Partnerships

Partner's basis limit

*A partner's basis in the partnership cannot be reduced below zero*. If the net change in basis in the partnership interest due to debt being assumed by the partnership exceeds the total basis of the assets contributed, the partner must *recognize gain equal to that excess* to prevent negative basis from occurring. Example: Partner R, a 25% partner, contributes property to the partnership with an adjusted basis of $20, FMV of $50, and a liability of $30 which the partnership assumes. R's basis is first increased by $20 for the basis of the property, then decreased by $30 for the debt assumption. However, since the partnership debt increased by $30, and R is responsible for 25% of the debt, or $7.50, his basis is increased by $7.50. The net effect on basis is a decrease of $2.50 (basis of $20 less $22.50 of debt shifted to other partners).

Nonliquidating (or Current) Distributions

A distribution to a continuing partner, including a draw by the partner. Arm's-length sales to partners are not distributions. Basis Effects—For partners, nonliquidating distributions are a return of capital that reduces outside basis (in a specific order). First, basis is reduced by cash received Second, by the adjusted basis of the other property receive Third - reduced by the AB of any other assets received. Amount received over the partner's basis is allocated to properties with unrealized losses, and any excess basis is allocated to properties with unrealized gains. Basis is not reduced below 0.

Liquidating Distributions

A liquidating distribution may result in gain or loss, and it requires the partner to transfer his or her outside basis to assets received from the partnership A liquidating distribution occurs when the entire partnership is liquidated or the interest of one partner is redeemed. The distribution can be a series of transfers. The partnership, generally, does not recognize any gains or losses. Basis Effect—Liquidating distributions are treated as a return of capital and the partner's outside basis is substituted for the inside basis of distributed property. *Loss Recognition*—Unlike nonliquidating distributions, partners can recognize losses on liquidating distributions, but only if two conditions are met: First, the distribution must consist only of cash, inventory, and unrealized receivables. Second, the outside basis of the partner's interest exceeds the sum of cash plus the inside basis of the receivables and inventory.

Increases in partnership interests

A partner's basis is increased by contributions of property, income, and increases in liabilities. 1. A partner's proportionate share of income includes gains and exempt income. 2. A partner's proportionate share includes increases in liabilities (treated like a contribution).

Termination

A partnership terminates for tax purposes if no part of the business continues to be carried on by any partner in the partnership form. Termination results in a deemed distribution of assets to the partners. In a two-person partnership, one partner sells his or her interest to the other partner. This sale terminates the partnership for tax purposes, because it will no longer have two owners (it is now a proprietorship). Generally, partnerships are contracts between the partners that are terminated with the death or withdrawal of any partner. However, the death or withdrawal of a partner doesn't necessarily terminate partnerships for tax purposes. The partnership only determines the share for the decedent partner.

Natural Business Year:

A year in which 25% or more of the gross receipts occur in the last two months of the year (three consecutive years).

General partners

Can participate in management and have joint and several liability for the partnership's debts. All partnerships must have at least one general partner.

Separately Stated Items Examples

Capital gains and losses Section 1231 gains and losses Charitable contributions Foreign income taxes Section 179 expense deduction Interest, dividend, and royalty income Interest expense on investment indebtedness Net income (loss) from rental real estate activity Net income (loss) from other rental activity Tax-exempt income

Capital Withdrawasl

Capital withdrawals do not affect income.

Partnership Interest Termination

For tax purposes, a partnership terminates when it stops doing business as a partnership or 50% or more interest in partnership capital and profits is exchanged within 12 months. When the partnership's business and financial operations are continued by other members, there is a deemed distribution of assets to the remaining partners and the purchaser and a hypothetical recontribution of assets to a new partnership.

Hot Assets

Generate ordinary income or loss because the partner has not yet been taxed on accrued, but unrealized, income. A distribution is disproportionate as to a partner's share of unrealized receivables or substantially appreciated inventory. Inventory is substantially appreciated if its FMV exceeds 120% of its basis. Hot assets are inventory and unrealized receivables. For distributions, inventory has to be substantially appreciated (FMV > 120% × adjusted basis) for it to be classified as a hot asset.

