Part 2 - Businesses - Unit 1 - Content Flashcards
1
Q
Sole Proprietorships
A
- A sole proprietorship is not a separate legal entity. It is an unincorporated business that is owned and controlled by one person.
- A sole proprietorship may be a single-person business, or it may have several employees, but there is only one owner who accepts all the risk and liability of the business. It is the simplest business type and also the easiest to start. An estimated 70% of businesses in the United States are sole proprietorships.
- If a business operated as a sole proprietorship is sold, it must be operated by the new owner as either a different sole proprietorship or as a different type of business entity through a sale of assets of the business.
2
Q
Partnerships
A
- An unincorporated organization with two or more owners is generally classified as a partnership for federal tax purposes if its members carry on a business and divide its profits. It can be anything from a small business run by a married couple to a complex business organization with thousands of general partners and limited partners.
- A partnership must file an annual information return to report the income, deductions, gains, and losses from its operations, but the partnership itself does not pay income tax. Instead, any profits or losses “pass through” to its partners, who are then responsible for reporting their respective shares of the partnership’s income or loss on their individual returns.
- A partnership can have an unlimited number of partners and can have partners that are foreign or domestic.
- A partnership must always have at least one general partner whose actions legally bind the business and who is legally responsible for a
partnership’s debts and liabilities. A partnership’s annual tax return is filed on Form 1065, U.S. Return of Partnership Income. - Partners are not employees of the business, and they should not be issued a Form W-2. Instead, the partnership must furnish a copy of Schedule K-1 to each of its partners, showing the income and losses allocated to him or her. A partnership return must show the name and address of each partner and the partner’s share of taxable income.
3
Q
Joint Undertaking
A
- However, a “joint undertaking” merely to share expenses is not automatically a partnership. For example, co-ownership of rental property is usually not considered a formal partnership unless the co-owners provide substantial services to the tenants.
- The IRS defines “substantial services” as services that are primarily for the tenant’s convenience, such as regular cleaning, changing linen, or maid service.
- This would be something like a hotel or bed-and-breakfast. In that case, the rental activity could not be classified as a joint undertaking, because it would not be reported on Schedule E as a passive rental. Instead, it would be reported on Schedule C, or, if the rental was owned and operated by more than one person, it would be classified as a partnership.
- Example: Cornell and Dolan are cousins who own a residential rental property together. Each owns a 50% interest in the rental. Cornell takes care of any repairs, and Dolan collects and divides the rent. They do not have any other business with each other. The co-ownership of the rental property is not considered a partnership for tax purposes. Instead, they would divide the income and
expenses based on their ownership percentages, and each would report his respective share on Schedule E on his individual return. - Example: Orlando and Suzanne are siblings. They purchase a Victorian home in downtown New Orleans. They spend a substantial sum to divide the home into four separate units, which they then advertise as a bed-and-breakfast. They offer maid service and daily breakfast to all their guests. The IRS would classify their business as a hotel, rather than a passive rental activity. Therefore, Orlando and Suzanne would be required to file a partnership return in order to report their earnings and profits.
4
Q
Limited Partnership
A
- A limited partnership (LP) is a partnership that has at least one limited partner in addition to its general partner(s). A limited partnership allows an investor (the limited partner) to own an interest in a business without assuming personal liability or risk beyond the amount of his or her investment in the partnership.
- A Limited Partnership (LP) is a state-level entity. Unlike a general partnership (GP), which can be formed merely with a handshake between two persons, in order to form an LP, a Certificate of Limited Partnership or Certificate of Formation must generally be filed with the Secretary of State in which the partnership chooses to do business.
- For example, in order to form an LP in California, a Certificate of Limited Partnership (Form LP–1) must be filed with the California Secretary of State, and the applicable filing fees must be paid.
- A limited partner generally has no obligation to contribute additional capital to the partnership and, therefore, does not have an economic risk of loss for partnership liabilities.
- A limited partner may not sign the partnership return or represent the business before the IRS in their capacity as a limited partner. In most states, a limited partner is restricted regarding how active they can be in the management of the partnership.
Example: Carter wants to open a dance club. He approaches his aunt, Marisol, for the funds. Marisol agrees to invest in her nephew’s business, but she does not want to be involved in the day-to-day running of the club. After consulting with a legal advisor, Carter and his aunt form a limited partnership (LP). Per their partnership agreement, Marisol is a limited partner. She is an investor in the club and contributes $250,000 to establish the club. Carter is an experienced restaurateur and nightlife expert, so he runs the club. Carter is the general partner.
5
Q
Limited Liability Partnership (LLP)
A
- A Limited Liability Partnership (LLP) is an entity that is formed under state law and is generally used for specific professional services, such as those offered by a law firm or CPA firm. Some professionals form an LLP because the option of an LLC is prohibited in their state for their particular business type.
- For example, in California and New York, LLCs cannot provide certain professional services. Doctors, CPAs, attorneys, veterinarians, and other similar, licensed professionals cannot form an LLC for those particular business activities, but they are allowed to form an LLP and offer these professional services.
- Typically, an LLP allows each partner to actively participate in management affairs but still provides limited liability protection to each partner. A partner in an LLP generally would not be personally liable for the partnership debts or the malpractice of other partners (or the employees under the management of other partners) and would only be at risk for his own malpractice and his interest in the partnership’s assets.
- Example: Paul and Barry are licensed attorneys in California who decide to go into business with each other. They form an LLP by registering their business with California’s Secretary of State. Once they complete their registration, they open an office and begin accepting new clients. For tax purposes, their business will be taxed as a partnership, and they will be required to file a Form 1065 every year. In a limited liability partnership, the partners enjoy some protection against personal legal liability.
6
Q
C Corporations
A
- A corporation is considered an entity separate from its shareholders and must elect a board of directors who are responsible for oversight of the company. A corporation conducts business, realizes net income or loss and distributes profits to shareholders.
- Most major companies are organized as C corporations. A C corporation may have an unlimited number of shareholders and may be either foreign or domestic. A C corporation must file annual income tax returns on Form 1120, U.S. Corporation Income Tax Return, to report its net income and losses, and pay tax on its income. Its after-tax profits may also be taxable income to its shareholders when distributed as dividends, resulting in double taxation.
- The corporation does not receive a tax deduction when it distributes dividends to shareholders, and shareholders cannot deduct any losses of the corporation.
- A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income, but it is also allowed certain special deductions. C corporations are now taxed at a flat rate.
- The Tax Cuts and Jobs Act permanently eliminated the graduated rates for C Corporations. All C corporations are now taxed at a flat rate of 21%.
7
Q
S Corporations
A
- An S corporation is a distinct form of entity organized as a corporation for legal purposes but elected with the IRS for tax purposes.
- For federal income tax purposes, an S corporation is generally not subject to tax; instead, its income, losses, deductions, and credits are passed through directly to its shareholders in a manner similar to a partnership. However, while not common, the S corporation itself may be responsible for income tax on certain built-in gains and passive investment income.
- We will cover these special rules that apply to S corporations in a later unit.
8
Q
Limited Liability Company
A
- A limited liability company (LLC) is another type of business entity that may be formed under state law. Depending upon whether it has a single owner or multiple owners, an LLC will be treated for federal tax purposes either as:
- A “disregarded entity,”
- A corporation; if the entity elects to be treated as a corporation, or
- As a partnership (if more than one owner).
- Most LLCs in the United States are taxed as partnerships. If a multi-member limited liability company (MMLLC) is treated as a partnership for tax purposes, it must file Form 1065 annually, and one of its owners/members must sign the return.
- A Professional Service Limited Liability Company, or PLLC is a type of limited liability company that is owned and operated by licensed professionals, such as doctors, lawyers, engineers, and CPAs. PLLCs are not available in every state and have ownership restrictions and can generally only offer services related to its profession.
