Tax analyst theory overview Mod 1 Partnerships

Question 1

What is a Partnership?

Answer 1

The Internal Revenue Code defines a partnership as an unincorporated organization with two or more members who carry on a trade, business, financial operation, or venture and share or split the income/loss, or the profits or losses from a business activity.

Each partner must contribute money, property, labor, or skill in exchange for a share of the profits and losses of the business, whether a formal partnership agreement is created or not.

Question 2

What is a Partnership?

Is co-owneship of property considered a property?

Answer 2

Answer:

No—unless additional services are provided. An arrangement to share expenses is also not a partnership.

Question 3

I. What are the ways that Partnerships can be formed

II. What is the most ideal method of froming a Partnership?

Answer 3

I. Partnerships may be formed by formal agreement, informal agreement, or even the conduct of the parties involved.

II. A formal agreement is the ideal method of forming a partnership because the partnership agreement can spell out key items pertinent to that partnership

Question 4

Formal Agreement

Formal agreements can be either written or oral

They may be modified at any time, also in writing or as an oral agreement. Putting the agreement and all modifications in writing is the best way to protect each of the partner’s interests. The partnership agreement should include key items such as:

Answer 4

• Each partner’s ownership percentage.
• The amounts of cash and property contributed by each partner at the start of the partnership, as well as any special skill of any one of the partners that is a part of their ownership agreement.
• Any guaranteed payments with specifics of the dollar amount, payment dates, and the conditions of the payment.
• Agreements regarding how distributions from the partnership will be handled, including dollar amounts, when, and under what conditions.
• How business expenses will be treated, such as partner reimbursements for out-of-pocket expenses.
• What will be done if a partner dies or wishes to sell or liquidate their share

Question 5

Can partnershps be informal or even accidental with no oral or written agreements guiding the relationshp?

Answer 5

Answer: Yes.

Question 6

What are types of Partnerships?

Answer 6

Partnerships can generally be classified as either a general partnership or a limited partnership

Other factors that need to be considered are:

• Limited liability partnerships (LLP).
• Limited liability companies (LLC).
• Qualified joint ventures (QJV).

Question 7

I.General Partnership vs. Limited Partnership ~ What is the difference?

II. What is the default type of partnership?

Answer 7

I.

A limited partnership is similar to a general partnership, except there are two classes of partners: general partners and limited partners. The general partner(s) have full management control of the partnership business and are personally liable for the debts of the partnership. There must be at least one general partner in all limited partnerships. There can be any number of limited partners in a limited partnership.

Because of the limited partners who have limited liability, most jurisdictions (states) require limited partnership agreements to be in writing and the certificate of limited partnership (registration, statement of qualification, application for registration, or certificate of limited liability partnership) must be filed with the state.

II. The default type of partnership is a general partnership.

A general partnership consists solely of general partners. All partners in a general partnership must be categorized as general partners, regardless of the amount of their share of the partnership.

Question 8

Check For Understanding 1.1

General partnerships consist of:

a. General and limited partners.
b. Managing partners and investors.
c. Only general partners.
d. General partners with limited liability.

Answer 8

Answer: C

General partnership is made up of only general partners.

Question 9

Limited Liability Partnerships, Limited Liability Companies, and Qualified Joint Ventures

Are limited liability partnerships (LLPs) and limited liability companies (LLCs) formed under state law?

Answer 9

Answer: Yes

Question 10

Limited Liability Partnerships, Limited Liability Companies, and Qualified Joint Ventures (Continued)

What is a LLP

A limited liability partnership (LLP) is a similar business structure to a limited partnership, but with two distinctions.

First, in limited liability partnerships, all the partners have limited personal liability for business debts.

Second, some states restrict this designation to professionals such as lawyers and accountants and have other state-specific regulations for this type of entity.

Question 11

Limited Liability Partnerships, Limited Liability Companies, and Qualified Joint Ventures (Continued)

What is a LLC?

A limited liability company (LLC) is an entity formed under state law by filing articles of organization. State laws regarding this type of entity vary widely. “Owners” in an LLC are called members or member managers. They are not called limited partners or general partners.

