Topic 5 - Tax Treatment for Partnerships Flashcards
When it comes to Partnership interest, what is the difference between capital interest and profit interest?
Partnership Interest represents your economic rights to receive a share of the partnership’s net assets
Capital Interest - an economic right attached to a partnership interest giving a partner the right to receive cash or property in the event the partnership liquidates. A capital interest is synonymous with the liquidation value of a partnership interest.
Profit Interest - an interest in a partnership giving a partner the right to share in future profits but not the right to share in the current value of a partnership’s assets (ex. joined partnership because of your qualifications but did not contribute money or property)
How is a gain or loss recognized when there is a contribution of property?
No gain or loss recognized when contribution occurs.
This is treated as a tax-deferred transaction because the partner still technically owns the property contributed.
Because of this, it is a bad idea to contribute property with a built in loss (basis greater than FMV) because you would not get to recognize the loss. Better to sell it, take the loss, and contribute the cash.
How do you determine a partner’s inital basis in a partnership?
We determine basis so we can determine gains or losses when you sell your partnership interest.
OUTSIDE BASIS - a partner’s tax basis
INSIDE BASIS - the partnership’s basis
1) if you give cash, your basis is the amount of cash
2) if you give property with a FMV of $100,000 and your basis in the land is $50,000, your outside basis will be $50,000. The partnership’s inside basis is $100,000.
If the partnership has debt, then you must include your newly acquired share of the debt in your basis.
If there is a liability on the property you give that the partnership assumes for you, you must decrease your outside basis by the debt relief you received.
In a Partnership, what is the difference between recourse debt and nonrecourse debt?
Recourse Debt - a legal agreement that gives the lender the right to pledged collateral if the borrower is unable to satisfy the debt obligation. If the partnership can’t pay, the partners have personally guaranteed the loan and the bank can seize items of the partners
Nonrecourse Debt - limit the lender to claiming only the specific asset pledged as collateral. If a borrower defaults and the value of the collateral does not cover the amount the borrower owes, the lender cannot attempt to recover the balance by seizing the borrowers other assets
How does a Partnership track equity of each partner?
Capital Account - an account reflecting a partner’s share of the equity in a partnership
Every year the capital account is adjusted to include earnings and losses, contributions, and distributions.
When is a Contribution of Services in exchange for partnership interest taxable?
It depends what type of interest the new partner receives for their services:
Capital Interest - The new partner must pay tax on the liquidated value. This will be treated as ordinary income. His tax basis will be the amount received, holding periods starts on day received his interest
Profit Interest - This is only to share in future profits of the partnership. The new partner is not taxed because there is no immediate liquidation value.
What does a Partnership need to consider when determining when its year-end is?
If partners have different personal tax year ends, this will result in some degree of tax deferral. The goal in determining a year-end is limiting tax deferral as much as possible.
If there is a majority interest tax year end, the Partnership will match that year end.
If no majority interest, if the principla partners all have the same tax year-end, the Partnership will match that year end.
If neither of the above are true, the Partnership will use the tax year-end with the least aggregate deferral.
What qualification allows a Partnership to use the cash accounting method?
Partnerships can use the Cash method if their annual gross receipts for the three prior taxable years do not exceed $25 million (if not in existence for at least three years, teest applies to number of years in existence)
What are the tax filing requirements for a Partnership?
Partnerships complete a Form 1065.
Must be filed with IRS by the 15th day of the third month after their year end.
Can file Form 7004 for an automatic 6-month extension
Partnership distributes a Schedule K-1 to partners
Partners include this information on their 1040
How is cash distribution handled in a Partnership?
Remember, a partner is taxed when the partnership earns the money (not when it is distributed).
As long as cash distributed does not exceed a partner’s outside basis, it reduces the partner’s tax basis. If cash distribution exceed partner’s basis, generally treated as a capital gain to the partner.
What are the Loss Limitations for a Partnership? (3)
If a partnership produces ordinary losses, they may be deductible for the partner against any type of taxable income if they meet three hurdles:
1) Tax-Basis Limitation. You can only use losses up to your tax basis. Basis represents what you have invested in the partnership. Once you take your basis down to $0, any additional losses can be carried forward indefinitely. So if you increase your tax basis in the future, then you can use your suspended losses to reduce your taxable income. If you sell your partnership interest, the remaining losses are lost.
2) At-Risk Limitation. YOu can only deduct up to the amount you are at risk to lose. You cannot deduct for nonrecourse debt (debt for which you are not responsible)
3) Passive Activity Loss Limitation. You cannot deduct if you are not an active participant in the business. Taxpayers who do not materially participate are considered passive. Ex. limited partners with no management rights are passive.
What is the Excess Business Loss Limitation for a partnership?
2018 and beyond, noncorporate taxpayers are not allowed to deduct excess business loss.
An excess business loss is the amount by which the total deductions attributable to all of your trades or businesses exceed your total gross income and gains attributable to those trades or businesses plus $250,000 ($500,000 in the case of a joint return)
Excess business losses that are disallowed are treated as a net operating loss carryover.
