Chp 10 - Partnerships: Formation, Operation, and Basis

Partnership's ordinary business income consists of

any income or expenses that are not required to be separately stated - e.g. partnership's sales revenues, utilities, rent expense, and depreciation expense related to business assets, and other ordinary and necessary business expenses - The partnership also calculates and claims the allowable business interest expense deduction, but any disallowed interest expense is treated as a separately stated item

Contributed property with a built-in capital loss at the contribution date

the partnership's later sale of that property within five years of the contribution date results in a capital loss - The capital loss is limited to the amount of the built-in loss on the date of contribution - Special allocations must be made relative to contributed property that is appreciated or depreciated. - The partnership's income and losses must be allocated to ensure that the inherent gain or loss is not shifted away from the contributing partner.

At-risk limitation

•Losses that are deductible under the basis limitation are deductible only to the extent the partner is at risk for the partnership interest (i.e., amounts that are economically invested in the partnership). •For example, recourse debt is included in the amount at risk, but nonrecourse debt is not.

Examples of separately stated items

•Net short and long-term capital gains and losses. •§1231 gains and losses. •Charitable contributions. •Interest income and other portfolio income. •Expenses related to portfolio income. •Personalty expensed under §179. •Special allocations of income or expense.

Items that increases a partners adjusted basis

•Partner's proportionate share of partnership income. •Partner's proportionate share of any increase in partnership liabilities. •Contributions of cash or property from the partner to the partnership after the partnership is formed.

$27M gross receipts test is met if

Partnership does not have average annual gross receipts of more than $27 million - Average annual gross receipts is the average of gross receipts for the three tax years ending with the tax period prior to the tax year in question

Initial cost of partnership

Partnerships may elect to deduct up to $5,000 of organizational and startup costs in the year business begins. - Remaining amounts are amortizable over 180 months beginning with the month the partnership begins business. - The treatment is elected by deducting the proper amounts on the tax return

Self-employment tax

SE individuals are liable for a self-employment tax - A 12.4% tax for Social Security on up to $147,000 of self-employment income in 2022, less any wages on which the tax is withheld. - A 2.9% tax for Medicare. (An additional Medicare tax of 0.9% percent applies to self-employment income in excess of $250,000 for married taxpayers and $200,000 for all other taxpayers)

Tax accounting elections

The partnership, rather than the partners, must make numerous elections stating how certain transactions or tax attributes should be handled •Taxable year. •Accounting method. •Treatment of organizational and startup expenditures. •Cost recovery methods and assumptions. •Inventory method. - each partner is bound by the decisions made by the partnership - if the partnership fails to make an election, a partner cant make the election individually

Partnership allocation

The total amounts for each item must be allocated among the partners - allocations must have economic effect and substantiality, and they must take into account and pre-contribution gains and losses - allocations are made in accordance with the partnership agreement or an LLCs operating agreement - allocations can be flexible (the profits, losses and cash flows are not required to be allocated in accordance with capital ownership, as is the case for most corporate entities

Limited partnership

Typically not permitted to participate in entity management, and they are not liable for partnership debts - Has at least one general partner and one or more limited partners. - Often have numerous limited partners and are used to raise capital for real estate development, oil and gas exploration, research and development, and various financial product investment vehicles. - Only general partners are personally liable to creditors. - General partners are often entities that have limited liability, such as C corporations or LLCs. - Limited partners' loss is limited to equity investment.

The required taxable year that the partnership must use, in order, is as follows

- Majority partners' tax year, if more than 50% of capital and profits is owned by partners who have the same taxable year. - Principal partners' tax year, if all partners who own 5% or more of capital or profits are principal partners and all have the same tax year. - The year with the smallest amount of income deferral, also known as the "least aggregate deferral rule."

Partner's basis

- basis is not reported on K-1 - partner must maintain a record of their basis in the partnership interest - partner's adjusted basis in partnership interest can never be reduced below 0

Form 1065 specifies on schedule k

accumulate info to be reported to partners - provides ordinary income (loss) and separately stated items

for new partnerships, partner's basis generally equals

adjusted basis of property contributed by the partner in exchange for partnership interest plus the fair market value of any services performed by the partner in exchange for partnership interest (i.e., the amount reported as ordinary income from services).

Basis limitation

allows a loss deduction only to the extent of the partner's outside adjusted basis

General partnership

can participate in managing the entity and can be legally required to repay a partnership's recourse debt - Consists of at least two general partners and no limited partners - partners are jointly and severally liable often used for operating activities or corporate joint ventures - creditors can collect from both partnership and partners' personal assets. - General partner's assets are at risk for malpractice of other partners even if not personally involved in malpractice.

If transfers of appreciated stock are made to an investment partnership

gain will be recognized by the contributing partner - Prevents multiple investors from diversifying their portfolios tax-free.

Partnerships: Separately Stated Items

if an item of income, expense, gain or loss might affect any two partners tax liabilities differently, it is separately stated separately states items fall under the aggregate concept - Each partner owns a specific share of each item of partnership income, gain, loss or deduction. - Character is determined at the partnership level. - Taxation is determined at the partner level.

Form 1065 specifies on page 2 & 3

information about the partnerships activities and general info about the partners

Capital interest

measured by the partners capital sharing ratio, which is the partners percentage ownership of the capital of the partnership - can differ for a given partner - specified in the partnership agreement

Profit (loss) interest

measured by the partners profit and loss sharing ratio, which is the partners percentage share of the partnerships operating result - can differ for a given partner - specified in the partnership agreement

Form 1065 specifies on page 5

provides several schedules - schedule L: balance sheet - schedule M-1: reconciliation of book and taxable income - schedule M-2: reconciliation of partners beginning and ending capital

The economic effect test

put into place to ensure that allocations do not result in undue tax revenue losses to the treasury

Schedule K-1

reports each partners share of ordinary income (loss) and separately stated items

Form 1065 specifies on page 1

reports ordinary income or less from its trade or business activities

Partnership agreement

signed by each partner, that outlines: - Rights and obligations of the partners. - Allocations, deductions, and cash flows. - Initial and future capital contribution requirements. - Conditions for terminating the partnership. Governing agreement of an LLC is known as an operating agreement

If additional costs are incurred for the acquisition of depreciable assets

the additional basis is treated as a new MACRS asset placed in service on the date the partnership places the asset in service - For example, legal fees and transfer taxes incurred in transferring assets to a partnership must be capitalized.

Entity concept

treats partners and partnerships as separate units - For example, the partnership must file an information return that summarizes its activities for the tax year.

Aggregate Concept

treats partnership as a channel with income, credits, deductions, and other items flow through to the partners - The partnership is regarded as a collection of taxpayers joined in an agency relationship. - For example, the income tax is imposed on the partners rather than the partnership.

loss limitations

•Basis limitation. •At-risk limitation. •Passive activity loss limitation. •Excess business losses.

Excess business losses

•If a loss passes the above three limitations, a noncorporate taxpayer must consider whether the excess business loss limitation applies. •Any loss that exceeds the threshold of $270,000 for single taxpayers or $540,000 for married taxpayers is an excess loss and not allowed in the current year.

A "person" in a partnership can be:

•Individual. •Trust. •Estate. •Corporation. •Association. •Another partnership.

Items that decrease a partner's adjusted basis

•Partner's proportionate share of partnership deductions and losses. •Partner's proportionate share of nondeductible expenses. •Partner's proportionate share of any reduction in partnership liabilities. •Distributions of cash or property from the partnership to the partner after the partnership is formed.

Two step approach for calculating partnership income

1. partnership calculates net ordinary income and expenses related to the trade or business of the partnership to determine ordinary business income 2. segregates and reports separately states items and other information the partners need to complete their returns

What is a partnership?

An association of two or more persons to carry on a trade or business, with each contributing money, property, labor, or skill, and with all expecting to share in profits and losses Must be unincorporated and cant be otherwise classified as a corporation, trust, or estate Formed under state law

Types of partnerships

Defined and formed under state law Distinguished based on the classification of partners as general partners or limited partners and the types of business permitted to be conducted - general partnership - limited partnership - LLC - LLP

Partnership reporting

Form 1065 - no tax is calculated or paid with the return this return is due by the 15th day of the 3rd month following the end of the tax year (march 15th for calendar year partnerships) - may request an automatic 6 mo extension for filing

Syndication costs

Capitalized, but no amortization election is available These costs include expenditures incurred for promoting and marketing partnership interest such as: •Brokerage fees. •Registration fees. •Legal fees. •Accounting fees related to the offering materials. •Printing costs of the prospectus and other selling materials.

Method of accounting

May adopt cash, accrual or hybrid method - If a partnership uses the accrual method of accounting, its income must be reported no later than the date that income would be reported on the partnership's applicable financial statements. - This rule is designed to ensure that any advance payments received by the taxpayer are reported in taxable income at least as quickly as they are reported in book income.

Combined concept

Recognizes that some rules are governed by both aggregate and entity concepts. - The aggregate concept governs most of the general rules for partnerships. - The entity concept governs many of the exceptions to those general rules.

If a partner contributes either of the following types the property, the partnership's later sale of the property results in ordinary income for

- Accounts receivable where the contributing partner has not yet recognized related income (e.g., cash basis accounts receivable). - Inventory (in the contributing partner's hands) that would have resulted in ordinary income if the partner had sold it, if the partnership sells the inventory within five years of the contribution date. (Inventory includes all tangible property except capital assets and real or depreciable business assets)

Situations in which the nonrecognition provision do not apply

- Appreciated stock is contributed to an investment partnership. - The transaction is essentially a disguised sale or exchange of properties. - The partnership interest is received in exchange for services rendered to the partnership by the partner.

If the required tax year is undesirable to the entity, three alternative tax years may be available

- Business purpose year - The partnership may use an IRS-approved year-end for which there is a business purpose. - Three-month deferral year - The partnership may use a year-end with a less than three-month deferral of income and pay an interest deposit on the deferred tax. - 52-53 week year - The partnership may use a year ending on a specific day of the week rather than the last day of a month.