9
Q
Qualified Joint Ventures
A
- Often, a small business is operated by spouses without incorporating or creating a formal partnership agreement. The business is usually considered a partnership, whether or not there is a formal partnership agreement.
- However, if both spouses materially participate as the only members of a jointly owned and operated business, the business may be treated as a qualified joint venture, or QJV. The spouses then file separate Schedules C and separate Schedules SE. This option is available only to married couples who file joint tax returns.
- A partnership would be required to file a partnership tax return (Form 1065) if the entity is a state-level entity (such as an MMLLC) In general, spouses cannot file as a Qualified Joint Venture.
- There is a narrow exception in the law for married couples who live in a community property state. Married couples who co-own and operate an MMLLC in a community property state may still file as a QJV. (See Rev. Proc. 2002-69, 2002-2). Community property states are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.
- Example: Roger and Joanna live in Hawaii, where they operate a small business together as husband and wife. They qualify for and treat their business as a qualified joint venture and file on two Schedule Cs. Later in the year, they decide to form an LLC. They must file a partnership return (Form 1065) for their business, starting with the date of formation of the LLC. They can no longer treat their business activity as a qualified joint venture.
- Example: Grant and Natalie are married and file jointly. They live in Texas and run a small grocery store together as a qualified joint venture. During the year, they form an LLC for liability protection. Since Texas is a community property state, they are allowed to continue treating their business as a qualified joint venture and report their income and loss on two Schedule Cs.
10
Q
Farmers
A
- Farming businesses are primarily engaged in crop production, animal production, or forestry and logging. They may include stock, dairy, poultry, fish, fruit, and tree farms, as well as plantations, ranches, timber farms, and orchards. It is the nature of the activity, and not the entity type that determines whether a business qualifies as a farming business.
- Farming businesses operating as sole proprietorships report income and loss on Schedule F, Profit or Loss from Farming, of Form 1040.
- Congress has enacted many tax laws specific to farming, which we will cover in detail in a later unit.
11
Q
Tax-Exempt Organizations
A
- Tax-Exempt Organizations (Nonprofit Entities)
- The Internal Revenue Code (IRC Section 501(c)) outlines the requirements for tax-exempt organizations. These organizations must have a “tax-exempt” purpose, and none of their earnings may be used to benefit any private shareholder or individual.
- Nonprofit organizations may be created as corporations, trusts, or unincorporated associations, but never as partnerships or sole proprietorships.
12
Q
Employer Identification Numbers (EINs)
A
- An employer identification number is used for reporting purposes. Unlike Social Security numbers that are assigned to individuals, EINs are assigned to business entities.
- If a sole proprietor has no employees, the business owner is normally not required to obtain an EIN. However, an EIN can be requested by a sole proprietor who simply wishes to protect his Social Security number for privacy reasons. This way, a sole proprietor can provide his EIN rather than his SSN to companies that need to issue him a Form 1099-NEC for independent contractor payments. If a sole proprietor decides to form a business entity such as a partnership or corporation, he will be required to request an EIN for each separate entity. A business must apply for an EIN if any of the following apply:
- The business pays employees,
- The business operates as a corporation, exempt organization, trust, estate, or partnership for tax purposes,
- The business files any of these tax returns:
- Employment taxes (payroll taxes)
- Excise tax
- Alcohol, Tobacco, and Firearms
- The business withholds taxes paid to a nonresident alien
- The business establishes a pension, profit-sharing, or retirement plan
13
Q
Reporting Requirements
A
- Businesses are subject to a number of reporting requirements, including the following:
- Form W-2: A business must complete and file with the Social Security Administration Forms W-2, Wage, and Tax Statement, showing the wages paid and taxes withheld for the year for each employee no later than January 31 of the following year.
- Form 1099-NEC: A business must report nonemployee compensation paid during the year to certain independent contractors that provided services by providing a Form 1099-NEC by January 31 of the following year.
- Form 1099-MISC: Amounts that are reported on the 1099-MISC include:
- Payments of $600 or more for rents, prizes and awards, crop insurance proceeds, and certain medical and health care payments,
- Royalties over $10, and
- Gross proceeds paid to an attorney’s office, when the total amount is $600 or more.
- Except for incorporated attorneys, payments to corporations are generally exempt from Form 1099 reporting requirements. Forms 1099 should only be used for payments that are made in the course of a trade or business. Personal payments are not reportable.
- A business should only include payments made by cash, check, ACH transfer or other direct means on Form 1099-MISC or 1099-NEC.
- Credit card payments, including third party network transactions, must be reported on Form 1099-K by the payment settlement entity and are not subject to reporting on Form 1099-MISC or 1099-NEC.
- Example: Stephanie hires Robert, a professional painter, to paint the exterior of her home. The job costs $3,500. Stephanie is not required to report the payment to the painter because it is for her personal residence. Since it was a personal payment, she cannot deduct the cost on her income tax return. However, the painter is still required to report the income on his income tax return. The following year, Stephanie calls Robert again, to paint the interior of her business office, which she owns. The painting job costs $2,000. Since the cost is a business expense, Stephanie is required to issue a Form 1099-NEC to the contractor.
14
Q
Form 1099-K
A
- Form 1099-K: The Form 1099-K, Payment Card and Third-Party Network Transactions, is an IRS information return used by payment settlement entities (like PayPal and Stripe) to report online payment transactions.
- Note: Rideshare drivers, like those that work for Uber and Lyft, generally receive a Form 1099-K for their driving services, since the payments made to them are processed by a third-party network.
- The 1099-K includes a breakdown of the driver’s annual gross earnings. Not every driver receives a 1099-K. The 2023 Form 1099-K reporting threshold is either (1) $20,000 in gross earnings and (2) 200 transactions. A driver would typically receive a 1099-K if they earned more than $20,000 in fees and provided more than 200 rides to passengers.
15
Q
Cash Transactions
A
- Form 8300, Report of Cash Transactions over $10,000: When a business receives a cash payment of more than $10,000 from one transaction (or two or more related transactions), it must file Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business within 15 days after they receive the cash. This type of transaction is also called a “designated reporting transaction.”
- A business must also provide a written statement to each person or customer named on any Form 8300 that is filed. The statement must be provided to the customer no later than January 31 of the following year.
- For the purposes of this rule, “cash” includes the coins and currency of the United States, cashier’s checks, bank drafts, traveler’s checks, as well as cash in a foreign currency.
- “Cash” does not include bank wire transfers, credit card transactions, ACH transactions, or amounts paid with personal checks.
- Example: Adam’s Used Autos, LLC is a small, family-owned car dealership. On January 6, 2023, Jennifer Jones buys a used car from Adam’s Used Autos and pays $17,000 in cash. The dealership asks Jennifer for her driver’s license and verifies her identification, in order to get the necessary information to complete Form 8300. Adam’s Used Autos must file the Form 8300 no later than January 21, 2023 (15 days later). The dealership must also send a statement to Jennifer by January 31, 2024 (the following year).
- Example: Sheena is an elementary school teacher. She decides to sell her personal vehicle. She places an ad in her local newspaper listing her car for $12,500. She finds a buyer for the car, who pays her $12,500 in cash a week later. Sheena does not have to report the sale on Form 8300 because she is not a professional car dealer, and the transaction was not a business transaction.
16
Q
Worker Classification
A
- Because businesses are responsible for withholding and paying income, employment, and FUTA taxes, as well as reporting payments to independent contractors, they must accurately determine whether a person they pay is an independent contractor or an employee.