An LLC, by definition, is not a partnership; however, a multi-member LLC is taxed as a partnership unless an election is made using Form 8832, Entity Classification Election, to be classified as a corporation. (A single member LLC is a disregarded entity treated as a sole proprietor unless an election is made using Form 8832 to be classified as a corporation.)

Question 12

Limited Liability Partnerships, Limited Liability Companies, and Qualified Joint Ventures (Continued)

What is a QJV

Answer 12

A partnership, whose only partners are a married couple, may elect to file as a qualified joint venture (QJV). In doing so, they will not file Form 1065. Instead, they will report the partnership income and expenses on their personal tax return using two Schedules C. Spouses make the election on a jointly-filed Form 1040 by dividing all items of income, gain, loss, deduction, and credit between them in accordance with each spouse’s respective interest in the joint venture. The tax return will include a separate Schedule C for each of them and, if required, a separate Schedule SE.

In order to make this election:

• They must file their tax return using the married filing jointly filing status.
• The spouses must be the only partners of the partnership.
• They both must materially participate in the partnership.
• They both must agree to file with Schedule C rather than Form 1065.
• They cannot be organized in their state as an LLC.

Question 13

Elections

When determining whether a business entity is a partnership, consideration is given to whether any partnership elections have been made.

Examples of elections made by the partnership include election of:

Answer 13

• A fiscal tax year, rather than the required tax year.
• Accounting method.
• Depreciation method.
• Using IRC §179 for capital assets.
• Inventory method.
• Amortization vs. expensing of startup costs and organizational expenses.

Question 14

Election of the Tax Year

When must a partnership determine the required tax years

Answer 14

Answer: At the beginning of the partnershp

In general, the ordinary income of a partnership is computed on the basis of a tax year. A tax year is the accounting period used for keeping records and reporting income and expenses.

At the beginning of a partnership, the partners must determine the required tax year according to a specific set of rules, applied in this specific order:

Question 15

Election of the Tax Year (Continued)

At the beginning of a partnership, the partners must determine the required tax year according to a specific set of rules, applied in this specific order:

What is the order?

Rule 1

What is majority interest tax year?

Answer 15

Rule 1

If one or more partners having the same tax year own an interest in partnership profits and capital of more than 50% (a majority interest), the partnership must use the tax year of those partners. This is known as the majority interest tax year. Thus, a partnership consisting of only individuals will usually have a calendar year under the majority interest rule because each of the partners as individuals use a calendar year.

Question 16

Election of the Tax Year (Continued)

Rule 2

What is a pricipal partner?

Answer 16

Rule 2

If there is no majority interest tax year, and all the principal partners have the same tax year, then the partnership must use the same tax year as the principal partners. A principal partner is a partner who has a 5% or more interest in the profits or capital of the partnership.

Question 17

Election of the Tax Year (Continued)

Rule 3

Answer 17

If no tax year is established by either the majority partners or the principal partners, the partnership must use a tax year that results in the least aggregate deferral of income to the partners. This requires an analysis to determine which of the partners’ current tax years should be used for the partnership, resulting in the least amount of delay (number of months) when reporting the income for taxation purposes

Question 18

Election of the Tax Year (Continued)

Each of the 3 above rules is based strictly on. . .what?

Answer 18

Election of the Tax Year

Each of the above rules is based strictly on the percentage of ownership and the applicable tax years of the partners, not on the types of partners, whether a general partner or a limited partner.

There is also a set of rules that allow a partnership to change from a required tax year to a different fiscal year. This can be accomplished if the partnership establishes a business purpose and receives IRS permission using Form 1128, Application To Adopt, Change, or Retain a Tax Year. Or they can make a fiscal tax year (§444) election by filing Form 8716, Election to Have a Tax Year Other Than a Required Tax Year.

Question 19

What is a Business Purpose Tax Year

If a partnership can establish an acceptable business purpose for having a tax year other than the one required under the three rules discussed earlier, they may use the business purpose tax year. This election must usually pass .. .what?

Answer 19

If a partnership can establish an acceptable business purpose for having a tax year other than the one required under the three rules discussed earlier, they may use the business purpose tax year. This election must usually pass a facts and circumstances test.

Question 20

Business Purpose Tax Year

What does Rev. Proc. 2002-38 do?

What is a natural business year?

Answer 20

Rev. Proc. 2002-38 doallows a partnership to automatically adopt a fiscal year that meets a mechanical test, the 25% test. The test involves comparing gross receipts for three 12-month periods. Using the last two months for each of the three “years,” calculate the percentage by dividing the 2-month total by the 12-month total. If the receipts in the last two months of each 12-month period exceed 25% of the total receipts, then a natural business year is said to exist and the business year is automatically allowed. A business year adopted under this procedure is called a natural business year.

What is a natural business year?

If the receipts in the last two months of each 12-month period exceed 25% of the total receipts, then a natural business year is said to exist and the business year is automatically allowed. A business year adopted under this procedure is called a natural business year.

Question 22

Business Purpose Tax Year (continued)

A partnership that wants to adopt a business-purpose tax year must file . . .what?

Answer 22

They must file a Form 1128, Application To Adopt, Change, or Retain a Tax Year. This must be filed at least one day after the end of the first tax year for which the change is effective. It must be filed no later than the due date of the return of the first tax year, not including extensions.

Question 23

Business Purpose Tax Year (continued)

What is Sectin 444 Election?

Answer 23

A partnership may elect a tax year other than the required tax year if the elected tax year results in a deferral period of not more than three months for any one of the partners. This election is made by filing Form 8716, Election To Have a Tax Year Other Than a Required Tax Year. A partnership that makes the election must make a required payment representing the value of the deferral to the partners for any year an election is in effect. Use Form 8752, Required Payment or Refund Under Section 7519, to compute the required payment.

See IRS Publication 538, Accounting Periods and Methods, for more information on the business purpose tax year and the §444 election, including the filing requirements for making the election.

Question 24

Election of Accounting Method

What must the accounting method reflect?

Answer 24

One of the elections that partnerships make is the election of an accounting method, sometimes without realizing it. The accounting method must clearly reflect how income is received and recorded, and how expenses are recorded and paid

Question 25

Election of Accounting Method

What are the three types of Accounting Methods?

Answer 25

Answer:

• Cash Mehod
• Accrural Method
• Other

Question 26

Election of Accounting Method (Continiued)

What is the Cash Method

Answer 26

Cash method – Only income and expenses actually or constructively received or paid during the year are reported. Income is constructively received when it is credited to the client’s account or set aside for the client’s use. Expenses are constructively paid when checks are written and mailed or are paid through use of a credit card.

Question 27

Election of Accounting Method (Continiued)

What is the Accrual Method

Answer 27

Accrual method – Under this method, income is recorded as sales when charges are incurred, regardless of whether payment is actually received. Likewise, expenses are reported as they are incurred, not when they are paid. These income and expense transactions that affect the timing of accrual reporting involve the use of “credit.”

Partnerships that produce, purchase, or sell merchandise must maintain inventory, unless they qualify under the small business taxpayer rules. Partnerships with inventory must use the accrual method of accounting for their inventory and the sales related to the product inventory. The accrual method must also be used if the partnership has a C corporation as one of its partners.

Question 28

Election of Accounting Method (Continiued)

What is the Other Method

Answer 28

Generally, a partnership may use the cash method of accounting, unless it’s required to maintain inventories, has a C corporation as a partner, or is a tax shelter (as defined in Section 448(d)(3)). Any partnership qualifying as a small business taxpayer may use the cash method for tax years after 2017.

A small business taxpayer can adopt or change its accounting method to account for inventories in tax years after 2017:

• To conform to the taxpayer’s treatment of inventories in books and records prepared in accordance with the taxpayer’s accounting procedures.
• To conform with the taxpayer’s applicable financial statement (AFS).
• In the same manner as materials and supplies that are non-incidental. If this method is elected, the taxpayer can deduct the cost of goods at the later date of when they are paid for or when they are provided to a customer.

Question 29

Election of Accounting Method (Continued)

What constituttes a small business owner?

Answer 29

A small business taxpayer is a taxpayer that (a) has average annual gross receipts of $25 million or less for the prior three tax years, and (b) isn’t a tax shelter. The threshold for 2020 is $26 million.

Question 30

Election of Depreciation Method

What is the method of depreciation that a partnership must use?