Guaranteed Payments

Guaranteed payments are those made to partners without regard to partnership income. Guaranteed payments are ordinary income to the recipients at the partnership year-end. Guaranteed payments (for deduction purposes) reduce partnership income and thereby reduce each partner's distributive share of such income. Guaranteed payments are deemed to be paid to the partner on the last day of the partnership's tax year, regardless of when payment was actually made.

Section 754

If a Section 754 election is in effect, then basis adjustments to partnership property may be needed. These basis adjustments benefit the new partner who purchased the partnership interest.

Ordinary income

If a partner sells or exchanges his/her partnership interest and the partnership has either unrealized receivables or substantially appreciated inventory, the partner recognizes an ordinary gain to the extent that the amount realized by the partner due to the unrealized receivables or substantially appreciated inventory is greater than the partner's basis in the items.

Passive losses

Limited partners' losses are passive by definition (for more information see the lesson "Limitations on Business Deductions").

Optional Section 754 Adjustment to Basis of Partnership Property

On a distribution of property to a partner or on a sale by a partner of a partnership interest, the partnership may elect to adjust the basis of its assets to prevent any inequities that otherwise might occur.

Deferred Gain or Loss

Partners and partnerships recognize no gain or loss on contributions in exchange for a partnership interest.

Fringe benefits

Partners are generally not considered to be employees for purposes of employee fringe benefits (e.g., cost of $50,000 of group-term life insurance, exclusion of premiums or benefits under an employer accident or health plan, etc.). The value of a partner's fringe benefits are deductible by the partnership as *guaranteed payments* and must be included in a partner's gross income.

Loss Limitations

Partners can only deduct losses if all three of the following hurdles are passed (in this order): 1. Partners must have enough basis to deduct the loss. 2. Partners can deduct losses only to the extent of their at-risk amount. 3. If the loss is a passive loss, the partner can deduct the loss only to the extent of passive income. Disallowed losses are carried over and used in future years when the remaining criteria are met.

qualified business income deduction

Partners may be able to receive a deduction equal to 20% of the income that flows through to them from a partnership as a qualified business income deduction

Allocations of Income

Partners receive a share of income or a (potentially different) share of loss, according to the partnership agreement. Any special allocation must pass a judgmental substantial economic effect test that ensures that partners with special allocations bear the economic burden or receive the economic benefit of the special allocation. If no special allocation is provided in the partnership agreement, then separately stated items are distributed in the same proportions as income and loss.

Distributive Share

Partnerships are not subject to tax, but report taxable income on Form 1065. Profits and losses are allocated to each partner based on each partner's profit and loss sharing ratio. All items of income, gain, deduction, loss, or credit that are required to be separately stated, or that are specially allocated, are removed from the partnership's ordinary income or loss determination process. Each partner's proportionate share of these items is reported on Schedule K-1. The remaining items are lumped together to produce the net ordinary income or loss, which is also proportionately reported to each partner

Mergers

Partnerships can merge with or divide from the original partnership continuing as the reporting entity. In a merger of partnerships, the resulting partnership is a continuation of the merging partnership whose partners have a more than 50% interest in the resulting partnership. Example: Partnerships AB and CD merge on April 1, forming the ABCD Partnership in which the partners' interests are as follows: Partner A, 30%; B, 30%; C, 20%; and D, 20%. Partnership ABCD is a continuation of the AB Partnership. The CD Partnership is considered terminated and its taxable year closed on April 1.

Gain/Loss Deferral

Partnerships generally do not recognize gains or losses on distributions. Partners can recognize gains on nonliquidating or liquidating distributions of cash. Cash distributed in excess of outside basis causes gain recognition. Nonliquidating distributions of property never trigger loss recognition, but losses may be recognized on a liquidating distribution.

