses in that category do not exceed $50,000. If costs in the category exceed the base amount, the deduction is phased out, dollar for dollar. When costs exceed the phaseout amount in that category, no portion of the current deduction is permitted. Any amount that may not be deducted is amortized over 180 months.
Zion Corporation was formed on July 1, 2018 and started business on November 1. Zion adopts a calendar year. During 2018, Zion incurred $40,000 in legal fees for drafting the LLC’s operating agreement and $12,000 in accounting fees for tax advice of an organizational nature. If Zion wants to take the largest deduction for organizational expenses, how much can they deduct for 2018?
a. $4,633.
b. $5,000.
c. $5,522.
d. $3,544.
e. $2,167.
D
The partnership may deduct up to $5,000 of organizational expenditures in the year in which it begins business. This amount must be reduced, however, by organizational expenditures that exceed $50,000. Excess expenditures are amortizable over 180 months, beginning with the month in which the partnership begins business.
Total organizational expenses $52,000
Less (50,000)
Excess $2,000
Maximum amount deductible $5,000 Less (2,000) Permitted deduction $3,000 Amortization ($52,000 – $3,000)/180 months × 2 months 544 Total deduction $3,544
The partnership makes the election as to what cost recovery methods and assumptions are used.
True
False
True
The partnership makes elections regarding everything from the partnership’s taxable year to the depreciation method for partnership assets.
Tempe LLC was organized on June 1 and began business on August 1 of 2018. Tempe has adopted a calendar year and incurred the following costs during 18:
Legal fees for drafting the operating agreement $18,000
Syndication costs $19,000
Preopening advertising expenses $20,000
Accounting fees for tax advice of an organizational nature $15,000
Training costs for new employees before opening the business $12,000
The maximum amount Tempe can deduct as startup costs on its tax return for 2018 is:
a. $6,800.
b. $2,133.
c. $5,750.
d. $5,000.
e. None of these choices are correct.
C
Startup costs include the preopening advertising expenses and the training costs for new employees before opening the business ($20,000 + $12,000 = $32,000). The partnership may deduct up to $5,000 of startup costs in the year in which it begins business. This amount must be reduced, however, by startup costs that exceed $50,000. Excess expenditures are amortizable over 180 months, beginning with the month in which the partnership begins business.
Permitted deduction $5,000
Amortization ($32,000 – $5,000)/180 months × 5 months 750
Total deduction $5,750
Syndication costs arise when partnership interests are being marketed to investors. These costs are deducted on the partnership’s first tax return.
True
False
False
Under § 709, these costs are neither amortizable nor deductible.
The cash method may not be adopted by a partnership that has one or more C corporation partners.
True
False
True
The cash method may not be adopted by a partnership that has one or more C corporation partners. However, a partnership may be able to use the cash method of accounting if the partnership has never had “average annual gross receipts” in excess of $25 million in any prior three-year period, if the C corporation partner is a qualified personal service corporation, or if the partnership is engaged in the farming business.
Which of the following statements is false regarding accounting methods available to a partnership?
a. If a partnership has a partner that is a personal service corporation, it cannot use the cash method.
b. If a partnership has a partner that is a C corporation, it cannot use the cash method.
c. If a partnership is a tax shelter, it can use the cash method of accounting.
d. None of these choices are correct.
e. All of these choices are correct.
E
“If a partnership is a tax shelter, it can use the cash method of accounting” is false because a partnership must use the accrual method if it is considered to be a tax shelter. A partnership must often use the accrual method if it has a partner that is a C corporation (“If a partnership has a partner that is a C corporation, it cannot use the cash method” is false). However, the partnership can use the cash method if (1) the C partner is a personal service corporation (“If a partnership has a partner that is a personal service corporation, it cannot use the cash method” is false) or (2) the partnership has average annual gross receipts of $25 million or less for all prior three-year tax periods.
