US Taxation of Partnerships Flashcards
Passive vs Non Passive Income
-Imagine your financial activities as gardens
- One garden active requires a lot of effort on your side: you water it, you trim it, etc
- The passive garden (investment activities where you dont participate) requires less effort from your side
- Tax rules prohibit using losses generated from your passive activities to offset your active income
Material Participation
You materially participated in the operation of a business activity if you meet ANY of the following tests:
500-Hour Test: Participated for more than 500 hours during the tax year.
Sole Participation Test: You are the only person who substantially participates, including non-owners.
100-Hour + Lead Participation Test: Participated more than 100 hours, and no one else participated more than you, including non-owners.
Significant Participation Activities Test: The activity is significant, you participated in multiple such activities for more than 100 hours each, and the total exceeds 500 hours.
Key Point: Meeting any one of these criteria establishes material participation in a business activity for tax purposes.
At Risk Rules
- Prevent you from claiming losses that exceed your investment in a business
- i.e if you invest 100 you can’t claim a loss for 200
Your loss is considered the lesser of
- The loss
- The amount you have at risk in the activity / investment
- You are at risk up to the amount of cash and the adj basis of the other property you have contributed to the activity
- Funds that you borrowed on which you are personally responsibe can be added to the at risk amount
You are not considered to be at risk if you:
- Do not have to repay borrowed amounts becuase you have non-recourse financing
- Borrow money from a lender who has an interest in the business other than as a creditor (ie you borrow money from yourself. The dual role of lending and equity creates conflict of interest and is view by the IRS as potentially impactful to the terms of the loan
Disallowed losses due to not meeting the “at-risk” requirements can be carried forward to future tax years when you have sufficient amounts at risk.
What are the reportable ordinary income / deductions:
These components affect the taxpayer’s overall income calculation and may impact tax liability.
Proper documentation and understanding of tax rules governing each component are crucial for accurate tax reporting.
Taxpayers should consult tax professionals to navigate the complexities of these items, especially concerning exceptions and specific qualifications for deductions.
Section 179 Deduction: Immediate expense deduction business owners can take for purchases of business equipment instead of capitalizing and depreciating the asset over time.
Section 59(e)(2) Expenses: Certain expenditures that can be amortized over a period of years, such as research and experimental costs.
Unreimbursed Expenses: Expenses incurred in the course of business activities that were not reimbursed by the business.
Depletion Expense: Deduction for the depletion of natural resources, applicable to businesses involved in mining, timber, oil and gas extraction, etc.
Interest Expense: Cost incurred from borrowing funds. Deductible if the loan was used for business purposes.
Cancellation of Debt (COD): Income realized when a debtor is relieved from the obligation to repay a debt, considered taxable income unless specific exceptions apply.
Commercial Revitalization Deduction: A deduction allowed for certain expenditures made for rehabilitating or constructing buildings in designated revitalization areas.
Non-portfolio Short-term Capital Loss: Losses from the sale of capital assets held for one year or less, excluding investments in portfolio assets like stocks and bonds.
Short-term Loss on Sale of Supplemental Business Asset: Losses from the sale or exchange of business assets held for one year or less that are not central to the business’s main operations.
Short-term Loss Sale of Partnership Interest: Loss realized from the sale of a partnership interest held for one year or less, treated as ordinary loss to the extent of the partner’s share of partnership’s ordinary income items.
Capital Loss
In partnership taxation, a capital loss occurs when the partnership sells an asset for less than what it bought it for
Capital assets typically include property like real estate, stocks, or bonds, but in a partnership context, they can also cover interests in the partnership itself or investments made by the partnership.
Understanding Capital Loss in Partnerships
Imagine a partnership as a group of friends pooling their money to buy a rare comic book. If they later sell the comic book for less than what they paid, the loss they incur is akin to a capital loss in a partnership.
How is the adjusted basis for an asset calculated?
The adjusted basis of an assets is calculated as
Original cost + improvements - minus depreciation
Capital Losses
Capital Asset Disposal: A capital loss arises when the partnership sells or exchanges a capital asset at a loss. The calculation of this loss depends on the difference between the asset’s selling price and its adjusted basis (original cost plus improvements minus depreciation).
Partnership Interest: Selling a partnership interest at a loss also results in a capital loss for the selling partner. This situation is similar to selling shares of a company at a price lower than the purchase price.
Non-Portfolio Short-term Capital Loss: This refers to a capital loss on assets not held for investment purposes and sold within a year of acquisition by the partnership. It contrasts with portfolio losses, which arise from investment activities.
Short-term vs. Long-term: Capital losses are classified as short-term if the asset was held for one year or less before being sold. If held for more than a year, the loss is considered long-term. This classification affects how the loss can be used to offset capital gains.
Tax Implications of Capital Losses
Partnerships can use capital losses to offset capital gains. If there are more losses than gains, the excess loss can be passed through to the partners, who may then use it to offset their other capital gains. If the total capital losses exceed total capital gains, the excess losses can sometimes be used to offset up to $3,000 ($1,500 if married filing separately) of other types of income per year, with the remainder being carried forward to future years.
capital losses
In summary, capital losses in partnership taxation reflect the decrease in value of the partnership’s capital assets, impacting the tax liabilities of the partners based on their share of the loss and the tax rules governing loss deductions and carryforwards.
