R4 Partnerships

John and Jane Dorian currently operate a very successful business selling pet supplies. Their CPA has advised them to consider forming an LLC. Which of the following would be a reason to select the LLC form?

LLCs can select whether to be taxed as a partnership, corporation or sole proprietorship. An LLC with at least two owners is taxed as a partnership unless an election is made to be taxed as a corporation.

Holding period of partnership interest when capital assets are exchanged?

The holding period of a partnership interest acquired in exchange for a contributed capital asset begins on the date the partner's holding period of the capital asset began.

What is the basis for the partner when a nonliquidating distribution of land is received?

A partner who receives a distribution of non-cash property from a partnership takes the partnership's basis as his basis, but in no case an amount greater than his basis in his partnership interest.

The at-risk limitation provisions of the Internal Revenue Code may limit:

A partner's tax deduction for his or her distributive share of partnership losses is limited to the partner's adjusted basis in the partnership, which is increased by any partnership liabilities that he or she is personally liable for (called the "at-risk" provision). Any unused loss can be carried forward and used in a future year when basis becomes available; therefore, the at-risk limitation does not limit a partner's net operating loss carryover.

What is the tax treatment of net losses in excess of the at-risk amount for an activity?

Any losses in excess of the at-risk amount are suspended and carried forward without expiration and are deductible against income in future years from that activity. The at-risk amount is also referred to as basis. Note that although we discuss this in the textbook for partnerships, the concept applies to all activities that have flow through income and losses.

In computing the ordinary income of a partnership, a deduction is allowed for:

Guaranteed payments to partners are deductible in arriving at the partnership's ordinary income. Ordinary income is the "taxable income" of the partnership excluding all items required to be separately-stated. Charitable contributions, dividend income, and capital losses are all separately-stated items.

Guaranteed payments made by a partnership to partners for services rendered to the partnership, that are deductible business expenses under the Internal Revenue Code, are:

Guaranteed payments to partners are deductible on Form 1065, Line 10, to arrive at partnership ordinary income. On Schedule K-1, guaranteed payments are shown as income on Line 5 and flow through as ordinary income.

Rule for Taxability of partnership distribution?

IRC Section 731 controls the taxability of partnership distributions. A partner who receives a distribution from a partnership realizes gain only to the extent that he receives cash in excess of the adjusted basis of his interest in the partnership immediately before the distribution.

How is the basis determined for a individual who receives interest in the capital of a partnership for services rendered?

If a person receives an interest in the capital of a partnership as a result of prior employment service, the fair market value of the interest acquired represents ordinary income to the recipient and is his basis in the partnership interest acquired.

What happens when a controlling partner purchases land from the partnership at a loss to the partnership?

Losses between a controlling partner (over 50% interest in capital and profits) and his controlled partnership from the sale or exchange of property are not allowed.

When is members partnership officially liquidated when they receive a series of payments over a specific period of time to terminate their partnership interest?

Payments made in liquidation of the interest of a retiring partner are considered a distribution by the partnership. Therefore, a retiring partner continues as a partner until his interest has been completely liquidated by partnership distributions:

In the absence of an election to adopt an annual accounting period, the required tax year for a partnership is:

Per IRC Section 706(b), a partnership tax year must have the same taxable year as the common taxable year of the partners that, in the aggregate, have interest greater than 50%, which is determined based on the "testing day," the first day of the partnership's tax year (not considering the majority interest rule). Note: After a change is made to the "majority-interest" tax year end, the partnership does not have to change to another tax year for two years following the year of change. Exceptions to the rule exist. (1) If there is no "majority-interest" tax year, then the tax year is the tax year of all of the principal partners of the partnership (those owning 5% or more of the income or capital of the partnership). (2) If the partnership is still unable to determine a tax year using the general rule or the first exception, then the tax year that causes the least aggregate deferral of income to the partners must be adopted.

Under Section 444 of the Internal Revenue Code, certain partnerships can elect to use a tax year different from their required tax year. One of the conditions for eligibility to make a Section 444 election is that the partnership must

Sec. 444 permits a partnership to elect a tax year different from the required tax year if the deferral period (i.e., the number of months between the beginning of the tax year and the end of the required tax year) is 3 months or less.