Cash method cant be adopted if a partnership:

- Has one or more C corporation partners - is a tax shelter

If the transaction is essentially a disguised sale or taxable exchange of properties, gain will be recognized

- If a partner contributes property to a partnership and shortly thereafter the partner receives a distribution from the partnership, the IRS may view this as a purchase of the property by the partnership and treat it as a taxable exchange between the partner and the partnership.

Substantial effect

- In general, an allocation does not meet the "substantial" test unless it has economic consequences in addition to tax consequences that might benefit a subset of the partners. - In other words, allocations are not permitted if they are for tax reasons only.

Tax effects of partnership formation

- Partners contribute cash and other property in exchange for the partnership interest - generally, no gain or loss is recognized by a partner or partnership on the contribution of money or property - Gain (loss) is deferred until the taxable disposition of property by the partnership or the partnership interest by the partner

Inside basis

- Refers to the partnership's adjusted basis for each asset it owns. - Each partner owns a share of the partnership's inside basis for all of its assets.

Outside basis

- Represents each partner's basis in the partnership interest. - The partnership's total inside basis in all assets equals the sum of the outside basis of all partners' partnership interests.

Limited liability company LLC

- The owners, termed members, are a hybrid type of partner. (They are treated as limited partners with respect to the LLC's debts, but they generally participate in management) - Combines the corporate benefit of limited liability with benefits of partnership taxation. - Unlike corporations, income is subject to tax only once. - Special allocations of income, losses, and cash flow are available.

A non tax shelter partnership with a C corporation can use the cash method if:

- The partnership meets the $27 million gross receipts (small business) test, - The C corporation partner(s) is a qualified personal service corporation, or - The partnership is engaged in the farming business.

Tax basis for partnerships

- The partnership takes a carryover basis in the contributed assets it receives (i.e., the partner's basis in the asset carries over to become the partnership's inside basis in the asset)\ - the partners takes a substituted basis in the partnership interest (i.e., the partner's basis in the contributed assets transfers over to become the partner's outside basis in the partnership interest).

Holding period for assets

- The partnership's holding period for the contributed assets includes the period during which the partner owned the assets - For capital and §1231 assets, the partner's holding period in the partnership interest is the same as the partner's holding period of the assets contributed. - For other assets, including cash, the holding period in the partnership interest begins on the date the partnership interest is acquired.

Exchange for services

- The receipt of a fully vested interest in partnership capital in exchange for services is generally taxable to the partner as ordinary income - When a partner receives a fully vested interest in the partnership's future profits in exchange for services rendered, the partner is not typically required to recognize any income at the time of receipt - The partnership may deduct the amount included in the service partner's income if the services are of a deductible nature

How are partners taxed?

- They file a 1065 and prepare schedule K1 for each partner that shows the partners share of partnership items - no federal income tax - partners report their distributive share of the partnerships income or loss on their individual tax returns and pay any tax due

Limited liability partnership (LLP)

- Used primarily by service entities. - An LLP partner is not personally liable for malpractice committed by other partners. - Popular organizational form for large accounting firms. Lets you share in ownership and profits easier and can keep stuff more secret. No skin in the game if elect as a corporation

Passive activity loss limitation

- any losses that survive the second limitation are subject to the limitation - Passive activity losses are only deducted to the extent they offset passive activity income. - If the partner's involvement in the partnership is not considered passive, then this limitation does not apply.

A disguised sale is presumed to exist if both of the following occur:

- A contractual agreement requires a contribution by one partner to be followed within two years by a specified distribution from the partnership. - The distribution is to be made without regard to partnership profits.

Two unique legal concepts for partnership tax

1. Aggregate concept 2. Entity concept 3. Combined concept

Economic effect test has 3 general requirements

1. Capital accounts must reflect contributions and distributions at their fair market values (i.e., an allocation of income or gain to a partner must increase their capital account, and an allocation of deduction or loss must decrease their capital account). 2. When a partnership interest is liquidated, a partner with a positive capital account must receive assets with a fair market value equal to the positive balance. 3. When a partnership interest is liquidated, a partner with a negative capital account must restore that account upon liquidation, generally by contributing cash.

for existing partnerships, partner's basis depends on how the interest is acquired

1. If the interest is purchased from another partner, the basis is the amount paid for the interest. 2. If the interest is acquired by gift, the basis is the donor's basis plus, in certain cases, a portion of the gift tax paid on the transfer. 3. If the interest is acquired through inheritance, the basis is the fair market value on the date of death.

Two types of partnership debt

1. recourse debt: partnership or at least one partner is personally liable 2. non-recourse debt: partnership debt for which no partner is personally liable

Tax issues related to contributed property

If a partner contributes depreciable property or intangible assets, the partnership "steps into the shoes" of the contributing partner and continues to use the same cost recovery and amortization calculations - The partnership cannot expense contributed depreciable property under §179. - Section 197 intangible assets are amortized over fifteen years and other intangible assets are amortized over their useful life.