- A business is generally not required to withhold or pay taxes in connection with payments to independent contractors. However, it must understand the relationship that exists with each person it pays to perform services. A person performing services for a business may be:
- An independent contractor
- An employee
- A statutory employee
- A statutory nonemployee
17
Q
Statutory Employees
A
- Some workers are classified as statutory employees. Statutory employees are unique, because they are issued Forms W-2 by their employers, but report their wages, income, and allowable expenses on Schedule C, just like self-employed taxpayers.
- Statutory employees are usually salespeople or other employees who work on commission. The difference is that statutory employees are not required to pay self-employment tax, because their employers must treat them as employees for Social Security tax purposes. Examples of statutory employees include:
- Full-time life insurance salespeople,
- Traveling salespeople,
- Certain commissioned truck drivers,
- Certain home workers who perform work on materials or goods furnished by the employer.
- If a person is a statutory employee, the “statutory employee” in box 13 of Form W-2 should be checked.
- Example: Avery is a full-time life insurance salesman working for Provident Life Insurance Company. Avery sells life insurance and annuity contracts, and he works out of a business office that he rents himself. Provident Life Insurance issues Avery a Form W-2 with the box for “statutory employee” checked. Avery will report his income and loss on Schedule C, but a Schedule SE will not be generated by his software, because Social Security and Medicare taxes have already been withheld and remitted to the IRS by his employer. Avery is classified as a statutory employee.
18
Q
Statutory Nonemployees
A
- There are three categories of statutory nonemployees: direct sellers, licensed real estate agents and certain companion sitters. They are treated as self-employed for federal tax purposes, including income and employment taxes, if:
- Payments for their services are directly related to sales, rather than to the number of hours worked, and
- Services are performed under a written contract providing that they will not be treated as employees for federal tax purposes.
- Compensation for a statutory nonemployee is reported on Form 1099-NEC. The taxpayer then reports the income on Schedule C.
- Example: Eugenia works as a full-time real estate agent for Trusty Realty Services. She visits the realty office at least once a day to check her mail and her messages. She manages dozens of real estate listings and splits her real estate commissions with Trusty Realty. She sets her own schedule, but she does not work for any other real estate company. Eugenia is classified as a statutory nonemployee. Trusty Realty issues Eugenia a Form 1099-NEC for her real estate commissions. Eugenia files Schedule C to report her income and expenses from her realty business.
- Example: Mandy sells cosmetics, perfumes and personal products as an independent sales representative of Mary Kare. Mandy’s customers pick products directly out of catalogs. Mandy then orders the products and delivers them to her customers personally. Sometimes she will host Mary Kare parties at her home, where customers can socialize and try different products. Mandy earns a 40% commission on her product sales. She is not an employee of Mary Kare. She will file a Schedule C to report her income and expenses.
19
Q
Employing Family Members
A
- A child working for a parent: If the parent’s business is a sole proprietorship or a partnership in which each partner is the child’s parent, payments for the child’s services are subject to income tax withholding.
- However, if the child is under 18, wage payments are not subject to Social Security and Medicare taxes (also called FICA taxes, or “payroll taxes”). If the child is under 21, payments are not subject to FUTA tax. This special rule for employee children does not apply if the business is organized as a corporation.
- Spouse employed by a spouse: The wages for the services of a spouse are subject to income tax, Social Security, and Medicare taxes, but not FUTA tax if the business is a sole proprietorship. However, FUTA tax is applicable if the spouse works for a corporation or a partnership in which the employing spouse is a partner.
- Example: Kendra is 17 and works as a part-time administrative assistant for her father’s company, Real-Time Sporting Goods, Inc. Her father is the sole shareholder and owner. Since Real-Time Sporting Goods is organized as a C corporation, Kendra’s wages are subject to all payroll taxes, including Social Security tax, Medicare tax, and FUTA.
- Example: Deborah and Richard are married. They are partners in the Sandwich Shoppe, a small restaurant that they co-own and operate. Their daughter, Angie, age 16, works as a hostess on the weekends. Her parents pay her $15 an hour, which is a reasonable wage in their locality. Deborah and Richard must withhold income tax on Angie’s earnings. However, because of her age, and because she is working directly for her parents, her wages are not subject to Social Security, Medicare, and FUTA (federal unemployment taxes).
20
Q
FUTA Tax
A
- The Federal Unemployment Tax Act (FUTA), provides for payments of unemployment compensation to workers who have lost their jobs. A business reports and pays FUTA tax separately from federal income tax, and Social Security and Medicare taxes.
- FUTA tax is paid only by the employer, never by the employee. The current FUTA tax rate is 6% on the first $7,000 of each employee’s wages. Most employers receive a maximum credit of up to 5.4% against this FUTA tax for any unemployment tax paid to the state. The tax is reported on Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return.
- Once an employee earns $7,000 in gross wages for the year, that is the maximum amount of wages that are subject to FUTA. Which means that the business no longer has to pay FUTA for that particular employee. However, if an employee quits, and a new employee is hired, then the FUTA tax must be collected on the new employee’s wages, as well, up to the $7,000 limit.
- Example: Pathway Brokers, Inc. hires a new receptionist on January 10. The receptionist only works a month before quitting. She had earned $2,300 in wages in January before she quit. Pathway Brokers must pay $138 in FUTA tax on her wages ($2,300 x 6% = $138). If the company hires another employee to replace her, it will be required to pay FUTA tax on the new employee’s wages as well, up to the $7,000 threshold.
21
Q
Trust Fund Recovery Penalty (TFRP)
A
- This penalty is also called the “100% penalty.” If a business does not deposit its trust fund taxes in a timely manner, the IRS may assess a trust fund recovery penalty (TFRP). The amount of the penalty is equal to the unpaid balance of the trust fund taxes.
- The TFRP may be assessed against any person who:
- Is responsible for collecting or paying withheld income and employment taxes, or for paying collected excise taxes, and
- Willfully fails to collect or pay them.
- Once the IRS asserts the penalty, it can take collection action against the personal assets of anyone who is deemed a “responsible person.” It is not only the executives of businesses or the top finance and accounting personnel who may be held responsible for the TFRP. A responsible person may also include a person who signs checks for the company or who otherwise has the authority to spend business funds, such as a bookkeeper.
Example: Clora ran her own tax preparation business and also processed the payroll for her local church. The church had four employees. Clora prepared and signed the payroll tax returns and all the checks and then gave them to the pastor to mail. The pastor did not mail the payroll tax reports or remit the payments to the IRS. Instead, he used the money to purchase a new piano for the church. Clora knew the pastor was misusing the funds but did not report the information to authorities. The IRS assessed the TFRP against the pastor, the church, and Clora. Even though Clora was just the bookkeeper, she knew that the pastor was improperly handling the payroll tax funds, and she did nothing about it, so the IRS can assess 100% of the penalty against Clora.
22
Q
Tax Year
A
- The tax year is an annual accounting period for reporting income and expenses. Individuals file their tax returns on a calendar-year basis. Certain businesses have the option to file their tax returns on either a calendar-year or a fiscal-year basis.
- Calendar Tax Year: A calendar tax year is always twelve consecutive months beginning January 1 and ending December 31.
- Fiscal Tax Year: Generally, a fiscal tax year covers twelve consecutive months ending on the last day of any month except December. However, one variation of a fiscal year-end does not fall on the same date each year.
- A 52/53-week tax year is a fiscal tax year that varies from 52 to 53 weeks but does not necessarily end on the last day of the month. For example, some businesses choose to end their fiscal year on a particular day of the week, such as the last Friday in June or the Saturday that falls closest to January 31.
- Short Tax Year: This is a tax year of fewer than 12 months. A short tax year may result in the first or last year of an entity’s existence, or when an entity changes its accounting period (for example, from a fiscal year to a calendar year, or vice versa).
