Partnership and Entity Comparison
Partnership Interest
Bundle of economic rights granted to partners under the partnership agreement. Includes: if assets liquidate receive a portion of partnership net assets (capital interest-contribute property), right to receive a share of future profits (profit interest-contribute services).
Guaranteed Payments
Common items reported separately to the partners who receive them. Fixed amounts paid to partners regardless of whether the partnership shows a profit or loss for the year. Typically deducted in computing a partnership's ordinary income or loss for the year. Similar to salary payment and treated as ordinary income.
Property Contribution: Partner's initial tax basis.
Need to know basis of capital interest so when they sell partnership interest now how much to allocate to gains/losses. Partners will simply have a basis in their partnership interest equivalent to the tax basis of the property and cash they contributed. G/L deferred until either the contributing partner sells her partnership interest or the partnership sells the contributed property.
Property Contribution: Gain and Loss Recognition
Don't recognize a gain or loss when contributing property (contributions when it is formed and subsequent contributions). Property is tangible or intangible ASSETS but not services. Encourages contributed property with built-in gains (FMV > Tax Basis). Property with built-in losses are usually better off selling the property, recognizing the related tax loss, and contributing the cash from the sale to the partnership so it can acquire property elsewhere.
Ordinary Business Income (Loss) and Separately Stated Items
File information returns annually. Distribute info to each partner about the amount and character of items and loss in entity and report it on tax return (even non-cash). Determine: Ordinary Business Income (Loss):all partnership income (loss) exclusive of any separately stated items of income (loss). Separately Stated Items: they are treated differently from a partner's share of ordinary business income (loss) for tax purposes. Common separately stated items=short-term capital gains and losses, long-term capital gains and losses, §1231 gains and losses, charitable contributions, dividends, interest income, guaranteed payments, self-employment earnings, rental real estate income, investment interest expense, and 179 deduction. The character of separately stated items is determined at the partnership level rather than at the partner level.
Acquisitions of Partnership Interests
New or existing partners can acquire partnership interests in exchange for contributing property and/or services, in which case the tax rules previously discussed in the context of forming a partnership still apply. Or new partners may purchase partnership interests from existing partners. Partners who purchase their partnership interests don't have to be concerned with recognizing taxable income when they receive their interests. Still need to determine basis and holding period for these categories when they receive or purchase.
Property Contribution: Non-recourse Debt
Non-recourse debt(generally treat LLC debt as nonrecourse because they, like corporate shareholders, are shielded from the LLC's creditors OR 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): 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 nonrecourse debts only to the extent the partnership generates sufficient profits, such debts are generally allocated according to partners' profit-sharing ratios.
Property Contribution: Partner's initial tax basis w/ debt
Partner include her share of the partnership's debt in calculating the tax basis in her partnership interest because partnership tax law treats each partner as borrowing her proportionate share of the partnership's debt and then contributing the borrowed cash to acquire her partnership interest. Essentially, the contributing partner must treat her debt relief as a deemed cash distribution from the partnership that reduces her outside basis.16 If the debt securing the contributed property is nonrecourse 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. EXCEPTION the contributing partner recognizes gain only if the cash deemed to have been received from a partnership distribution exceeds the contributing partner's tax basis in her partnership interest prior to the deemed distribution. Any gain recognized is generally treated as capital gain.
Cash Distributions in Operating Partnerships
Partners are taxed on income as the partnership earns it instead of when it distributes it. aA 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. However, as we highlighted in our discussion of property contributions earlier in this chapter, cash distributions (deemed or actual) in excess of a partner's basis are taxable gains and are generally treated as capital gains.
Profits Interests
Profits interests are fundamentally different from capital interests, because the only economic benefit they provide is the right to share in the future profits of the partnership. (no liquidation value). Don't have to forgo their current share of capital in the partnership and may not ever have to give up anything if the partnership is ultimately unprofitable. (More risky for a service partner). Service partner typically will not recognize income and the nonservice partners will not receive deductions. Future profits and losses attributable to the profits interest are allocated to the service partner (and away from the nonservice partners) as they are generated. In addition, the partnership must adjust debt allocations based on profit-and-loss-sharing ratios to reflect the service partner's new or increased share of profits and losses.
Property Contribution: Recourse Debt
Recourse debt(Recourse debts in limited partnerships are typically allocated only to general partners. Limited partners, however, may be allocated recourse debt if they forgo their legal protection by guaranteeing some or all of the recourse debt.): partners have economic risk of loss—that is, they may have to legally satisfy the debt with their own funds. Recourse debt is usually allocated to the partners who will ultimately be responsible for paying it.