At the beginning of the year, Penny’s “tax basis” capital account balance in the PAL Partnership was $60,000. During the tax year, Penny contributed property with a basis of $10,000 and a fair market value of $30,000. Her share of the partnership’s ordinary income and separately stated income and deduction items was $26,000. At the end of the year, the partnership distributed $10,000 of cash to Penny. Also, the partnership allocated $15,000 of recourse debt and $25,000 of nonrecourse debt to Penny. What is Penny’s ending capital account balance determined using the “tax basis” method?
a. $96,000.
b. $86,000.
c. $136,000.
d. $101,000.
e. $126,000
B
Penny’s beginning capital account balance of $60,000 is “rolled forward” by adding the basis of the property she contributed ($10,000) and her share of partnership income ($26,000), and subtracting the distribution to her ($10,000). Liabilities are not included in the partner’s capital account.
A partner’s profits (loss) interest may differ from their capital sharing ratio.
True
False
True
Each partner’s profit-, loss-, and capital-sharing ratios are reported on that partner’s Schedule K–1. In many cases, the three ratios are the same. However, if the partnership agreement provides for special allocations or if capital contributions or distributions differed at some point from the profit- or loss-sharing percent, these ratios may differ for a given partner.
The sum of the partner’s ending basis on Schedule K–1 equals the total of the partner’s ending capital account on Schedule L.
True
False
False
The partner’s basis is not shown on Schedule K–1 or anywhere else on the tax return. The partner’s capital account is shown on Schedule K–1, but it does not generally equal the partner’s basis. The amounts are not equal for various reasons, one being that the partner’s share of partnership debt is not included in the capital account.
A limited liability company provides limited liability for all of its members, regardless of whether they are active in the management of the LLC.
True
False
True
If a partner treats an item differently than the partnership, the IRS should be notified of the inconsistent treatment.
True
False
True
The partnership must use the interim closing method to allocate income among the partners when ownership interests vary during the year.
True
False
False
In general, the partnership may use the interim closing method or the proration method to allocate income among the partners when ownership interests vary during the year.
Cornelius is a 25 percent owner in the NICE LLC (a calendar year entity). At the end of the last tax year, Cornelius’s basis in his interest was $40,000, including his $10,000 share of LLC liabilities. On July 1 of the current tax year, Cornelius sells his LLC interest to Inga for $50,000 cash. In addition, Inga assumes Cornelius’s share of LLC liabilities, which, at that date, was $15,000. During the current tax year, NICE’s taxable income is $100,000 (earned evenly during the year). Cornelius’s share of the LLC’s unrealized receivables is valued at $5,000 ($0 basis). At the sale date, what is Cornelius’s basis in his LLC interest, how much gain or loss must he recognize, and what is the character of the gain or loss?
a. $57,500 basis; $5,000 ordinary income and $2,500 capital gain.
b. $57,500 basis; $2,500 ordinary income and $5,000 capital loss.
c. $65,000 basis; no gain or loss.
d. $65,000 basis; $15,000 capital gain.
e. $55,000 basis; $5,000 capital loss.
A
Cornelius’s beginning $40,000 basis is increased by the $5,000 increase in his share of LLC liabilities and by his $12,500 share of LLC income for the year ($100,000 × 25% × 1/2 year), for a basis of $57,500 at the date the interest is sold. As the selling price of the interest was $65,000 ($50,000 cash plus $15,000 assumption of liabilities), Cornelius’s total gain is $7,500. Because his share of the LLC’s hot asset is $5,000, he has $5,000 of ordinary income and the remaining $2,500 is capital gain.
If the partnership interest being sold is classified as a “carried interest,” any gain on the sale of that interest is treated as a short-term capital gain, unless the interest has been held for more than one year.
True
False
False
If the partnership interest being sold is classified as a “carried interest,” any gain on the sale of that interest is treated as a short-term capital gain, unless the interest has been held for more than three years.
Lilly sells her 25 percent partnership interest to Luna for $50,000 on July 1 of the current tax year. Lilly’s basis in her partnership interest at the beginning of the year was $40,000, including a $15,000 share of partnership liabilities. The partnership’s income for the entire year was $100,000, and Lilly’s share of partnership debt was $10,000 as of the date she sold the partnership interest. Assume the partnership has no hot assets and that its income is earned evenly throughout the year. Lilly recognizes a gain of $2,500 on the sale.
True
False
True
Lilly’s $40,000 basis is reduced by the $5,000 decrease in her share of partnership debt and is increased by her $12,500 share of partnership income for one-half of the tax year ($100,000 × 25% × 1/2 year) to become $47,500. Thus, $50,000 (sale price) – $47,500 (adjusted basis) equals $2,500 gain on the sale.
The purchasing partner includes any assumed indebtedness as part of the consideration paid for the partnership interest.
True
False
True
The purchasing partner includes any assumed indebtedness as a part of the consideration paid for the partnership interest, just as the selling partner includes the share of liabilities in the basis in the partnership interest.
Tyler and Josie formed a partnership. Tyler received a 25 percent interest in partnership capital and profits in exchange for land with a basis of $40,000 and a fair market value of $60,000. Josie received a 75 percent interest in partnership capital and profits in exchange for $180,000 of cash. Three years after the contribution date, the land contributed by Tyler is sold by the partnership to a third party for $76,000. How much taxable gain will Tyler recognize from the sale?
a. $0.
b. $24,000.
c. $36,000.
d. $9,000.
e. None of these choices are correct.
B
Section 704(c)(1)(A) requires that any precontribution gain must be allocated entirely to Tyler. Therefore, Tyler is allocated the $20,000 precontribution (“built-in”) gain and 25 percent ($4,000) of the $16,000 postcontribution gain.
For a partner, qualified business income (QBI) includes guaranteed payments received for services provided to the partnership.
True
False
False
For a partner, QBI does not include guaranteed payments received for services provided to the partnership or payments from the partnership under § 707(a) for services unrelated to the partnership’s business (e.g., payments by a restaurant LLC to a member for providing accounting services).
Travis and Granger are equal partners in the TG Partnership. Just before TG liquidated, Travis’s capital account balance was $50,000, and Granger’s capital account balance was $30,000. To meet the substantial economic effect requirements, any liquidating cash distribution must be allocated equally between the partners.
True
False
False
One of the three requirements of the economic effect test is that the partnership agreement must provide that liquidating distributions will be in proportion to the partners’ ending capital account balances. In addition to the “economic effect” test, all allocations must meet the “substantial” requirement.
Miguel and Ann formed a partnership. Miguel received a 40 percent interest in partnership capital and profits in exchange for land with a basis of $100,000 and a fair market value of $140,000. Ann received a 60 percent interest in partnership capital and profits in exchange for $210,000 of cash. Three years after the contribution date, the land contributed by Miguel is sold by the partnership to a third party for $160,000. How much taxable gain will Miguel recognize from the sale?
a. $48,000.
b. $68,000.
c. $110,000.
d. $0.
e. $35,000.
A
Section 704(c)(1)(A) requires that any precontribution gain must be allocated entirely to Miguel. The total gain is $60,000 ($160,000 selling price less the $100,000 basis). Miguel’s precontribution gain is $40,000 ($140,000 fair market value less $100,000 basis). The $40,000 precontribution (“built-in”) gain is allocated all to Miguel plus 40 percent ($8,000) of the $20,000 postcontribution gain.
A partnership’s allocations of income and deductions to the partners are required to be proportionate to the partners’ percentage ownership of partnership profits in order to meet the substantial economic effect tests.
True
False
False
A partnership may allocate items of partnership income, gain, loss, deduction, or credit in any manner agreed upon by the partners, provided the allocation meets the three substantial economic effect tests or certain alternate tests for economic performance.
Proportionate liquidating distributions must consist of a series of distributions.
True
False
False
Proportionate liquidating distributions consist of a single distribution or a series of distributions that result in the termination of the partner’s entire interest in the partnership.
In a proportionate liquidating distribution, DFG Partnership distributes to partner Daniella cash of $10,000, accounts receivable (basis of $0 and fair market value of $20,000), and land (basis of $25,000 and fair market value of $20,000). Daniella’s basis was $40,000 before the distribution. On the liquidation, Daniella recognizes a gain of $10,000, and her basis is $20,000 each in the land and accounts receivable.
True
False
False
A partner only recognizes a gain on receipt of a proportionate liquidating distribution when the distributed cash exceeds the partner’s basis in the partnership interest before the distribution. Daniella’s $40,000 basis is first reduced by the cash distribution to $30,000. Thus, the accounts receivable take a $0 carryover basis, and the remaining $30,000 basis is allocated to the land.
Normally, a distribution of property from a partnership does not result in gain recognition. However, a distribution of bonds may be treated, in part, as a distribution of cash that could result in gain recognition.
True
False
True
A partnership that combines the corporate benefit of limited liability for the owners with the benefits of partnership taxation, including the single level of tax and special allocations of income, losses, and cash flows.
Limited Liability Company
A partnership that is treated similarly to a general partnership in most states. The primary difference is that the partner is not personally liable for any malpractice committed by other partners.
Limited Liability Partnership
A partnership consisting of two or more partners who are general partners and who may participate in management of the entity; there are no limited partners.
General Partnership
A partnership with at least one general partner and one or more limited partners.
Limited Partnership
Self-employment income includes a general partner’s distributive share of income from a partnership’s trade or business, whether or not that income is distributed.
True
For both general and limited partners, any guaranteed payments for services are subject to the self-employment tax.
True
Certain types of income allocated from a partnership are treated as net investment income, including dividends, interest, passive income, and gains from property not used in a trade or business.
True
A partner’s distributive share is not considered net investment income if the partner is a “passive” investor, as defined under § 469.
False
A partnership is an association formed by two or more taxpayers (which may be any type of entity) to carry on a trade or business.
True
In a limited liability company, all members are protected from all debts of the partnership unless they personally guaranteed the debt.
True
An example of the “aggregate concept” underlying partnership taxation is the fact that the partners (rather than the partnership) pay tax on partnership income.
True
George received a fully-vested 10% interest in partnership capital and a 20% interest in future partnership profits in exchange for services rendered to the GHP, LLC (not a publicly-traded partnership interest). The future profits of the partnership are subject to normal operating risks. George will report ordinary income equal to the fair market value of the profits interest, but the capital interest will not be currently taxed to him.
True
False
False
Tara and Robert formed the TR Partnership four years ago. Because they decided the company needed some expertise in multimedia presentations, they offered Katie a 1/3 interest in partnership capital if she would come to work for the partnership. On July 1 of the current year, the unrestricted partnership interest (fair market value of $25,000) was transferred to Katie. How should Katie treat the receipt of the partnership interest in the current year?
a. $25,000 long-term capital gain.
b. Carried interest.
c. Nontaxable.
d. $25,000 ordinary income.
e. $25,000 short-term capital gain.
d
DIP LLC reports ordinary income (before guaranteed payments) of $120,000, rent expense of $40,000, and interest income of $4,000 for the year. In addition, DIP paid guaranteed payments to partner Percy of $20,000. If Percy owns a 40% capital and profits interest, how much income will he report for the year and what is its character?
a. $32,000 ordinary income, $1,600 interest income.
b. $25,600 ordinary income.
c. $24,000 ordinary income.
d. $32,000 ordinary income, $1,600 interest income, $20,000 guaranteed payment.
e. $24,000 ordinary income, $1,600 interest income, $20,000 guaranteed payment.
E
A cash distribution from a partnership to a partner is generally taxable to the partner.
True
False
False
A partner who is fully liable in an individual capacity for the debts owed by the partnership to third parties. A general partner’s liability is not limited to the investment in the partnership. See also limited partners.
general partners
A partner whose liability to third-party creditors of the partnership is limited to the amounts invested in the partnership. See also general partners and limited partnership (LP).
limited partners
A partnership that is owned by one or more general partners. Creditors of a general partnership can collect amounts owed them from both the partnership assets and the assets of the partners individually.
general partnership (GP)
A partnership in which some of the partners are limited partners. At least one of the partners in a limited partnership must be a general partner.
limited partnership (LP)
A legal entity in which all owners are protected from the entity’s debts but which may lack other characteristics of a corporation (i.e., centralized management, unlimited life, free transferability of interests). LLCs are treated as partnerships (or disregarded entities if they have only one owner) for tax purposes.
limited liability company (LLC)
A legal entity allowed by many of the states, where a general partnership registers with the state as an LLP. All partners are at risk with respect to any contractual liabilities of the entity as well as any liabilities arising from their own malpractice or torts or those of their subordinates. However, all partners are protected from any liabilities resulting from the malpractice or torts of other partners.
limited liability partnership (LLP)
The governing document of a partnership. A partnership agreement should describe the rights and obligations of the partners; the allocation of entity income, deductions, and cash flows; initial and future capital contribution requirements; conditions for terminating the partnership; and other matters.
partnership agreement
The governing document of a limited liability company. This document is similar in structure, function, and purpose to a partnership agreement.
operating agreement
Definition: A perspective taken towards a venture that regards the venture as an aggregation of its owners joined together in an agency relationship rather than as a separate entity. For tax purposes, this results in the income of the venture being taxable directly to its owners. For example, items of income and expense, capital gains and losses, tax credits, etc., realized by a partnership pass through the partnership (a conduit) and are subject to taxation at the partner level. Also, in an S corporation, certain items pass through and are reported on the returns of the shareholders. See also entity concept.
aggregate (or conduit) concept
A perspective taken toward a venture that regards the venture as an entity separate and distinct from its owners. For tax purposes, this results in the venture being directly responsible for the tax on the income it generates. The entity perspective taken toward C corporations results in the double taxation of income distributed to the corporation’s owners.
entity concept
A partnership’s basis in the assets it owns.
inside basis
A partner’s basis in his or her partnership interest.
outside basis
Any item of a partnership or an S corporation that might be taxed differently to any two owners of the entity. These amounts are not included in the ordinary income of the entity, but are instead reported separately to the owners; tax consequences are determined at the owner level.
separately stated items
Usually, the percentage of the entity’s net assets that a partner would receive on liquidation. Typically determined by the partner’s capital sharing ratio.
capital interest
The extent of a partner’s entitlement to an allocation of the partnership’s operating results. This interest is measured by the profit and loss sharing ratios.
profits (loss) interest
A partner’s percentage ownership of the entity’s capital.
capital sharing ratio
Specified in the partnership agreement and used to determine each partner’s allocation of ordinary taxable income and separately stated items. Profits and losses can be shared in different ratios. The ratios can be changed by amending the partnership agreement or by using a special allocation. § 704(a).
Profit and loss sharing ratios
Under the § 704(b) Regulations, partnership allocations will be respected only if capital accounts are maintained in accordance with those regulations. These so-called “§ 704(b) book capital accounts” are properly maintained if they reflect the partner’s contributions and distributions of cash; increases and decreases for the fair market value of contributed/distributed property; and adjustments for the partner’s share of income, gains, losses, and deductions. Certain other adjustments are also required. See also economic effect test and Section 704(b) book capital accounts.
capital account maintenance
Any amount for which an agreement exists among the partners of a partnership outlining the method used for spreading the item among the partners.
special allocation
A tax information form prepared for each partner in a partnership, each shareholder of an S corporation, and some beneficiaries of certain trusts. The Schedule K–1 reports the owner’s share of the entity’s ordinary income or loss from operations as well as the owner’s share of separately stated items.
Schedule K-1
When a partner contributes property to the entity and soon thereafter receives a distribution from the partnership, the transactions are collapsed and the distribution is seen as a purchase of the asset by the partnership. § 707(a)(2)(B).
disguised sale
A “partnership interest held in connection with performance of services,” as defined under § 1061. Long-term capital gains from such an interest are reclassified as short-term capital gains (with potential ordinary income treatment) unless the underlying asset that triggered the gain had more than a three-year holding period. This provision only applies to income and gains arising from managing portfolio investments on behalf of third-party investors, including publicly traded securities, commodities, certain real estate, or options to buy/sell such assets. Section 1061 was enacted in the TCJA of 2017 in an effort to curtail an industry practice that resulted in fund managers receiving partnership profits interests in exchange for services: these “profits partners” received long-term capital gain allocations from the fund, rather than ordinary income for the services provided in managing the fund’s assets. In addition to § 1061, the IRS has, from time to time, announced that it might issue regulations (under its general “anti-abuse” authority) to expand the scope of the carried interest rules.
carried interest
Incurred in promoting and marketing partnership interests for sale to investors. Examples include legal and accounting fees, printing costs for prospectus and placement documents, and state registration fees. These items are capitalized by the partnership as incurred, with no amortization thereof allowed.
Syndication costs
A partnership or limited liability company must use a required tax year as its tax accounting period, or one of three allowable alternative tax year-ends. If there is a common tax year used by owners holding a majority of the entity’s capital or profits interests or if the same year end is used by all “principal partners” (partners who hold 5 percent or more of the capital or profits interests), then that tax year-end is used by the entity. If neither of the first tests results in an allowable year-end (e.g., because there is no majority partner or because the principal partners do not have the same tax year), then the partnership uses the least aggregate deferral method to determine its tax year.
required taxable year
Payments made by a partnership to a partner for services rendered or for the use of capital to the extent the payments are determined without regard to the income of the partnership. The payments are treated as though they were made to a nonpartner and thus are deducted by the entity. A guaranteed payment might be subject to self-employment tax (guaranteed payment for services) or net-investment income tax (guaranteed payment for capital). In addition, a guaranteed payment for capital might be eligible for the qualified business income deduction, but a guaranteed payment for services is not.
guaranteed payment
Definition: Requirements that must be met before a special allocation may be used by a partnership. The premise behind the test is that each partner who receives an allocation of income or loss from a partnership bears the economic benefit or burden of the allocation.
economic effect test
Capital accounts calculated as described under Reg. § 1.704–1(b)(2)(iv). All partnerships must maintain § 704(b) book capital accounts for the partners with the intent that final liquidating distributions are in accordance with these capital account balances. Partnership allocations will not be accepted unless they are properly reflected in the partners’ § 704(b) book capital accounts. These capital accounts are a hybrid of book and tax accounting methods. They reflect contributions and distributions of property at their fair market values, but the capital accounts are otherwise generally increased by the partnership’s tax-basis income and decreased by tax-basis deductions (as reported on the partner’s Schedule K–1). Liabilities are only reflected in these capital accounts to the extent the partnership assumes a partner’s liability [reduces that partner’s § 704(b) book capital account] or a partner assumes a partnership liability [increases that partner’s § 704(b) book capital account]. See also capital account maintenance and economic effect test.
Section 704(b) book capital accounts
Definition: Partnerships allow for a variety of special allocations of gain or loss among the partners, but gain or loss that is “built in” on an asset contributed to the partnership is assigned specifically to the contributing partner. § 704(c)(1)(A).
precontribution gain or loss
Debt for which the lender may both foreclose on the property and assess a guarantor for any payments due under the loan. A lender also may make a claim against the assets of any general partner in a partnership to which debt is issued, without regard to whether the partner has guaranteed the debt.
Recourse debt
Debt secured by the property that it is used to purchase. The purchaser of the property is not personally liable for the debt upon default. Rather, the creditor’s recourse is to repossess the related property. Nonrecourse debt generally does not increase the purchaser’s at-risk amount.
Nonrecourse debt
Debt issued on realty by a bank, retirement plan, or governmental agency. Included in the at-risk amount by the investor. § 465(b)(6).
Qualified nonrecourse financing
The means by which recourse debt is shared among partners in basis determination.
constructive liquidation scenario
A payment made by a partnership to a partner when the partnership’s legal existence does not cease thereafter. The partner usually assigns a basis in the distributed property that is equal to the lesser of the partner’s basis in the partnership interest or the basis of the distributed asset to the partnership. The partner first assigns basis to any cash that he or she receives in the distribution. A cash distribution in excess of the partner’s basis triggers a gain. The partner’s remaining basis, if any, is assigned to the noncash assets according to their relative bases to the partnership.
current distribution
A distribution by a partnership that is in complete liquidation of the entity’s trade or business activities or in complete liquidation of a partner’s interest in the partnership. A liquidating distribution is generally a tax-deferred transaction if it is proportionate with respect to the partnership’s hot assets. In a proportionate liquidating distribution, the partnership recognizes no gain or loss. The partner only recognizes gain if the distributed cash (and cash equivalents, such as debt relief or certain marketable securities) exceeds the partner’s basis in the partnership. The partner recognizes a loss if only cash and hot assets are distributed and their combined inside (partnership) basis is less than the partner’s basis in the partnership interest. In any case where no gain or loss is recognized, the partner’s basis in the partnership interest is fully assigned to the basis of the assets received in the distribution.
liquidating distribution
A distribution in which the partners’ interests in hot assets does not change. This can happen, for instance, when no hot assets are distributed (e.g., a proportionate cash distribution) or when each partner in a partnership receives a pro rata share of hot assets being distributed. For example, a distribution of $10,000 of hot assets equally to two 50 percent partners is a proportionate distribution.
proportionate distribution
A distribution from a partnership to one or more of its partners in which at least one partner’s interest in partnership hot assets is increased or decreased. For example, a distribution of cash to one partner and hot assets to another changes both partners’ interest in hot assets and is disproportionate. The intent of rules for taxation of disproportionate distributions is to ensure that each partner eventually recognizes his or her proportionate share of partnership ordinary income.
disproportionate distribution
Amounts earned by a cash basis taxpayer but not yet received. Because of the method of accounting used by the taxpayer, these amounts have a zero income tax basis. When unrealized receivables are distributed to a partner, they generally convert a transaction from nontaxable to taxable or an otherwise capital gain to ordinary income (i.e., as a “hot asset”).
Unrealized receivables
Under § 1221(a)(1), a taxpayer’s stock in trade or property held for resale. For partnership tax purposes, inventory is defined in § 751(d) as inventory (per the above definition) or any partnership asset other than capital or § 1231 assets. See also appreciated inventory.
Inventory
Unrealized receivables and substantially appreciated inventory under § 751. When hot assets are present, the sale of a partnership interest or the disproportionate distribution of the assets can cause ordinary income to be recognized.
hot assets
consists of two or more partners who are general partners and who may participate in management of the entity; there are no limited powers. _____often are used for operating activities and corporate joint ventures.
general partnerships (GP)
a partnership with at least one general partner and one or more limited partners. These partnerships often have numerous limited partners and are used to raise capital for real estate development, oil and gas exploration, research and development, and various financial product investment vehicles.
limited partnership (LP)
the owners (termed “members”) are a hybrid type of partner. An ____ combines the corporate benefit of limited liability for the owners with the benefits of partnership taxation, including the single level of tax.
limited liability company (LLC)
treated similarly to a general partnership. An ____ partner is not personally liable for any malpractice committed by other partners.
limited liability partnership (LLP)
Treats partnerships as a channel through which income, credits, deductions, and other items flow to the partners. Under this concept, the partnership is regarded as a collection of taxpayers. A partnership is a “common pool” to which the partners contribute capital or services in pursuit of profit.
Aggregate (or Conduit) Concept.
Treats partners and partnerships as separate units and gives the partnership its own tax character.
Entity concept
Rules governing the formation, operation, and liquidation of a partnership contain a blend of both the entity and aggregate concepts.
Combined Concepts
refers to the parnership’s adjusted tax basis for each asset it owns.
Inside basis
represents each partner’s basis in the partnership interest.
Outside basis
A partner’s capital sharing ratio, which is the partner’s percentage ownership of the parnership’s capital. It determines the percentage of the net asset value a partner would receive upon immediate liquidation of the partnership.
A capital interest
the partner’s percentage allocation of current partnership operating results. Partnerships can change the profit and loss allocations at any time simply by amending the partnership agreement.
A profits (loss) interest
This rule prevents investors from using the partnership form to diversify their investment portfolio on a tax-free basis.
Investment Partnership
If a transaction appears to be a sale or exchange of property rather than a contribution, it is deemed a disguised sale and section 721 cannot be used to defer a gain or loss.
Disguised Sale or Exchange