Organization and start up costs

Partnerships may elect to amortize organization and start-up costs. Organizational expenses in the amount of $5,000 may be deducted, but the $5,000 is reduced by the amount of expenditures incurred that exceed $50,000. Start-up expenses in the amount of $5,000 may be deducted, but the $5,000 is reduced by the amount of expenditures incurred that exceed $50,000. Expenses not deducted must be capitalized and amortized over 180 months, beginning with the month that the corporation begins its business operations.

Basis of accounting

Partnerships may use the cash basis of accounting unless the partnership is a "tax shelter" or at least one partner is a C corporation. Cash basis allowed for cash basis or a small business with gross receipts of $5 million or less for the three prior years.

Schedule K-1

Partnerships report taxable income (ordinary income) and separately stated items to each partner on Schedule K-1. Separately Stated Items: Any tax items (deductions, income, preferences, etc.), that might affect partners differently—these items retain their character to the owners.

Required Tax Year:

Partnerships use the same year-end as its majority interest partner(s) (more than 50% capital and P&L). If the partnership has no single year for the majority, then the partnership uses same year-end as all of its principal partners (5% P&L interest or more). If neither the majority interest nor principal partner test is met, the required tax year is determined by using the least aggregate deferral method. This method is computationally intensive, but determines the year-end which will provide the least amount of deferral for the entire partnership group. If a partnership does not want to use the required tax year, the partners can elect a fiscal year-end (with IRS permission) if there is a business purpose; a natural business year can also be used.

Basis Issues at Formation

Partnership—A partnership takes a carryover basis (the adjusted basis of the property in the hands of the partners) for contributed property.Including the holding period and depreciation methods. Inside Basis of Property: The aggregate basis of assets in the hands of the partnership. Partner—Each partner takes a substituted basis in the partnership interest from the assets contributed to the partnership. Outside Basis of Property: The adjusted basis of each partners' interest in the partnership.

Passive income

Passive activity rules prevent the offsetting of nonpassive income with passive losses and credits from passive activities. Passive activity rules do not apply to partnerships, but the rules do apply to the individual partners.

Profits Interest

Profits interest don't give any interest in the capital of the partnership, and are not taxable, the partner has income when profits flowthrough to him or her at the end of each tax year. Partnership interests that are profits interests received in return for services that hold investments or real estate have special rules. *The profits allocated to the profits-interest partners must be from assets held for more than three years to produce long-term capital gain*. *Additionally, the partnership interest itself must be held for more than three years when it is sold for any resulting gain to be longterm*.

Precontribution (Built-In) Gains and Losses

Property that has appreciated (declined) in value at the time of its contribution to the partnership (the value of gain property is greater than its adjusted basis, whereas the value of loss property is less than its adjusted basis). These are allocated back to the original contributing partners when the property is sold. The characterization of income or loss as ordinary from a sale of inventory is limited to five years

Recourse and Non-Recourse Debt

Recourse debt—For recourse debt, each partner's share of debt is measured by his or her economic risk of loss assuming a constructive liquidation scenario occurred. While this material is likely too complex for the exam, *you should be aware that limited partners are not allocated any share of recourse debt*. Nonrecourse debt—This is debt for which the lender's only recourse, in the event of default, is to take back the property. As above, the allocation of nonrecourse debt is likely too complex for the exam. However, you should be aware that *nonrecourse debt is often allocated based on the partners' profit sharing ratios. Also, contrasted with recourse debt, both general and limited partners are allocated nonrecourse debt*.

Ordinary income and deductions (non-separately stated items) include

Sales less cost of goods sold Business expenses such as wages, rents, bad debts, and repairs Deduction for guaranteed payments to partners Depreciation Amortization (over 180 months) of partnership organization and start-up expenditures Section 1245 and 1250, recapture

Services rendered for partnership interest

Services contributed for a partnership interest create income in the amount of the value of the partnership interest (which also becomes the adjusted basis of the partnership interest). X received a 10% capital interest in the ABC Partnership in exchange for services rendered. ABC's net assets are 30,000 with a FMV of $50,000. X must recognize compensation income of $5,000, and would have a basis of $5,000 for the partnership interest.