23
Q
Adopting a Tax Year
A
- A business adopts a tax year when it files its first income tax return. Any form of business entity may potentially adopt the calendar year as its tax year.
- However, not every business can choose a fiscal year, with the exception of a new C corporation, which may generally elect to use any fiscal year it chooses.
- If a business wishes to change its tax year, it must file Form 1128, Application to Adopt, Change, or Retain a Tax Year, is used to request a change in the tax year.
24
Q
Required Tax Year
A
- Partnerships and S corporations generally must use a “required” tax year. For partnerships, this means that, unless the partnership can establish a legitimate business purpose for a different tax year, a partnership’s “required” tax year must conform to its partners’ (or shareholders’) tax years.
- If one or more partners with the same tax year own a majority (more than 50%) interest in the partnership’s capital and profits, the tax year of those partners is the required tax year for the partnership.
- A partnership or S corporation may establish a bona-fide “business purpose” for a tax year by filing Form 1128, Application to Adopt, Change, or Retain a Tax Year.
- Unless it can establish a business purpose for using a fiscal year, an S corporation or partnership must generally use the calendar year.
25
Q
Natural Tax Year
A
- A business is always allowed to use a year other than a “required” tax year if it can establish a “substantial business purpose” for using a different tax year.
- A seasonal business, such as a ski resort, may use a tax year that follows the natural cycle of the business itself. This is sometimes called a “natural tax year.” A “natural tax year” is a fiscal year in which the last two months of the year provide over 25% of the business’s gross receipts for the entire year.
- A business may normally elect a fiscal year based on a genuine business purpose; however, it is not considered a “legitimate” business purpose to elect a particular fiscal tax year just so that partners or shareholders may defer income recognition.
- Example: Donna and Thomas are clothing designers. They decide to form a 50/50 partnership in order to sell designer swimwear for men and women. Although Donna and Thomas are both individuals who report their personal income on a calendar year, they file Form 1128 in order to request a natural business year for their partnership. Their natural business year would end in September, after the summer is over, when most swimsuits for the year are sold. Their request for a natural business year is granted. They will file their partnership return with a fiscal year-end of September 30.
26
Q
Section 444 Election
A
- A partnership or S corporation can also request to use a tax year other than its required tax year by filing Form 8716, Election to Have a Tax Year Other Than a Required Tax Year. This is known as a section 444 election, and it does not apply to any business that establishes a genuine business purpose for using a different tax year.
- A business can request a section 444 election if it meets all of the following requirements:
- It is not a member of a tiered structure.
- It has not previously had a section 444 election in effect.
- It elects a year that meets the deferral period requirement.
27
Q
Accounting Methods
A
- An accounting method is a set of rules used to determine when and how income and expenses are reported. No single accounting method is required of all taxpayers. However, the taxpayer must use a system that properly reflects income and expenses, and it must be used consistently from year to year. Businesses generally report taxable income under one of the following accounting methods:
- Cash method: Under the cash method, a taxpayer generally deducts expenses when they are paid.
- Accrual method: Under the accrual method, a taxpayer generally deducts expenses as they are incurred, and income when it is earned.
- Hybrid method (using elements of the methods above).
- Special methods for farming businesses (covered later)
28
Q
Cash Method Threshold
A
- Under the TCJA, all businesses (except tax shelters) are permitted to use the cash method of accounting if they meet the annual gross receipts test of $29 million, (in 2023) even if the business produces, manufactures, or sells inventory.
- Average annual gross receipts are determined by adding the gross receipts for the three preceding tax years and dividing the total by three. If the business has been in existence for less than three years, then the applicable average gross receipts will be determined based on the applicable number of years in existence.
- The most common accounting method is the cash method, which is used by most small businesses. The accrual method is used by most large corporations and is considered a more accurate method of recognizing income and expenses, because it reflects when taxable income is actually earned. The accrual method is required for publicly traded corporations (such as Coke, Nike, etc.).
- Note: Large nonprofit entities are often required to use the accrual method because many of them receive government funding (such as federal grants) and must have audited financial statements.
29
Q
Multiple Businesses
A
- A business owner may use different accounting methods if he or she has two separate and distinct businesses. Two businesses will not be considered “separate and distinct” unless a separate set of books and records is maintained for each business.
- Example: Anthony is a self-employed enrolled agent. He prepares returns from January through April every year. He is also a part-time baseball umpire who is usually booked on weekends to officiate baseball games for various amateur leagues. He reports his tax preparation business using the accrual method and his earnings as an umpire using the cash method. He keeps separate books and records for each business and files a separate Schedule C for each business. Anthony may choose to use different accounting methods because he has two distinct businesses with separate sets of records for each.
30
Q
12 Month Rule
A
- There is an exception to the timing of the deductibility on prepaid expenses under the “12-month rule” under which the cash-basis taxpayer is not required to capitalize amounts paid for periods that do not extend beyond the earlier of the following:
- 12 months after the benefit begins, or
- The end of the tax year after the tax year in which payment is made.
- Example: Lizbeth is a sole proprietor who rents retail space for her eyebrow threading business. She pays two years of rent in advance in order to receive a substantial discount from her landlord. She cannot use the 12-month rule because the benefit from her advance payment exceeds the 12-month time period. She must recognize the rent expense over the two-year period, regardless of which method of accounting she uses.
31
Q
Changing Accounting Methods
A
- When a business files its first tax return, it may choose any permitted accounting method. Subsequent changes, either in the overall accounting method or the treatment of a material item, generally require that the taxpayer obtain IRS approval. Prior approval is needed for:
- Changes from cash to accrual or vice versa, unless the change is required by law.
- Changes in the method used to value inventory, (inventory methods are covered in your book).
- Changes in the method of depreciation or amortization. This includes situations where a taxpayer changes from an “impermissible method” of depreciation or misses depreciation on an asset altogether.
- The taxpayer must file Form 3115, Application for Change in Accounting Method, to request a change in either an overall accounting method or the accounting treatment for an individual item.
- Automatic changes in accounting methods do not require IRS consent. But both automatic and non-automatic changes are requested on Form 3115.
- Example: Hagerman Farms, Inc. is a profitable C corporation that grows and produces animal feed. This year, the company exceeds $29 million in average annual gross receipts. It was using the cash method in the past year, but now is required to switch to the accrual method. This is an accounting method change that is mandated by law and does not require prior consent from the IRS. Hagerman Farms will switch to the accrual method of accounting and file the Form 3115 along with its corporate income tax return. The Form 3115 is filed in the first affected year that contains the change.
- Note: Unclaimed depreciation, for closed as well as open years, is allowed through a Section 481(a) adjustment that reduces income in the year of change. If the entire adjustment is less than $25,000, a de minimis rule permits taxpayers to take 100% of the amount into account in the year of change (see IRS Rev. Proc. 96-31 for more information).
- Example: Five years ago, Karen bought a residential rental condominium for $97,500. The land value was $15,000, and the building’s depreciable basis was $82,500. Karen self-prepared her own returns for several years and did not claim any depreciation on the rental. Karen visits an enrolled agent, Gordon, and he discovers the missed depreciation deductions that went on for many years. Gordon tells Karen that she can claim her missed depreciation by filing Form 3115. The unclaimed depreciation of $14,500 is treated as a negative adjustment on Schedule E, with the annotation of “§481(a) adjustment”.
32
Q
Cost of Goods Sold (COGS)
A
- Cost of goods sold (COGS) is deducted from a business’s gross receipts to determine its gross profit. COGS is calculated by adding up the cost of goods available minus any ending inventory. COGS is also referred to as “cost of sales.” The following expenses related to inventory sold are included in the calculation of COGS:
- The cost of products or raw materials, including freight
- Storage costs of raw materials and finished products
- Direct labor costs to produce the goods
- Factory overhead
The equation for cost of goods sold is as follows:
Beginning Inventory + Inventory Purchases and Production Costs - Ending Inventory = Cost of Goods Sold (COGS)
- Cost of goods sold is the direct costs attributable to the production (or purchase) of the goods or services sold by a business. In a manufacturing business, labor costs allocable to the cost of goods sold include both the direct and indirect labor used in fabricating the raw material into a finished, saleable product.