Capital Interests
Right to receive a part of the partnership's capital if it liquidates. Must consider the capital interest as ordinary income. Tax basis in the capital interest he receives will equal the amount of ordinary income he recognizes, and his holding period will begin on the date he receives the capital interest. When the partnership deducts the value of capital interests used to compensate partners for services provided, it allocates the deduction only to the partners not providing services, or nonservice partners, because the deduction is related to the segment of the partnership tax year ending immediately before the admission of the new service partner.
Contribution of Services
Services contributed in exchange for partnership interests may create immediate tax consequences to both the contributing partner and the partnership, depending on the nature of the partnership interest received.
Organization, Start-up, and Syndication Costs
Syndication (to promote and sell partnership interests)-not deductible. Amortize these costs.
PARTNER'S ADJUSTED TAX BASIS IN PARTNERSHIP INTEREST
The basis in a partnership is dynamic and must be adjusted as the partnership generates income and losses, changes its debt levels, and makes distributions to partners. A partner will increase the tax basis in her partnership interest for: Contributions. Share of ordinary business income. Separately stated income/gain items. Tax-exempt income. A partner will decrease the tax basis in her partnership interest for: Cash distributions. Share of nondeductible expenses. Share of ordinary business loss. Separately stated expense/loss items. A partner's tax basis may not be negative.
Contribution of Property
The tax rules in this area allow entrepreneurs to organize their businesses without having to pay taxes. In addition, these rules follow the aggregate theory of partnership taxation because they recognize that partners contributing property to a partnership still own the contributed property, albeit a smaller percentage, since other partners will also indirectly own the contributed property through their partnership interests.
Net Investment Income Tax
An individual partner's share of gross income from interest, dividends, annuities, royalties, or rents is included in the partner's net investment income when calculating the net investment income tax. The partner's share of income from a trade or business that is a passive activity, income from a trade or business of trading financial instruments or commodities, and any net gain from disposing of property (other than property used in a trade or business that is not a passive activity) is also included in the partner's net investment income.
Allocating Partners' Shares of Income and Loss
Allocation up to partner as long as it is agreed upon and has substantial economic effect. If neither must comply with partners' interest in partnership. Partnership allocations inconsistent with partners' capital interests or overall profit-and-loss-sharing ratios are called special allocations. Special allocation: When a contributed property with a built-in gain/loss is sold the partnership must allocate, to the extent possible, the built-in gain or built-in loss solely to the contributing partner and then allocate any remaining gain or loss to all the partners in accordance with their profit-and-loss-sharing ratios.
Property Contribution: Partnership's tax basis and holding period in contributed property
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. Holding period of contributed asset carries over to the partnership. Character doesn't transfer over. Whether gains or losses on dispositions of contributed property are capital or ordinary usually depends on the manner in which the partnership uses contributed property. Non GAAP capital accounts: a new partnership would prepare its initial balance sheet using the tax basis for its assets. In addition, it would 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. Because each new partner's tax capital account measures that partner's equity in the partnership using tax accounting rules, it will later be adjusted to include the partner's share of earnings and losses, contributions, and distributions. Calculate each partner's share of the inside basis of partnership assets by adding the partner's share of debt to her capital account. Acquire their interests by contributing property (without having to recognize any gain) will have an outside basis equal to their share of the partnership's total inside basis. GAAP capital accounts:Partners set up §704(b) capital accounts in much the same way as tax capital accounts, except that §704(b) capital accounts reflect the fair market value rather than the tax basis of contributed assets, and once it starts adjust account so it is the fair market value. Usually a better measure of a partner's value of capital interest.
Guaranteed Payments and Self-Employment Tax
General partners report guaranteed payments for services they provide and their share of ordinary business income (loss) as self-employment income (loss) because they are actively involved in managing the partnership. Limited partners share of ordinary business income (loss) is conceptually more like investment income than trade or business income, not subject to self-employment tax. If limited partners receive guaranteed payments for services provided to the partnership, they treat those payments as self-employment income. LLC's: LLC members who have personal liability for the debts of the LLC by reason of being an LLC member, who have authority to contract on behalf of the LLC, or who participate more than 500 hours in the LLC's trade or business during the taxable year should be classified as general partners when applying the self-employment tax rules (not consistently applied).
Partnership Compliance Issues
Have to file form 1065. Must also prepare a schedule K-1.
Property Contribution: Partner's holding period in partnership interest.
Holding period determines whether gains or losses from the disposition of the partnership interest are short-term or long-term capital gains or losses. When partners contribute capital assets or §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, it begins on the day the partnership interest is acquired.