Permitted Tax Years

Since the partnership and the partners may not have the same year-ends, the partners only report income once the partnership closes its books at the partnership year-end. ABC is a partnership with a June 30 fiscal year-end. Partner A, however, has a calendar year-end. This year ABC earned $24,000 for the fiscal year and also earned an additional $9,000 from July through December. If A is an equal partner in ABC, he should report $8,000 of income this year (one-third of $24,000). A's share of the income from July through December will not be taxed until ABC closes its books next year.

Buying partnership interests

The adjusted basis for partnership interests purchased from existing partners or interests received as gifts or inheritances are determined like other assets (cost or carryover basis, respectively).

Formations

The formation of a partnership does not trigger income, but requires that both the partners and the partnership calculate adjusted basis. Contributions to a partnership are not taxable events, but require partners to calculate a substituted basis for their partnership interest.

Look-Through Rules.

The look-through rules also impact, beginning in 2018, the character of gain for the sale of a partnership interest by a foreign person if the partnership is engaged in a U.S. trade or business. Such gain or loss is allocated to partners in the same manner as non-separately stated income and loss.

Sales of Partnership Interests

The sale, exchange, or liquidation of a partner's entire interest closes the partnership's tax year for that partner, but not for other partners or for the partnership as a whole. The income for a partner that dies during the year passes to the partner for the portion of the year that he or she was alive. The selling partner's amount realized includes the buyer's assumption of the selling partner's share of the partnership liabilities. Miller sold her partnership interest to Carter for $150,000 cash, plus Carter's assumption of Miller's $60,000 share of partnership liabilities. The amount realized by Miller on the sale of her partnership interest is $150,000 + $60,000 = $210,000.

Form 1065 and Form 1065K-1

The tax form (US Return of Partnership Income) for partnerships filing business income taxes.

attempts to diversify stock holdings.

There is no deferral for contributions that are essentially disguised sales or attempts to diversify stock holdings. 1. There is no deferral of gain on appreciated stock contributed to an investment partnership. 2. TP contributes property ($100 FMV and basis of $20) to partnership PS in exchange for a 5% interest. Five days later, TP withdraws $100 cash. This is a disguised sale, and TP will recognize a gain of $80 on the "contribution" of the property.

If the distributed property consists of multiple assets

Two parcels of inventory (Parcel A and Parcel B) are distributed to a partner in a nonliquidating proportionate distribution at a time when the partner has an outside basis of $12. Parcel A has an inside basis of $6 and Parcel B has an inside basis of $18. Each parcel is worth $20. In this situation, one-fourth [($6/($6 + $18) × $12] or $3 of the outside basis is allocated to parcel A. The remaining three-fourths of the outside basis ($9) is allocated to parcel B [$18/($6 + $18) × $12].

Section 444

Under Code Section 444, partnerships, S corporations and personal service companies may elect to have a tax year that differs from their required tax year, provided the tax year chosen does not have a deferral period of longer than three months.

Check-the-Box

Under the "check-the-box" regulations, unincorporated entities may elect to be taxed as an association (corporation) or a partnership. Some associations are automatically taxed as corporations and are not eligible to make an election. These per se corporations include business entities formed under statutes that refer to the entities as incorporated.

Capital Account

While basis represents one's investment in a partnership for tax purposes, capital account represents the amount a partner should receive when the partnership is liquidated. Basis and capital account are computed in a similar fashion, except: Liabilities of the partnership do not affect the capital account. The fair market value of contributions and distributions impact the capital account, rather than the tax basis.

Decreases in partnership interests

partner's basis is decreased by distributions, expenses, and deemed distributions. 1. A partner's proportionate share of expenses, including deductions, losses, and nondeductible expenses (not capital expenditures) 2. A partner's proportionate share of decreases in liabilities (deemed distributions) Deemed Distribution: Occurs with any decrease in the partnership liabilities.

Related Party Rules

*No losses* are deductible from sales or exchanges of property between a partnership and a person owning (directly or indirectly) more than 50% of the capital or profits interests in such partnership, or between two partnerships in which the same persons own (directly or indirectly) more than 50% of the capital or profits interests. A gain later realized on a subsequent sale by the transferee will not be recognized to the extent of the disallowed loss. *A gain recognized* on a sale or exchange of property between a partnership and a person owning (directly or indirectly) more than 50% of the capital or profits interests in such partnership, or between two partnerships in which the same persons own (directly or indirectly) more than 50% of the capital or profits interests, will be treated as ordinary income if the property is not a capital asset in the hands of the transferee. Partnership X is owned by three equal partners, A, B, and C, who are brothers. Partnership X sells property at a loss of $5,000 to C. Since C owns a more than 50% interest in the partnership (i.e., C constructively owns his brothers' partnership interests), the $5,000 loss is disallowed to Partnership X. Assume the same facts as in the above example #1. C later resells the property to Z, an unrelated taxpayer, at a gain of $6,000. C's realized gain of $6,000 will not be recognized to the extent of the $5,000 disallowed loss to the Partnership X. Thus, C will recognize $1,000 gain.

death or entry of a partner

*The taxable year of a partnership ordinarily will not close as a result of the death or entry of a partner, or the liquidation or sale of a partner's interest*. But the partnership's taxable year closes as to the partner whose entire interest is sold or liquidated. Additionally, the partnership tax year closes with respect to a deceased partner as of date of death. *A partner sells his entire interest in a calendar-year partnership on March 31. His pro rata share of partnership income up to March 31 is $15,000. Since the partnership year closes with respect to him at the time of sale, the $15,000 is includible in his income and increases the basis of his partnership interest for purposes of computing gain or loss on the sale. However, the partnership's taxable year does not close as to its remaining partners*.

Ordinary income vs Capital gain/loss

1. If a partner contributes unrealized receivables, the partnership will recognize ordinary income or loss on the subsequent disposition of the unrealized receivables. 2. If the property contributed was inventory property to the contributing partner, any gain or loss recognized by the partnership on the disposition of the property within five years will be treated as ordinary income or loss. 3. If the contributed property was a capital asset, any loss later recognized by the partnership on the disposition of the property within five years will be treated as a capital loss to the extent of the contributing partner's unrecognized capital loss at the time of contribution. This rule applies to losses only, not to gains.

Excess Business Losses

After 2017, no deduction is allowed for: A noncorporate taxpayer's, Excess business loss, That exceeds $500,000/$250,000 (married filing joint/other). The disallowed amount is added to the taxpayer's NOL carryforward. This limitation applies after application of the passive loss rules.The limit applies to the aggregate net loss from all the taxpayer's trades or businesses. For partnerships and Scorporations, the limitation applies at the owner level. If a sinle TP has $300,000 loss from different business, they can deduct $250,000 and carry-forward the rest as NOL.

Partnership

An association of two or more taxpayers to operate a business that is not taxed as a corporation. An entity may be exempt from partnership rules if organized for investment purposes. A partnership must be an association of two or more taxpayers with the objective of making a profit. Certain publicly traded partnerships (i.e., master limited partnerships) are taxed as corporations.

Debt Allocations—Changes in Liabilities Affect a Partner's Basis

An increase in the partnership's liabilities (e.g., loan from a bank, increase in accounts payable) increases each partner's basis in the partnership by each partner's share of the increase. Any decrease in the partnership's liabilities is considered to be a distribution of money to each partner and reduces each partner's basis in the partnership by each partner's share of the decrease. Any decrease in a partner's individual liability by reason of the assumption by the partnership of such individual liabilities is considered to be a distribution of money to the partner by the partnership (i.e., partner's basis is reduced). Any increase in a partner's individual liability by reason of the assumption by the partner of partnership liabilities is considered to be a contribution of money to the partnership by the partner. Thus, the partner's basis is increased.

Limited partners

Are only liable up to their investment, but they cannot participate in management without losing their limited status. A partnership loss will be a passive loss to a limited partner.

