Tax Chapter 20 - Partnerships

When do you apply the at risk limitation

after the tax basis limitation Losses limited under the at-risk rules are carried forward indefinitely until the partner generates additional at-risk amounts to utilize the losses, or until they are applied to reduce any gain from selling the partnership interest.

Capital Accounts

partnerships create a tax capital account for each new partner reflecting the tax basis of any property contributed (net of any debt securing the property) and cash contributions. The tax capital account will later be adjusted to include the partner's share of earnings and losses, contributions and distributions. Each partner's inside basis can be easily calculated by adding the partner's share of debt to their capital account.

Partnership formations

When a partnership is formed, partners may transfer cash, tangible and intangible property, and services in exchange for an equity interest called a partnership interest

Least Aggregate Deferral

The tax year that provides the partner group as a whole with the smallest amount of aggregate tax deferral.

Types of Flow through entities

Unincorporated businesses such as general partnerships, limited partnerships and limited liability companies are taxed as partnerships Corps whose owners elect to treat them as flow through entities are taxed as S Corps

Losses from passive basket

Losses from the passive basket are not allowed to offset income from other two baskets. The passive activity losses are suspended until the taxpayer generates passive income or until the taxpayer sells the activity that generated the passive loss. Upon sale, the taxpayer will be allowed to deduct suspended passive losses as ordinary losses.

Section 704(b) account

Many partnership agreements require the partnership to main Section 704(b) accounts for the partners in addition to tax basis capital accounts. Section 704(b) capital accounts reflect the fair market value of contributed assets. Partnerships often prefer this approach over simply maintaining tax capital accounts because 704(b) capital accounts may be a better measure of the true value of each partner's capital interests.

Partner's initial tax basis

Need to determine the tax basis in their partnership interest to properly compute their taxable gains and losses when they sell their partnership interests Tax basis in his partnership interest is his outside basis The Partnership's basis in its assets is the inside basis tax basis = basis of their property contributed

Gain or loss nonrecognition

Neither partnerships nor partners recognize gain or loss when contribute property to partnerships

self employment tax

Depends on partners status as general partners or limited partners GPs report guaranteed payments for services they provide and their share of ordinary business income as self-employment income because they are actively involved in managing the partnership Limited partners are generally not allowed to participate in the management of limited partnerships. Therefore, their share of ordinary business income (loss) is conceptually like investment income and thus not subject to self- employment tax. However, if limited partners receive guaranteed payments for services provided to the partnership, they must treat these payments as self-employment income.

Partnership compliance issues

File form 1065 with the IRS by the 15th day of the 3rd month after year end May receive an automatic 6 month extension to file by filing form 7004 the partnership is also responsible for preparing a Schedule K-1 for each partner detailing his or her individual share of the partnership's ordinary business income (loss) and separately stated items for the year. Once prepared, Schedule K-1's are included with Form 1065 when it is filed with the IRS, and Schedule K-1's are also separately provided to all partners (each partner receives a Schedule K-1 with their income and loss allocations).

Contribution of services

Partners who receive capital interests in exchange for services have the right to receive a share of the partnership's capital should the partnership liquidate. Must treat the amount they would receive if the partnership were to liquidate as ordinary income. The tax basis in the capital interest received by the service partner will equal the amount of ordinary income he recognizes and his holding period will begin on the date the partner receives the capital interest It is fairly common for partnerships to compensate service partners with profits interests rather than capital interests. Profit interests are fundamentally different from capital interests, because the only economic benefit they provide is the right to share in future profits of the partnership. Unlike capital interests, profit interests have no liquidation value at the time they are received.

Allocating Partners' Shares of Income and loss

Partnership tax rules provide partners with tremendous flexibility in allocating overall profit and loss as well as specific items of profit and loss to partners, as long as partners agree to the allocations and they have "substantial economic effect." Partnership allocations designed to accomplish business objectives other than reducing taxes will generally have substantial economic effect. Partnership allocations inconsistent with the partner's capital interest or overall profit and loss sharing ratios are called special allocations. Certain special allocations of gains and losses from the sale of partnership property are mandatory. Specifically, when property contributed to a partnership with built-in gains (fair market value greater than tax basis) or built-in losses (tax basis greater than fair market value) is subsequently sold, the partnership must allocate the built-in gain or build-in loss (at the time of the contribution) solely to the contributing partner and then allocate the remaining gain or loss to all the partners in accordance with their profit and loss sharing ratios. This rule prevents contributing partners from shifting their build-in gains and build-in losses to other partners.

accounting methods

Partnerships with C Corporation partners are generally not eligible to use the cash method. However, if the partnerships' average annual gross receipts for the three prior taxable years are less than $5 million, partnerships with C corporation partners may use the cash method.

Passive activity loss limitation

Prior to 1986, a partnership tax shelter industry thrived by marketing to wealthy investors partnership interest designed to generate ordinary losses they could use to shield other income from tax. To combat this practice, Congress introduced the passive activity loss (PAL) rules. These rules are applied after the tax basis and at-risk limitations. The passive activity loss rules limit the ability of partners in rental real estate partnerships and other partnerships they do not actively manage (passive activities) from using their ordinary losses from these activities to reduce other sources of taxable income. Participants in rental activities (including rental real estate) and limited partners are automatically deemed to be passive participants. In addition, participants in all other activities are deemed passive unless their involvement in an activity is "regular, continuous and substantial." An individual is classified as a material participant in an activity by participating more than 500 hours during the year.

at risk limitation

The at-risk hurdle is more restrictive than the tax basis limitation. Partners allocated recourse debt have an economic risk of loss, while partners allocated nonrecourse debt have no risk of loss. Instead, the risk of loss on nonrecourse debt is borne by lenders. The at-risk rules were adopted to limit the ability of partners to use nonrecourse debt as a means of creating tax basis to use losses from tax shelter partnerships expressly designed to generate losses for the partners.

Partner's holding period in partnership interest

The length of a partner's holding period for a partnership interest acquired by contributing property depends on the nature of the assets the partner contributed. When partners contribute capital assets or Sec. 1231 assets (assets used in a trade or business and held for more than one year), the holding period of the contributed property "tacks on" to the partnership interest. Otherwise, the holding period begins on the day the partnership interest is acquired.

Majority Interest Taxable year

The required tax year is the taxable year of one or more partners who together own more than 50 percent of the capital and profits interest in the partnership.

Principal Partners Test

The required tax year is the taxable year the principal partners all have in common. For this purpose, principal partners are those who have more than a 5 percent interest in the partnership profits and capital.

Profits interest

The right to receive a share of future profits or losses Common for partners contributing property to receive both capital and profits interest in exchange Partners who contribute services instead of property frequently receive only profits interest

Capital interest

The right to receive a share of the partnership assets if the partnership were to liquidate

Recourse debts

Those for which partners have economic risk of loss (may have to legally satisfy the debt with their own funds - usually allocated to the partners who will ultimately be responsible for paying it In limited partnerships are typically allocated only to general partners because limited partners are protected from a limited partnership's recourse debt holders

Partner's tax basis and holding period in contributed property

To ensure built-in gains and losses on contributed property are ultimately recognized if partnerships sell contributed property, partnerships generally take a basis in the property equal to the contributing partner's basis in the property at the time of the contribution. Like the adjusted basis of contributed property, the holding period of the contributed assets also carries over to the partnership.

Income and loss baskets

Under the passive activity rules, each item of a partner's income or loss from all sources for the year is placed in one of three categories or baskets. 1) Passive Activity Income or Loss - income or loss from an activity in which the taxpayer is not a material participant. 2) Portfolio Income - income from investments, including capital gains and losses, dividends, interest. 3) Active Business Income - income from sources in which the taxpayer is a material participant. For individuals, this includes salary and self-employment income.

Loss limitations

Unlike capital losses, ordinary losses from partnerships are deductible against ordinary income. However, such losses are deductible on the partner's tax return only when they clear three hurdles: 1. Tax basis 2. At -risk amounts 3. Passive activity loss rules

Ordinary Business income and loss and separately stated items

Although partnerships are not taxpaying entities, they are required to file information returns annually Partnerships must determine each partner's share of ordinary business income (loss) and separately stated items. Common separately stated items include short-term capital gains and losses, long-term capital gains and losses, Sec.1231 gains and losses, charitable contributions and dividends.

Flow through entities

Partnerships are flow through entities - income earned is not taxed at the entity level because the owners of the entity are taxed on their share of the entity level income - taxed only once when it flows through to the owners of the entity

partners must make the following adjustments to the basis in their partnership interest annually in the following order:

1) Increase for cash and property contributions to the partnership during the year. 2) Increase for partner's share of ordinary business income and separately stated income items. 3) Increase for partner's share of tax-exempt income. 4) Decrease for cash and property distributions from the partnership during the year. 5) Decrease for partner's share of nondeductible expenses (fines, penalties). 6) Decrease for partner's share or ordinary business loss and separately stated loss items. Basis adjustments that decrease basis may never reduce a partner's tax basis below zero. Partners are taxed on income as the partnership earns it instead of when it distributes it. As long as a cash distribution does not exceed a partner's tax basis before the distribution, it reduces the partner's tax basis but is not taxed. Cash distributions in excess of a partner's basis are taxable and are treated as capital gains.

qualified nonrecourse financing

A partner's at-risk amount is the same as his tax basis except that the partner's share of nonrecourse debts is not included in the at-risk amount. The only nonrecourse debt considered to be at-risk is nonrecourse real estate mortgages from lenders unrelated to the borrowers

Partner's adjusted tax basis in Partnership interest

A partner's basis in the partnership must be adjusted as the partnership generates income and losses, changes its debt levels, and makes distributions to partners.

Tax basis limitation

A partner's basis limits the amount of partnership losses the partner can use to offset other sources of income. In theory, a partner's basis represents the amount a partner has invested in a partnership. As a result, partners may not utilize partnership losses in excess of their investment (outside basis) in the partnership. Any losses allocated in excess of their basis must be suspended and carried forward indefinitely until they have sufficient basis to utilize the losses. Any suspended losses remaining when partners sell or otherwise dispose of their partnership interest are lost forever. Partners may create additional tax basis in the future by making capital contributions, by guaranteeing more partnership debt, and by helping the partnership become profitable.

guaranteed payments

Guaranteed payments are fixed amounts paid to partners regardless of whether the partnership shows a profit or loss for the year Partnerships treat them as economically equivalent to cash salary payments made to partners for services provided guaranteed payments are deducted in computing a partnership's ordinary income or loss for the year - must be separately states to the partners who receive them - serves the same purpose as providing w-2 forms to employees ' Partners treat them as ordinary income

When partnerships have debt

When partnerships have debt, each partner must include their share of the partnership's debt in calculating the tax basis in their partnership interest. Each partner is treated as borrowing a proportionate share of the partnership's debt and then contributing the borrowed cash to acquire the partnership interest.

Exception to not recognizing gains on property contributed

When property secured by debt is contributed to a partnership - the contributing partner recognizes gain if the cash deemed to have been received from a partnership distribution exceeds the contributing partner's tax basis in his partnership interest prior to the deemed distribution Any gain recognized is generally treated as capital gain this is the equivalent to increasing what would have been a negative basis by the recognized gain to arrive t a zero basis

Partner's Basis Increased by Any Debt Relief

When the partnership assumes debt secured by property which the partner contributes to the partnership, the contributing partner must treat his debt relief as a deemed cash distribution from the partnership that reduces his outside basis. If the debt securing the contributed property is non-recourse debt, the amount of the debt in excess of the basis of the contributed property is allocated solely to the contributing partner, and the remaining debt is allocated to all partners according to their profit sharing ratios.

Non-recourse debts

do not provide creditors the same level of legal recourse against partners. Non-recourse debts such as mortgages are typically secured by real property and only give lenders the right to obtain the secured property in the event the partnership defaults on the debt. Because partners are responsible for paying non-recourse debts only to the extent the partnership generates sufficient profits, such debts are allocated according to the partners' profit-sharing ratios. LLC members generally treat LLC debt as non-recourse debt because they are shielded from the LLC's creditors LLC members may treat debt as recourse debt to the extent they contractually assume risk of loss by agreeing to be legally responsible for paying the debt