Built in Gain example: When the AQR partnership was formed, partner Acre contributed land with a fair market value of $100,000 and a tax basis of $60,000 in exchange for a one-third interest in the partnership. The AQR partnership agreement specifies that each partner will share equally in the partnership's profits and losses. During its first year of operation, AQR sold the land to an unrelated third party for $160,000. What is the proper tax treatment of the sale?

The difference between the tax basis of $60,000 and FMV of $100,000 on the date the partnership was formed is a built-in gain to partner Acre. Accordingly, the first $40,000 of gain is allocated to Acre and the remaining gain of $60,000 is then shared equally by all of the partners.

When a partner's share of partnership liabilities increases, that partner's basis in the partnership:

When a partner's share of partnership liabilities increases, that partner's basis in the partnership increases by his share of the increase. Since the partner has unlimited liability, the partnership liabilities are treated as if the partner personally borrowed the money and then contributed it to the partnership.

Curry's sale of her partnership interest causes a partnership termination. The partnership's business and financial operations are continued by the other members. What is (are) the effect(s) of the termination?

When a partnership is terminated for tax purposes and its remaining partners decide to carry on the partnership business in a (deemed) new partnership, tax law treats this as a distribution of the prior partnership's assets followed by a recontribution of the (deemed) distributed assets to the new partnership.

Formula to determine Partners basis in partnership?

Cash contributions + Adjusted Basis of non-cash property - share of partnership liabilities assumed by other parties

What are hot assets?

Hot assets are: (1) Unrealized receivables and, (2) Appreciated inventory.

What amount does a partner recognize in the complete liquidation of a partnership?

In a complete liquidation of a partnership, the partner's basis in property received is the same as the adjusted basis of his partnership interest reduced for any monies actually received and is generally a nontaxable event. However, if a partner receives only money that exceeds his basis in the partnership, gain or loss is recognized.

Partners basis for property in a liquidating distribution?

In a liquidating distribution, the partner's basis for the distributed property is the same as the adjusted basis of his partnership interest (as the partner is simply exchanging his partnership interest for the distributed assets), reduced by any monies received in the same transaction.

The individual partner rather than the partnership makes which of the following elections?

Most elections that affect the calculation of taxable income of a partnership are made by the partnership itself rather than by an individual partner. For example, the elections as to methods of accounting, methods of depreciation and the Section 179 expensing of a limited amount of depreciable property, the election not to use installment method accounting, and similar elections are made by the partnership and apply to all partners. However, individual partners can make the election to take a deduction or a credit for taxes paid to foreign countries.

What is the amount deductible loss for a partner?

A partner's deductible loss is limited to his basis plus any amounts that he is personally liable for ("at risk" provision).

Which of the following is both an item that is an allowable tax deduction to the partnership and is reported separately on the individual partner's Schedule K-1?

A partnership calculates net business income or loss and passes each partner's distributive share through on the Schedule K-1. Guaranteed payments paid to partners for services rendered or for the use of capital, without regard to partnership income or profit and loss sharing ratios, are an allowable tax deduction to the partnership and are separately reported on Schedule K-1 for inclusion on the partner's tax return.

Rules regarding partnership selecting a different deferral period?

A partnership may elect to have a tax year other than the generally required tax year if the deferral period for the tax year elected does not exceed three months.

What will cause a partnership to terminate?

Among other events, a partnership terminates for income tax purposes when 50% or more of its interests change hands within 12 months.

Rule for contributing property for ownership in a partnership?

Generally, no gain or loss is recognized on the contribution of property to a partnership in return for a partnership interest. The basis of the partnership interest is the basis of the property in the hands of the partner upon contribution. The partnership takes on the contributor's basis of the contributed property; however, if the fair market value of the property differs from the basis, the amount of the unrealized gain or loss at the date of contribution is specially allocated to the contributing partner upon the sale of that contributed property.

How is the gain or loss calculated when a partners share is liquidated? What type of gain or loss is recognized?

partner who sells his interest in a partnership has a recognized gain or loss that is measured by the difference between the amount realized for the sale and the adjusted basis of the partnership interest. If there are any partnership liabilities allocated to the interest and transferred to the buyer, they are considered part of the amount realized. Any gain that represents a partner's share of "hot assets" (unrealized receivables of appreciated inventory) is treated as ordinary income if cash is taken. Clark's capital gain on the sale is calculated as follows: