ACCT 441 - Chapter 10 Partnerships: Formation, Operation, and Basis
What are some *key concepts in partnership taxation*?
1. *Conceptual Theories of Partnership Taxation* 2. *Separately Stated Items: WTF Are They?* 3. *Partnerships and You: Allocation of Ownership Interest * 4. *Inside and Outside Basis* 5. *Anti-Abuse Provisions* • The Code has some regulations to thwart unwarranted allocations
What *types of partnerships* are there?
1. *General Partnership (GP)*: • Consists of ONLY general partners, all of whom are jointly liable for all entity debts • Partners can be subject to malpractice judgments brought against the partnership, even if not personally involved 2. *Limited Liability Company (LLC)*: • Offers combined benefits of limited liability for owners and partnership taxation • Loss is restricted to partner's contributed capital • Governed by *operating agreements* 3. *Limited Partnership (LP)*: • Often consists of several limited partners and one general partner, who is designated to be liable for all entity debts • Like a LLC, losses of limited partners are restricted to contributed capital 4. *Limited Liability Partnership (LLP)*: • Treated similarly to a GP, except that a LLP partner is NOT personally liable for any malpractice committed by other partners 5. *Limited Liability Limited Partnership (LLLP)*: • Extension of the LP where ALL partners, whether general or limited, are accorded limited liability
Why are *services rendered for partnership interest an exception* to ♫721?
○ *Capital interest* received in exchange for services is generally taxable to the partner as ordinary compensation income, which is the amount the partner would get if the p/s was liquidated right after the service contribution less cost paid for the interest ○ *Profits interest* is interest in the p/s's future profits, and is taxable if: 1. The future income of the p/s is assured, 2. The p/s interest is sold within two years of receipt, or 3. the interest relates to a LP interest in a publicly traded partnership ○ EX: 9
What is the *inside and outside basis?*
○ *Inside basis* refers to the partnership's adj. tax basis for each asset it owns ○ *Outside basis*, on the other hand, refers to EACH partner's basis in the partnership interest ○ Usually, sum of partners' basis = partnership basis ○ EX: 3
What are the *alternative tax years* a partnership can use?
○ *Natural business year*: p/s must establish to IRS that a business purpose exists for selecting a natural business year (usually after busy season) ○ *Section 444 taxable year*: tax year that results in less than a three-month deferral of income from the required taxable year ○ *52-3 week year*: elect a 52-53-week taxable year that ends the same week as the required taxable year
What are *organizational and startup costs*?
○ *Organizational costs* are expenditures that are: 1. incident to the creation of the partnership, 2. chargeable to a capital account, and 3. if fulfills requirement 1 and has ascertainable life, would be amortized over that life ○ *Startup costs* include operating costs incurred after the entity has formed, but before business begins ○ Both types of costs follow similar tax rules: • p/s may deduct up to $5,000 of each expenditure, an amount that must be reduced by expenditures in that category that exceed $50,000 ○EX: 14 & 15
What are *tax accounting elections* in partnerships?
○ *Tax accounting elections* are formal decisions on how to treat a particular transaction/tax attribute for a newly formed partnership - the partnership, NOT the individual partners, make this election ○ The three cases in which the individual partner makes the election are: 1. Whether to reduce the basis of depreciable property first when excluding income for discharge of indebtedness 2. Whether to claim cost or percentage depletion for oil and gas wells 3. Whether to take a deduction or a credit for taxes paid to foreign countries and U.S. possessions
What is a *partnership*?
○ A partnership is an association consisting of two or more "persons" (persons can be either an actual person, trust, estate, a corporation, or even another partnership) ○ A partnership is considered a *flow-through* or *pass-through* entity because the owners are taxed on a proportionate share of the partnership's income, and do NOT treat the partnership as a separate taxable entity ○ *Partnership agreements* detail the rights and obligations of partners, allocation of income, etc. etc.
Why are *investment partnerships an exception* to ♫721?
○ A partnership is considered an investment partnership when a *transfer contribution consists of appreciated stocks* ○ At the time of contribution, the realized gain on the stocks is recognized in order to prevent multiple investors from diversifying their portfolio on a tax-free basis
So *how does partnership reporting work* exactly?
○ All that good *income stuff is reported in Form 1065*, which contains *five* pages chalk-full of info ○ *Page 1* summarizes ordinary income and loss from p/s business activities ○*Page 2 and 3* provides info about o/s activities and general info about the partners ○ *Page 4*, AKA *Schedule K*, summarizes p/s ordinary income/loss, *separately stated items*, and other info needed for partners to prepare their returns ○ *Page 5* provides several schedules, including *Schedule L *(balance sheet), *Schedules M-1* and Analysis of Net Income (reconciliation book), and *Schedule M-2* (reconciliation of partners' beginning and ending capital)
Okay, so after all that partnership income stuff is determined and reported, *how do you allocate and report among partners*?
○ Allocations all depend on things like: 1. Economic effect test 2. Substantiality 3. Disguised payments 4. Precontribution gain/loss AKA Built-in gain or loss ○ After all is said and done, the partnership items are allocated among partners and reported on their individual Schedule K-1's
What is the *basis for each property* and the *basis of each partnership interest*?
○ As mentioned above, the *inside basis* (AKA partnership's basis in assets) is equal to the partner's basis in the property prior to its transfer • AKA *carryover basis*, since partner's basis carries over to partnership ○ The *outside basis* ( AKA partner's basis in partnership interest) is the same as the partner's basis in the contributed asset • AKA *substituted basis* since the basis in assets is substituted for the basis in partnership interest
What is a *partnership's taxable year*?
○ At the end of a partnership's taxable year, the partnership taxable income flows through to each partner ○ A partnership must use the first of the following tax years that applies: 1. *Majority partners' tax year*: more than 50% of capital and profits is owned by majority partners who have the same taxable year 2. *Principal partners' tax year*: more than 5% of capital or profits is owned by principal partners who have the same tax year 3. *Least aggregate deferral rule*: year with smallest amount of income deferral ○ EX: 17
How does partner ownership interest work?
○ Each partner owns a *capital interest* and a *profit and loss sharing interest* in the partnership ○ *Capital sharing ratio* measure the capital interest by the partner's % ownership of the partnership capital ○ *Profit and loss sharing ratios* measure profit and loss sharing interest by partnership agreement, resulting in each partner's allocation of income/loss and separately stated items ○ *Special allocation* provisions may also be specified in the agreement
Why is an *essentially taxable exchange of property an exception* to ♫721?
○ Essentially, this is when a partnership is created to exchange assets between partners on a tax-free basis, but not really because it would be considered an exchange in property ○ EX: 7
What are *separately stated items*?
○ Expanding upon the aggregate concept... the items that flow through to partners (income, deductions, losses. etc.) are required as separately stated items because they *MAY affect any two partners' tax liabilities in some way*, and so proper tax fo each partner must be determined ○ EX: Charitable contributions are separately stated items because each partner has to calculate their own deduction limitations
What does the partnership report then if considered as separate entity?
○ Expanding upon the entity concept... *partnerships must file Form 1065*, a tax return that has info related to the partnership's operations and separately stated items ○ The *return must also include Schedule K-1*, detailing each partner's share of the partnership items ○ No tax paid or calculated with this return
What are *guaranteed payments*?
○ Guaranteed payments are payments to partner for services performed or for the use of the partner's capital, essentially resembling salary/interest ○ Usually a fixed-dollar amount or percentage of capital the partner invested in the p/s ○ Can be deducted or capitalized ○ EX: 19
How is a partnership's income measured?
○ Two kinds of income are measured and reported: *separately stated items* and *nonseparately stated ordinary income* ○ Nonseparately stated income and expenses are reported as income from operations on page 1 of 1065, and then the net amount is allocated to partners on Schedules K and K-1 ○ Separately stated items are reported separately on the partnership's Schedule K and each partner's K-1 ○ A p/s cannot claim the following deductions: • Net Operating Losses (NOLs) • Depletion of oil and gas interests • Dividends received deduction ○ EX: 18
What occurs during partnership formation?
○ When formed, pertnership interest is given to partners in exchange for cash and other property
Why is a *disguised sale an exception* to ♫721?
○ ♫707 outlines some situations in which a disguised sale exists: 1. When a partner makes a contribution of appreciated property, *a distribution is handed out within 2 years* under contractual agreement 2. Distribution is made without regard to partnership profits
*Are gains or losses recognized* during partnership formation (♫721)?
○ ♫721 provides that *NO GAIN/LOSS is recognized* when a partner contributes property (or cash, w.e.) to a partnership during formation, or during a alter contribution • This occurs because: 1. Investors can combine their assets into a partnership to realize an economic goal, and 2. The partner may not have sufficient cash to pay the tax ○ *Gain/loss is REALIZED* however, and is deferred ○ EX: 4 & 5
What *method of accounting* do new partnerships use?
○ Newly formed p/s can adopt the accrual or cash method, or even a hybrid ○ *One exception*, however, is that the cash method CANNOT be adopted if: 1. The partnership has one or more C corporation partners 2. The partnership is a tax shelter ○ *An exception to the exception above* is that a C corporation partner can still use the cash method only if: 1. The partnership does NOT receive average annual gross receipts of more than $5 million for the three tax years ending with the period PRIOR TO the tax year in question 2. The C corporation partner is a qualified personal service corporation like an incorporated attorney, or 3. The partnership is engaged in the farming business ○ EX: 16
What is *substantiality*?
○ P/S allocations must have a substantial effect, meaning it has economic and tax consequences that may benefit a partner ○ Allocations made for tax reasons only are not permitted ○ EX: 25
WHAT HAVE WE LEARNED SO FAR?
○ Page 10-12 • Concept Summary 10.1
RECAP OF TAX YEARS? OKAY!
○ Page 10-17 • Concept Summary 10.2
What's the *holding period* for the contributed assets and the partnership interest?
○ Partnership's holding period in assets *includes the period during which the partner owned the asset* ○ Partner's *holding period in the partnership interest depends* • If *contributed only capital + ♫1231 assets*, then holding period in interest is same as holding period for these assets • If *contributed assets that aren't capital + ♫1231 assets*, then partnership interest holding period starts on date of acquirement of interest ○ EX: 6
What is the *economic effect test*?
○ Put in place to *avoid manipulation of special allocations* (read: special allocations in partnership agreements) to skew tax benefit allocations among partners ○ The test requires the following: 1. *Allocation of gains to a partner MUST increase partner's capital account*; same principle applies to losses 2. If a partner's interest liquidates, he/she must *receive net assets with a FMV equal to the positive balance in the capital account* 3. If it was a *negative balance in the capital account, then the partner must restore that account* (basically contribution of cash) upon liquidation of interest ○ EX: 24
Are there any *exceptions to ♫721*?
○ Remember: ♫721 does NOT recognize a realized gain or loss ○ The most widely applicable exceptions are: 1. *Investment Partnerships* 2. *Essentially taxable exchange of properties* 3. *Disguised sales* 4. *Services rendered in exchange for partnership interest*
Are there any other issues that come with property contributed under ♫721?
○ Several issues arise, concerning the following: 1. *Contribution of depreciable property* 2. *Contribution of ♫197 intangible assets* 3. *Disposition of receivables, inventory, and built-in loss property* 4. *Special allocations to partners*
What are the *conceptual theories* for partnership taxation?
○ Tax treatment of partnership is traced to two legal concepts: 1. Aggregate (AKA conduit) concept • Partnership is treated as a channel through which income, credits, deductions, and other items flow to the partners 2. Entity concept • Partnerships and partners are treated as separate entities
What are the *initial costs of a partnership*?
○ The following expenses are incurred with initial costs: 1. *Organizational costs* (forming the partnership) 2. *Startup costs* (starting operations) 3. *Admitting partners to p/s* 4. *Syndication costs* (marketing/selling partnership units to prospective partners) 5. *Acquisition costs of Depreciable Assets*
What issues arise with the *contribution of depreciable property*?
○ The p/s is required to use the same cost recovery method as used by the contribution partner, essentially "step into the shoes"
What issues arise with the *contribution of ♫197 intangible assets*?
○ The p/s must "step into the shoes" of the contributing partner to determine future amortization deductions ○ ♫197 intangible assets include: goodwill, going-concern value, information systems, patents, governmental licenses, trademarks, franchises, etc. ○ EX: 10
What are *disguised payments*?
○ These are special allocations of income treated as a disguised payment for services
What are *syndication costs*?
○ These costs are capitalized and includes promoting and marketing partnership interests: 1. brokerage fees 2. registration fees 3. legal fees 4. accounting fees 5. printing fees
What issues arise with the *disposition of receivables, inventory, and built-in loss properties*?
○ To prevent ordinary income from being converted to capital gain, the *gain is treated as ordinary under the disposition of the following*: 1. Contributed receivables that are unrealized at date of contribution 2. *Contributed property, which is disposed of within 5 years of contribution*, that was once inventory in the contributor's ownership on contribution date 3. If *contributed property is disposed of at a loss*, the loss is treated as a capital loss if it is disposed of within 5 years of contribution ○ EX: 11 & 12