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.