Answer 30

For tax purposes, partnerships must use the Modified Accelerated Cost Recovery System (MACRS), which is the current depreciation system used in the U.S. to report annual tax deductions of depreciable assets.

Question 31

Election of Depreciation (Continued)

What are the two systems of depreciation under MACRS

Answer 31

There are two systems of depreciation under MACRS,The General Depreciation System (GDS) and the Alternative Depreciation System ADS). GDS employees three methods of depreciation; these are described below. ADS uses one method: the straight-line method of depreciation.

Question 32

Election of Depreciation (Continued)

What is the type of deprection syssem that partnerships generally use to depreciate propery

Answer 32

Answer: GDS

Partnerships generally use GDS to depreciate property. As noted above, GDS uses three depreciation methods for calculating annual depreciation, and the partnership must elect the method they will use. The three depreciation methods under GDS are:

Straight-line recovers the basis of assets at the same rate every year.

150% declining balance is an accelerated method that recovers the cost of assets, in earlier years, at 1.5 times the straight-line rate.

200% declining balance is the fastest accelerated depreciation method that recovers the cost of assets twice as fast, in earlier years, as the straight-line method.

In general, shorter-term property classes are recovered under faster accelerated methods than longer-term property classes, unless an election is made to recover the asset cost under a slower method. Once a slower recovery method is elected by a taxpayer, it may not be revoked.

Question 33

Election of Depreciaton Method (Continued)

The three depreciation methods under GDS are:

Answer 33

Straight-line recovers the basis of assets at the same rate every year.

150% declining balance is an accelerated method that recovers the cost of assets, in earlier years, at 1.5 times the straight-line rate.

200% declining balance is the fastest accelerated depreciation method that recovers the cost of assets twice as fast, in earlier years, as the straight-line method.

In general, shorter-term property classes are recovered under faster accelerated methods than longer-term property classes, unless an election is made to recover the asset cost under a slower method. Once a slower recovery method is elected by a taxpayer, it may not be revoked

Question 34

Election of Depreciaton Method (Continued)

Rather than spreading the deduction for the cost of long-term assets over the life of the asset, partnerships may be able to maximize deductions in the period an asset was acquired and placed in service. They can do this by taking advantage of the special depreciation allowance or claiming the Section 179 deduction.

What is Special Depreciation Allowance?

Answer 34

The special depreciation allowance recovers a portion of the cost of qualified property placed in service during the tax year. In general, qualified property acquired and placed in service after September 28, 2017 is eligible for a 100% special depreciation allowance. Further research may be required for exceptions.

Question 35

Election of Depreciaton Method (Continued)

Rather than spreading the deduction for the cost of long-term assets over the life of the asset, partnerships may be able to maximize deductions in the period an asset was acquired and placed in service. They can do this by taking advantage of the special depreciation allowance or claiming the Section 179 deduction

What is the Election of 179

Answer 35

The partnership can elect to recover all or a portion of the costs of certain property, up to a statutory limit, by deducting it in the year the property is placed in service. This election only applies to the first year the property is placed in service, and the property has to be acquired through a purchase. This election applies to both original use and used property. Although the partnership must make the §179 election, the §179 limitations are applied at both the partnership and the individual levels.

When the partnership chooses the §179 election for new assets, these items will be separately stated items that pass through to the partners as reported on their respective Schedules K-1.

Question 36

Check for Understanding 1.2

Generally, which of the following forms is used to report the income and expenses of a partnership?

a. Form 1041.
b. Form 1065.
c. Form 1120.
d. Form 1120-S.

Answer 36

Answer: B

Form 1065. A partnership return is completed on IRS Form 1065, U.S. Return of Partnership Income, used to report income and expenses for a partnership

Question 37

Election of Inventory Method

When is the value of inventory measured?

Answer 37

The value of inventory is measured at the beginning and end of each tax year to determine the cost of goods sold. To determine the value of the inventory, the partnership selects a method for identifying the items of inventory and a method for valuing these items.

Question 38

Election of Inventory Method (Continued)

What are the two mmost popular ways to deep inventory?

Answer 38

The two most popular ways to keep inventory are the cost method, and the lower of cost or market method

Question 39

Election of Inventory Method (Continued)

What is the Cost Method for keeping Inventory

Answer 39

Under the cost method, goods are valued at the invoice price at the time of the original purchase, after all discounts have been applied. Add shipping charges and any taxes paid to the invoice price. The cost value of merchandise includes both direct and indirect costs.

Question 40

Election of Inventory Method (Continued)

What is the lower of cost or market method?

Answer 40

The lower of cost or market compares the market value of each item at the end of the year with its original cost. The lower of the two numbers is then used for valuation.

Question 41

Election of Inventory Method (Continued)

ARe there any other methods of keeping inventory besieds the cost method and the lower of cost or market method?

Answer 41

Answer: Yes

Although those are the most common options, business owners can choose one of several other methods and must attach a description of the alternate method to their return.

Answer 42

Answer: No

Inventory valuation rules are not the same for all kinds of businesses. The method used to value inventory must conform to generally accepted accounting principles (GAAP) for similar businesses and must clearly reflect income. Inventory practices must be consistent from year to year.

NOTE:

There is an exception for partnerships that qualify as small business taxpayers. Rather than keeping an inventory, they have the option of treating inventories as non-incidental materials and supplies. However, they must still use a method of accounting for inventory that reflects income. A small business taxpayer is a taxpayer that (a) has average annual gross receipts of $25 million or less (indexed for inflation) for the prior three tax years, and (b) isn’t a tax shelter. The threshold for 2020 is $26 million.

Question 43

Election of Amortization of Startup or Organizational Expenses

When a partnership starts a business, all eligible costs incurred before operations began should be treated as . . .?

Answer 43

When a partnership starts a business, all eligible costs incurred before operations began should be treated as capital expenditures. This means that most startup and organizational costs must be amortized, or spread out, over 15 years. However, some expenses may be deductible immediately.

Question 44

Election of Amortization of Startup or Organizational Expenses

When a partnership starts a business, all eligible costs incurred before operations began should be treated as . . .what?

II. Can any costs be deductible immediately

Answer 44

Answer: Capital Expenditures

I. When a partnership starts a business, all eligible costs incurred before operations began should be treated as capital expenditures. This means that most startup and organizational costs must be amortized, or spread out, over 15 years. However, some expenses may be deductible immediately.

II. Yes, some expenses may be deductible immediately

Question 45

Election of Amortization of Startup or Organizational Expenses (Continued)

Business Startup Costs

How much can a business immediately expense out on form 1065 for start up costs

II. What are the two tests that must be met

Answer 45

I: $5000

II.

A startup cost is amortizable if it meets two tests:

• The cost would be deducted if paid or incurred to operate an existing active trade or business.
• The cost is paid before the active trade or business begins. Examples include training wages, advertising, surveying the market, and rent or utilities of a storefront.

Question 46

Election of Amortization of Startup or Organizational Expenses (Continued)

Organizational Costs

I. Can organizational costs be expensed and if so how much?

II. The four requirements the expense must satisfy to qualify as an organizational cost are that the cost is

Answer 46

Organizational costs may be incurred prior to the start of the normal business activity but may also occur within the first year of the business and include the costs of creating a partnership, the cost of organizational meetings, state fees, and the cost of legal services. For IRC §709 organizational costs, the partnership can also immediately expense up to $5,000 on Form 1065 and amortize the remaining balance equally over a 180-month period. The $5,000 deduction must be reduced by the amount the total organizational costs exceeds $50,000.

II.

The four requirements the expense must satisfy to qualify as an organizational cost are that the cost is:

• Paid to create a partnership.
• Chargeable to a capital account.
• Amortized over the life of the partnership if the partnership had a fixed life.
• Incurred (and paid if a cash basis taxpayer) before the end of the first tax year in which the partnership is in business. Examples include legal fees, such as creating a partnership agreement, accounting or bookkeeping fees to set up the books, and fees paid to the state to register the business/partnership.

Question 47

Other Elections

There are other elections made at the partnership level that may affect the partner’s income allocation.

Examples include:

Answer 47

• Election out of the installment sale method of reporting gain.
• Election to expense intangible drilling costs.
• Election with respect to the sale or exchange treatment for timber.
• Basis adjustments to partnership property under IRC §754.

For a full discussion of elections made by partnerships, see IRS Publication 541, Partnerships.

Question 48

What constitutes the partners BAsis?