- Example: In calculating COGS, Nathan’s Custom Shoes includes the cost of leather and thread in the shoes it manufactures, as well as wages for the workers who produce and assemble the shoes. Inventory does not include the cost of advertising for the shoes. COGS is recorded as an expense when the company sells its finished goods.
- Example: Heritage Emporium, Inc. manufactures historical theater costumes. During the month of October, Heritage Emporium purchases extra raw materials to produce additional costumes for the Halloween holiday. All the materials and shipping costs associated with the inventory are capitalized rather than expensed. As the costumes are sold, Heritage Emporium expenses the costs associated with the inventory as cost of goods sold. At the end of each month, Heritage Emporium does a physical inventory count and adjusts COGS for any damaged or stolen inventory.
33
Q
UNICAP
A
- The uniform capitalization rules (commonly referred to as UNICAP) provide detailed guidance regarding the direct costs and certain indirect costs related to the production of goods or the purchase of merchandise for resale that businesses must capitalize as part of the cost of inventory.
- UNICAP rules apply to producers of tangible and intangible personal property, and producers of real property, as well as a business that acquires wholesale inventory for resale.
- A business that wishes to change its accounting treatment of inventory must file Form 3115 and request a change to its accounting method.
34
Q
Gross Receipts Test
A
- In general, only large businesses are subject to the uniform capitalization rules.
- The Tax Cuts and Jobs Act modified the UNICAP rules for small and mid-sized businesses.
- Businesses that do not exceed $29 million in gross receipts test in 2023 (based on average gross receipts for the prior three tax years) are not required to apply the uniform capitalization (UNICAP) rules.
- Example: Bloomington Studios is a professional film studio with average gross receipts of $170 million per year. Bloomington Studios produces cartoons and movies for Hollywood. Even though the company does not produce any tangible products, film production is subject to the UNICAP rules, so Bloomington Studios must capitalize all of its costs, including set design, costumes, special effects, film editing, and salaries for actors and production workers. When a film is finally completed and released to the public for distribution, Bloomington Studios is allowed to deduct the production costs as COGS.
- Example: Big Bargains Grocery, Inc. has six store locations and has $35 million in average gross receipts. Big Bargains Grocery employees take a physical inventory of each store at least once a month. During the physical inventory, store employees are required to record any damaged goods such as dented cans and ripped packaging. When the physical inventory is completed, each store manager does a final reconciliation, adjusting the books to reflect adjustments for expired food and damaged merchandise. If the business did not track its inventory, it would never know when products were stolen, damaged, or expired.
35
Q
Included in Inventory
A
- If a business is subject to the UNICAP rules, inventory should include all of the following, if applicable:
- Merchandise or stock in trade
- Raw materials, work in process, finished products
- Supplies that physically become a part of items for sale (labels, stickers, boxes, exterior packaging, etc.)
- Purchased merchandise if the title has passed to the taxpayer, even if the merchandise is still in transit or the business does not have physical possession of it for another reason
- Goods out on consignment, Goods held for sale in display rooms or booths located away from the taxpayer’s place of business
- Intangible costs (examples include film or video production)
- The following items are NEVER INCLUDED IN INVENTORY:
- Goods the business has sold if the legal title (ownership) has passed to the buyer,
- Goods consigned to the business (but not owned by the business),
- Goods ordered for future delivery, if the business does not yet have the legal title; or
- Land, buildings, and depreciable equipment that are used in the business are never included in the calculation of inventory.
36
Q
Not Subject to UNICAP
A
- Regardless of a business’ size, the following expenditures and entity types are not subject to UNICAP:
- Small businesses with average annual gross receipts under the threshold,
- Hobby activities
- Research and experimental expenditures, and marketing or advertising costs, regardless of business size.
- Intangible drilling and development costs of oil and gas or geothermal wells,
- Timber raised, harvested, or grown, and the underlying land,
- Qualified creative expenses incurred as self-employed writers, musicians, artists, etc.
- Loan originations,
- Warranty costs and product liability costs, and
- Property provided to customers in connection with providing services. The property must be de minimis and not be included in inventory in the hands of the service provider. An example would be a veterinarian who primarily provides veterinary services but carries a small amount of pet food and flea medication for sale to customers in their waiting room.
- Example: Earnest Brownwood is a self-employed writer that reports his business activity on Schedule C. His last novel became a blockbuster bestseller and was optioned for a Hollywood picture. As a result, Earnest’s income from writing was over $30 million in the prior year. Earnest writes novels about real historical figures. He often travels to foreign locations to do his research. Although it often takes him several years to write a novel, all his research expenses are deductible as they are incurred. His qualified creative expenses do not have to be capitalized because self-employed writers are exempt from UNICAP, regardless of their gross receipts.
37
Q
Inventory Shrinkage
A
- Inventory “shrinkage” is a general term for lost, stolen, or damaged inventory. Shrinkage reduces a businesses’ ending inventory and thus increases COGS. The discrepancy may occur due to shoplifting, goods being damaged or lost, supplier fraud, or even a natural disaster. Sales do not affect the shrinkage calculation.
- When a business incurs a casualty or theft loss of inventory, it has two options to record the loss. The business can:
- Adjust its cost of goods sold, or
- It can record the loss separately as a casualty or theft loss.
- If the business deducts the loss separately, it must eliminate the affected inventory items from the cost of goods sold by making a downward adjustment to opening inventory or purchases. The business must avoid counting the loss twice. If the business expects an insurance reimbursement for the loss, it should not claim a loss to the extent it has a reasonable prospect of recovery.
- Example: Cornerstone Computers, Inc. is a wholesale computer and electronics retailer. The business uses a point-of-sale inventory tracking system, but also does a periodic manual count. At the end of the year, the business has inventory records showing 20,000 computer laptop units on hand, but a physical count of the inventory shows only 19,850 units. Cornerstone Computers has an inventory discrepancy 150 (20,000 – 19,850). This is an example of inventory shrinkage, and might be due to shoplifting, inventory errors, or even employee theft. Cornerstone Computers will adjust its cost of goods sold, increasing the cost of goods sold to reflect the lost or stolen items.
38
Q
Partnerships in General
A
- An unincorporated business with two or more owners is generally classified as a partnership for federal tax purposes. A partnership is a pass-through entity.
- Income and loss is determined at the partnership level and are taxable to the individual partners. In this respect, a partnership is similar to a sole proprietorship, except that it is run by more than one person. A partnership must always have at least two partners, and at least one of them must be a general partner.
- Unlike corporations, general partnerships do not require any formal legal documents in order to form. Partnerships that have some form of liability protections for some of the partners (such as limited partnerships and limited liability partnerships) do require formal documents – including those filed with the state.
- A joint undertaking merely to share expenses is not a partnership. For example, a rental property owned by two people would generally not be classified as a business or a partnership.
39
Q
The Partnership Agreement
A
- The term partnership agreement refers to any written document or oral agreement that bears on the underlying economic arrangement of the partners, including allocations of income, gain, loss, deductions, and credits. Examples of such documents include:
- Loan and credit agreements
- Assumption agreements
- Indemnification agreements
- Subordination agreements
- Correspondence with a lender concerning terms of a loan
- Loan guarantees
- A partnership agreement can be modified during the tax year. However, the partnership agreement cannot be modified after the due date for filing the partnership return for the year, not including extensions.
- Example: Pierre and Rodney are friends who run Battlefield Tools, LLC, a cash-basis, calendar-year partnership. They split the partnership’s proceeds 50/50. They decide to alter their partnership agreement in order to include an accountable plan for reimbursements, because they want the partnership to reimburse them for business mileage that they incur on their own vehicles. They have until the unextended due date of the partnership return (March 15) to change the partnership agreement. Filing for an extension does not give them additional time to change their partnership agreement.
40
Q
Prohibited from Being Partnerships
A
- A corporation (although a corporation can be a partner in a partnership)
- A joint-stock company or joint-stock association
- An insurance company
- Certain banks
- A government entity
- Any organization required to be taxed as a corporation by the IRS
- Certain foreign organizations
- Any tax-exempt (non-profit) organization
- Any real estate investment trust (REIT)
- Any organization classified as a trust or estate
- Any other qualifying entity that elects to be classified as a corporation by filing Form 8832 (or Form 2553 for an S corporation)
41
Q
Filing Requirements
A
- A partnership must file a tax return unless it has neither any income nor any expenditures that would be treated as a deduction or credit for the year.
- A partnership reports its income or loss on Form 1065, U.S. Return of Partnership Income, which is due on the fifteenth day of the third month following the close of the tax year.
- The partnership return must show the name and address of each partner and the partner’s distributive share of taxable income (or loss) on Schedule K-1 (Form 1065). The individual partner then reports their share of partnership income on Schedule E of Form 1040.
- Most partnership returns are due on March 15. A six-month extension is allowed, with an extended due date of September 15.
- The extension is requested on Form 7004, Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns and must be filed prior to the original due date.
42
Q
E-Filing Requirements
A
- Beginning January 1, 2024, all partnerships are required to file Form 1065 and related forms and schedules electronically if they file 10 or more returns of any type during the tax year, including information returns, W-2s, excise tax returns, etc. If a partnership fails to do so, it will be subject to penalty unless it was unable to file electronically (e.g., because the e-filing was rejected, the return required paper attachments, etc.).
43
Q
Schedule K-1
A
- Partners who work in a partnership are not employees and generally do not receive wages or Forms W-2.
- Partners receive a Schedule K-1, which allows the individual partners to track their ownership stake and share of profits or losses.
- General partners are considered self-employed and therefore, must pay estimated payments just like other self-employed individuals.
- Limited partners are subject to self-employment tax only on guaranteed payments, such as salaries and professional fees for services rendered.
- Example: Iron Horse Investments, LP is a limited partnership that has only two general partners, Gary and Laurie, and 75 limited partners, who are just passive investors. Gary and Laurie are the only ones who actually work in the business on a daily basis. Gary and Laurie are considered self-employed and will owe self-employment tax on the ordinary income that they receive from the partnership. However, during the year, Iron Horse Investments decides to paint its main office. The partnership reaches out to Steve, who is a limited partner, who also owns a commercial painting business. Steve agrees to paint the partnership’s office for a guaranteed payment of $4,000. This is a one-time gig, and Steve normally does not perform any services for the partnership. Steve receives a Schedule K-1 at the end of the year showing his share of distributive partnership income, but he will only owe self-employment tax on the amount of the guaranteed payment, because that was a payment for services performed.
44
Q
Schedules K-2 and K-3
A
- Schedules K-2 and K-3 are recently introduced schedules that replace and expand the foreign transaction section of Schedule K-1. All partnerships must complete these schedules unless a reporting exception applies.
- Schedule K-2 and K-3 have a “domestic filing exception” that exempts partnerships from filing these schedules if certain criteria are met.
- Example: Reggie and Pamela Stanton are married and file jointly. Both are U.S. citizens. Each own a 25% partnership interest in Stanton Consulting, LLP, a domestic partnership. Stanton Consulting, LLP invests in a regulated investment company (RIC) and receives a Form 1099-DIV from the RIC reporting $100 of foreign taxes paid on passive category foreign source income. The partnership does not have any foreign activity other than that from the RIC, so this is considered “minimal” foreign activity. Reggie and Pamela receive a notification from Stanton Consulting, LLP on an attachment to their Schedule K-1s that they will not receive the Schedule K-3 unless they request it. Reggie and Pamela do not request Schedule K-3 from Stanton Consulting for tax year. Stanton Consulting notified all of its other partners the same way. The partnership qualifies for the domestic filing exception, and, as such, Stanton Consulting does not need to complete Schedules K-2 or K-3.
45
Q
General Partnership vs. Limited Partnership
A
- The two most common types of partnerships are general partnerships and limited partnerships. In a general partnership, all of the partners have unlimited liability for partnership debts. In a limited partnership, there must be at least one general partner and at least one limited partner.
- Limited partners have no obligation to contribute additional capital to the partnership under state law and therefore do not have an economic risk of loss related to partnership liabilities.
- In this respect, a limited partner is like an investor in a corporation. Limited partners generally cannot participate in the management or the day-to-day administration of the partnership.
- A limited partnership (LP), and other types of partnerships with some form of liability protections, such as a limited liability partnership (LLP) and, in some states, a limited liability limited partnership (LLLP), is formed under state limited liability law.
- Note: A general partnership is composed of only general partners. In other words, a general partnership cannot have limited partners. In order for a partner to have limited liability, formal documents have to be filed with the state, and a state-level entity must be formed.
46
Q
Limited Liability Partnership (LLP)
A
- An LLP is more similar to a general partnership, in that all the partners can take an active role in managing the day-to-day affairs of the business, but partners can still have liability protections (similar to the liability protection that a limited partner might receive).
- An LLP protects individual partners from liability for the malpractice of other partners. Most often, the owners of limited liability partnerships offer professional services (e.g., attorneys, engineers, architects, and doctors).
- For example, LLP ownership in the State of California is limited to persons licensed to practice in the fields of public accountancy, law, engineering, or architecture. In order to form an LLP in California, the business must first register with the California Secretary of State.
- Example: Casper and Brandon are licensed architects in the state of California. They form C&B Architects, LLP to offer architectural services to the public. They register their partnership with the Secretary of State and formed their LLP on July 1. The LLP allows Casper and Brandon to actively participate in the partnership’s management affairs, while still providing limited liability protection to each partner. Their first partnership return (Form 1065) will be due on March 15 of the following year.
47
Q
Special Partnership Allocations
A
- Unlike S corporations, which must report all income and expenses in proportion to stock ownership, partnerships have much more flexibility.
- Partnership agreements can be written to reflect special allocations of income, gain, loss, or deductions, as long as the allocations have substantial economic effect, which is defined in IRS regulations.
- For example, the partnership agreement may, with certain restrictions, allocate all of the depreciation deductions to one partner or specify that the partners share capital, profits, and losses in different ratios.
- Example: Mary, who has design and sewing skills, forms a partnership with Cortney, who has the money to invest in developing a clothing line. Cortney contributes $100,000 of cash to the partnership. Mary and Cortney agree to split the business profits 20/80 until Cortney recovers her entire investment; thereafter, profits will be split 50/50. These special allocations are written into their partnership agreement.
- Example: James and Kirk are licensed attorneys and form an LLP. James contributes only $1,000, and Kirk contributes $99,000. Due to James’ previous expertise in litigation and his existing political contacts, the partnership agreement provides that James will be allocated 40% of the business income. Thus, although James owns only 1% in partnership capital, his profit-sharing ratio is 40%. This income/loss allocation between is permissible because it correctly reflects the partner’s underlying economic arrangement.
48
Q
Guaranteed Payments
A
- They may compensate the partner for services or for the use of capital, as if they were made to a person who is not a partner. Guaranteed payments are generally deducted by the partnership on Form 1065 as a business expense and reported to the partner receiving the guaranteed payment on their Schedule K-1.
- The partner who receives a guaranteed payment reports the amount of the payment as ordinary income on Schedule E (Form 1040). Guaranteed payments are not subject to income tax withholding by the partnership.
- If the partnership pays for the health insurance premiums for its partners, it deducts the expense on the partnership return as a guaranteed payment.
- With regards to the Section 199A Qualified Business Income deduction, §199A excludes guaranteed payments made to a partner from qualified business income. This means that a partner cannot take a 199A deduction directly on their guaranteed payments (similar to how most employees cannot claim a 199A deduction on their wages). In other words, any amounts that are paid to a partner as guaranteed payments will reduce the amount of qualifying business income otherwise eligible for the QBI deduction.
- Example: Irving is a general partner in the Brandenburg Partnership. Under the terms of his partnership agreement, he is entitled to a guaranteed payment of $10,000 per year, regardless of how profitable the partnership is. Irvin’s distributive share of partnership income is 10%. Brandenburg Partnership has $50,000 of ordinary income after deducting Irving’s guaranteed payment. He includes $15,000 of ordinary income ($10,000 guaranteed payment + $5,000 [$50,000 × 10%] for his distributive share) on his individual income tax return.
49
Q
Separately Stated Items
A
- The following items must be separately stated on a partnership’s return:
- Net short-term & Long term capital gains and losses,
- Charitable contributions
- Dividends received from a corporation eligible for a dividends-received deduction
- Foreign income taxes (paid or accrued)
- Taxes paid to a U.S. possession (Guam, American Samoa, Puerto Rico, etc.)
- Section 1231 gains and losses
- Section 1250 depreciation recapture
- Section 179 deduction
- Any tax-exempt income and expenses related to the tax-exempt income
- Investment income and related investment expenses
- Rental income and any related expenses
- Qualifying section 199A wages paid by the partnership (to employees)
- Unadjusted Basis of assets immediately after acquisition (UBIA): Reporting UBIA on the partnership return is necessary for purposes of each partner calculating the 20% pass-through QBI deduction on their personal returns.
- Example: Foster is a 25% partner in Omaha Architects, LLP, a partnership with three other individual partners. Omaha Architects makes $20,000 of charitable contributions during the year that are reported on the partnership tax return, Form 1065. As Omaha Architects is a pass-through entity, it does not receive a tax benefit from deductible contributions. Instead, Foster’s Schedule K-1 shows $5,000 as his share of the partnership’s charitable contributions, which he can potentially claim on his individual tax return.
50
Q
Contributions to a Partnership
A
- When a partnership is formed, or new partners are added, the partners contribute property or cash in exchange for their partnership interests. Generally, neither the partner nor the partnership recognizes gain or loss in connection with contributions, whether made in connection with the partnership’s formation or after it is operating.
- When a partner contributes property (rather than money) to a partnership, the partner’s basis in their partnership interest as well as the partnership’s basis in the property is generally the same as the adjusted basis of the property contributed by the partner, including any gain recognized by the partner in connection with the contribution.
- For example, if a partner contributes a building with an FMV of $175,000 and a basis of $65,000, with no debt, the basis of the building in the hands of the partnership would also be $65,000. This amount would also be the partner’s basis in his own partnership interest. The partner’s holding period for the property is also carried over.
- Example: Reyna and Hamlin are both Certified Financial Planners. They come together to form Zenith Financial, LLP, an equal partnership to offer financial services. Reyna contributes an office building to the partnership that has an adjusted basis of $145,000 and an FMV of $300,000. The partnership will use the building as its main office. Hamlin contributes $125,000 in cash. The basis of Reyna’s partnership interest is $145,000, and the basis of Hamlin’s interest is $125,000. Even though the contributions to the partnership were not the same, they can still share partnership profits and losses equally.
51
Q
Taxable Contributions
A
- However, a partner’s contribution can result in gain or loss recognition in the following situations:
- When property is contributed to a partnership that would be treated as an investment company if it were incorporated.
- When contributed property is distributed to a different partner within seven years of the original contribution date. The contributing partner would recognize gain on the difference between the fair market value and the adjusted basis of the property as of the contribution date. The character of the gain or loss will be the same as would have resulted if the partnership had sold the property to the distributee partner.
- When a partner contributes cash or property to a partnership and then receives an immediate distribution of different property (or cash). In this case, the transaction may be considered a “disguised sale.” If a contribution and distribution occur within two years of each other, the transfers are presumed to be a “disguised sale” unless the facts clearly indicate they are not.
- Example: Benjamin transfers a factory building to Leeds Partnership and then, two months later, Leeds Partnership distributes $3,000,000 in cash to Benjamin. The factory building has a fair market value of $4,000,000 and a basis of $1,200,000. This transfer would likely be treated as a “disguised sale,” rather than a distribution. In this case, the transaction would not qualify for nonrecognition treatment, and Benjamin would be required to recognize income on the “sale” of the building to the partnership.
52
Q
Contribution of Services to a Partnership
A
- A partner can acquire an interest in a partnership as compensation for services performed. If a partner receives a capital interest as compensation for services, the partner must recognize ordinary income equal to the fair market value of a partnership interest that is transferred in exchange for services. The amount is treated as a guaranteed payment.
- Example: Dana is an attorney who contributes her legal services to a partnership in exchange for a 5% partnership interest. The fair market value of the partnership interest is $3,000. Dana is required to recognize $3,000 of ordinary income, and her basis in the partnership is $3,000.
53
Q
Partnership Loss Limitations
A
- The amount of a partnership’s loss that a partner is potentially allowed to deduct on their tax return is normally dependent on (1) the partner’s basis in the partnership, and (2) the amount the partner has at-risk in the partnership (i.e., the “at-risk” limitation).
- In general, a partner cannot deduct losses that exceed their partnership basis. Losses disallowed due to insufficient basis are carried forward until the partner can deduct them in a later year, typically when there is sufficient basis in the partnership. Debts incurred on behalf of the partnership can increase a partner’s individual basis.
- For example, if a partner takes out a $50,000 loan to finance partnership operations and he or she personally guarantees the debt, the debt is considered part of their basis in the partnership for purposes of deducting partnership losses.
- If a partner does not have any personal liability to satisfy the debt of a partnership, deductible losses may be limited by the at-risk rules.
- Example: Gary and Danica are two friends who form West Lake Winery, LLC, a 50/50 partnership. Gary invests $10,000 in cash. Danica also invests $10,000 in cash, and she also personally guarantees a business loan of $80,000 on behalf of the partnership to purchase wine-making equipment. Danica is the only signatory on the loan because Gary’s credit is poor. West Lake Winery has a net loss of ($24,000) for the year, which is allocated equally to the partners ($12,000 in losses each). The at-risk limitations limit Gary’s deduction to $10,000, the amount of his investment, as he is not personally liable for the note. Danica’s losses are not limited, because her basis includes the debt basis of the loan ($80,000), for which she is personally liable. She is allowed to deduct her $12,000 loss in full. Gary’s disallowed losses must be carried over to the following year.
- Example: Yellowstone Energy, LP is a limited partnership with over 100 partners. Raymond is a general partner, whereas Silvio is one of the limited partners. Yellowstone Energy has taken a recourse loan of $500,000 during the year to help fund its business operations. Raymond is a general partner, so he personally guarantees the loan. This may affect his partnership basis. Silvio is a limited partner and is simply an investor; he is not responsible for the borrowings of the business. Silvio’s basis is not affected by the loan or any other liabilities.
54
Q
The “At Risk” Limitation
A
- Do not confuse the “at-risk limitation” with the “passive activity loss” rules. They are not the same thing. The at-risk rules deal with a partner’s investment in an activity, while the passive activity rules deal with a partner’s participation in an activity. They are also reported on different forms.
- Form 6198, At-Risk Limitations, is for calculating profit or loss from an at-risk activity for the current year. Form 8582, Passive Activity Loss Limitations, is used to figure the amount of any passive activity loss (PAL) for the current tax year.
- The at-risk rule limits the deductibility of losses to the partner’s basis, not including his or her share of most nonrecourse debt. This means that a partner is prohibited from taking losses based on partnership liabilities unless the partner would be forced to satisfy the debt with their personal assets.
- This rule is intended to prevent abusive deductions from tax shelter activities.
- Example #1 (profitable partnership): Jordan is a limited partner in the Crypted Partnership, LP, a business that mines different types of cryptocurrencies. He invested $5,000 to obtain his 5% partnership interest. As a limited partner, Jordan is not required to invest any additional capital, his legal liability is limited to his partnership investment and he is not involved in its day-to-day business. Jordan’s at risk limitation is $5,000, the amount of his initial investment. If the partnership had losses, this is the most he would be able to deduct. However, the partnership is very profitable in the current year, and Jordan’s Schedule K-1 from the partnership reflects his distributive share of the partnership’s income, which is $39,000. Because Jordan is a limited partner who does not take an active role in the business, his income from the limited partnership is viewed as passive income, which is not subject to self-employment tax. So he has the double benefit of (1) limited liability, as well as (2) avoiding self-employment tax on his partnership earnings.
- Example #2 (unprofitable partnership): Emily is a limited partner in Arise Energy LP, a business that invests in different types of renewable energy. She owns a 1% partnership interest. Emily is also not involved in the partnership’s day-to-day business. Emily’s only other income for the year is $40,000 in wages. Arise Energy does poorly in the current year because a catastrophic storm wiped out its main offices. Emily’s Schedule K-1 from the partnership reflects her distributive share of the partnership’s losses, which are ($15,000). Emily cannot deduct any of the losses, because she cannot offset her wages (active income) with this passive activity loss. The ($15,000) loss is suspended and must be carried forward, until the partnership is profitable, or she disposes (sells) the activity.
55
Q
Distributions
A
- A partnership is not a taxable entity; its income and losses flow through and are reported on the partners’ individual tax returns. Partners are taxed on their distributive share of income, whether or not it is actually distributed. Partnership distributions may include the following:
- Distributions of the partnership’s earnings for the current or prior years.
- A withdrawal by a partner in anticipation of the current year’s earnings.
- A complete or partial liquidation of a partner’s interest.
- A distribution to all partners in complete liquidation of the partnership.
- All partnership distributions are either current or liquidating.
- A liquidating distribution terminates a partner’s entire interest in the partnership (generally either when a partner is no longer a partner in the partnership, or the partnership itself no longer continues to be in existence). A current distribution is one that does not terminate the partner’s interest in the partnership.
- A partnership distribution is not taken into account in determining the partner’s distributive share of the partnership’s income or loss.
56
Q
Cash and Property
A
- If the amount of a cash (or the cash portion of mixed cash and property) distribution exceeds a partner’s basis in the partnership, then the excess of the cash distribution over the partner’s basis will normally result in capital gain to the partner.
- If a property distribution exceeds a partner’s basis in the partnership, this will usually not result in taxable gain, but the partner’s basis will be transferred into the asset(s) received in the distribution.
- A partnership does not recognize any gain or loss because of distributions it makes to partners.
- A partner who receives a current (nonliquidating) distribution cannot recognize a loss, but a partner that receives a liquidating distribution may recognize a loss if (1) the amount of cash and the partnership’s basis in non-cash assets distributed to the partner is less than the partner’s basis in the partnership right before the distribution, and (2) only cash and “hot assets” are distributed to the partner.
- Example: Henry is a 10% partner in the Brockville Realty partnership. The basis of Henry’s partnership interest is $100,000 at the beginning of the year. He receives a distribution of $40,000 cash and a parcel of farmland that has an adjusted basis to the partnership of $80,000. Henry’s basis in the farmland is limited to $60,000 ($100,000 basis - $40,000, the cash he receives) since the total amount cannot exceed his partnership interest. After this distribution, his partnership basis would be zero, but he recognizes no gain on the distribution as the amount of the cash received is not in excess of his outside basis in the partnership. Later, if Henry decides to sell the farmland, then his basis for determining gain will be $60,000. Any gain on the land will be recognized when he eventually sells it.
57
Q
Hot Assets
A
- “Hot assets” are ordinary-income producing assets. The main two examples are inventory and accounts receivables. A gain or loss on a sale or exchange of unrealized receivables or inventory items a partner received in a distribution is generally treated as ordinary income or loss when later sold by the partner.
- They receive this treatment because these are assets that would have generated ordinary income for the partnership if they were sold.
- Example: Triple Crown Accountancy, LLP is a partnership with four equal partners, who are all licensed accountants. The partners have a major disagreement about the direction of the firm and decide to go their separate ways. Triple Crown Accountancy liquidates on December 10. The partnership does not distribute any cash to the partners, but it does distribute $30,000 in unrealized receivables to Dillon, one of the partners. The following year (In January) the clients pay the outstanding invoices (the unrealized receivables) and Dillon receives the money for the invoices. He must treat the income as ordinary income, just as if the income would have been received by the partnership itself.
58
Q
Sale of a Partnership Interest
A
- A partnership interest is a capital asset. As a result, a gain or loss on the sale or exchange of a partnership interest is normally treated as a capital gain or loss.
- However, if the partnership holds certain section 751 “hot assets”, some or all of the gain or loss may be recharacterized as ordinary.
- Gain or loss is calculated as the difference between the amount realized and the adjusted basis of the partner’s interest in the partnership. If the selling partner is relieved of partnership liabilities, he or she must include the liability relief as part of the amount realized for his or her interest.
59
Q
Related-Party Transactions
A
- A partnership cannot deduct a loss on the sale or trade of property if the transaction is directly or indirectly between related parties. Under the related party transaction rules, an individual is considered to be the owner of a partnership interest directly or indirectly owned by his or her family members.
- Members of a family, for this purpose, include siblings, half-siblings, spouses, ancestors, parents, and lineal descendants (children, grandchildren).
- For the purposes of this rule, “related parties” does not include: ex-spouses, in-laws, aunts, uncles, stepsiblings, cousins, or stepparents.
- Example: Mason and Addie are siblings. Addie is a 60% partner in the Crown Partnership, and Mason is a 55% partner in the Belkin Partnership. If one partnership sells property to the other at a loss, the loss will not be allowed because the partnerships are considered related parties, because the majority ownership in both partnerships is held by two closely-related family members (Mason and Addie). Losses will instead be suspended until the property is eventually disposed of in a non-related party transaction.
60
Q
Liquidation of a Partnership
A
- When a partnership dissolves or stops doing business, it is called a partnership liquidation, and the partnership will normally pay off existing debts and liabilities and distribute to the partners any remaining assets.
- A dissolution (or liquidation) marks the official ending of a partnership. A partnership may also dissolve when a partner dies, or when one partner drops out of the business.
- In a partnership liquidation, the liquidating distributions are similar to regular distributions except that the partner may recognize a loss if the total of cash and the basis of certain qualifying property received is less than their basis in the partnership.
- Example: Limestone Realty is having serious financial difficulties and decides to liquidate. Larissa is a 10% partner. Her basis right before the liquidation is $9,000. Limestone Realty distributes $1,550 in cash to Larissa, in complete liquidation of her interest. There are no other assets to distribute, and the partnership formally dissolves a week later. Larissa can recognize a $7,450 capital loss on the liquidating distribution ($9,000 basis – $1,550 cash received).