Examples for liquidating distributions

Day had a basis of $20,000 for his partnership interest before receiving a distribution in complete liquidation of his interest. The liquidating distribution consisted of $6,000 cash and inventory with a basis of $11,000. Since Day's liquidating distribution consisted of only money and inventory, Day will recognize a loss on the liquidation of his partnership interest. The amount of loss is the $3,000 difference between the $20,000 basis for his partnership interest and the $6,000 cash and the $11,000 basis for the inventory received. Day will have an $11,000 basis for the inventory. Assume the same facts as in Example #1 except that Day's liquidating distribution consists of $6,000 cash and a parcel of land with a basis of $11,000. Since the liquidating distribution now includes property other than money, receivables, and inventory, no loss can be recognized on the liquidation of Day's partnership interest. The basis for Day's partnership interest is first reduced by the $6,000 cash to $14,000. Since no loss can be recognized, the parcel of land must absorb all of Day's unrecovered partnership basis. As a result, the land will have a basis of $14,000.

Distributed properties

Distributed property retains its inside basis (in the hands of the partner) unless the partner runs out of outside basis, then the inside basis of the property is reduced to the outside basis. Sara receives a current distribution from her partnership at a time when the basis for her partnership interest is $10,000. The distribution consists of $7,000 cash and Section 1231 property with an adjusted basis of $5,000 and a FMV of $9,000. No gain is recognized by Sara since the cash received did not exceed her basis. After being reduced by the cash, her partnership basis of $3,000 is reduced by the basis of the property (but not below zero). Her basis for the property is limited to $3,000.

Partner Interests

Each partner owns a capital interest and a profits interest. The capital-sharing ratio represents each partner's share of partnership capital. Profit and loss (P&L) sharing ratios are each partner's share of profits and losses, respectively.

Family Partnerships

If the business is primarily service oriented (capital is not a material income-producing factor), a family member will be considered a partner only if the family member shares in the management or performs needed services. A family member is generally considered a partner if the family member actually owns a capital interest in a business in which capital is a material income-producing factor. Capital is a material interest 1. Where a capital interest in a partnership in which capital is a material income-producing factor is treated as created by gift, 2. the distributive shares of partnership income of the donor and donee are determined by first making a reasonable allowance for services rendered to the partnership, 3. and then allocating the remainder according to the relative capital interests of the donor and donee. Example: Dad is a half partner in a partnership where capital is a material income producing factor. Dad gives a 20% interest to his son. This year, the partnership earns $100 of income and Dad provides services worth $10. The son is allocated a partnership income of $18.

Hot Assets - Sale

If the partnership has hot assets at the time a partnership interest is sold, the selling partner must allocate a portion of the sale proceeds to these assets and recognize ordinary income. The portion of any gain or loss due to hot assets is not eligible for capital gain treatment. Hot assets are a) unrealized receivables (receivables of a cash basis taxpayer; includes depreciation recapture), and b) inventory. Inventory: All assets other than cash, capital assets, and Section 1231 assets. The remaining sale proceeds are allocable to the selling partner's capital asset interest and result in a capital gain or loss.

In addition to hot assets, other rules can also cause gain to be recharacterized.

If the partnership owns collectibles, the selling partners gain will be taxed at 28% to the extent it is due to collectibles (see Capital Gains and Losses lesson for more detail). If the partnership has Section 1250 assets, any unrecaptured Section 1250 gain will be taxed at 25% (see Capital Gains and Losses lesson for more detail).

Division

In a division of a partnership, a resulting partnership is a continuation of the prior partnership if the resulting partnership's partners had a more than 50% interest in the prior partnership. Example: Partnership ABCD is owned as follows: A, 40%; and B, C, and D each own a 20% interest. The partners agree to separate and form two partnerships—AC and BD. Partnership AC is a continuation of ABCD. BD is considered a new partnership and must adopt a taxable year as well as make any other necessary tax accounting elections. . The preceding result is automatic, no approval or even reporting is required.

GP's distributive shares

are subject to the self-employment tax, whereas limited partners' shares usually are not. However, guaranteed payments for both general and limited partners are subject to the self-employment tax.

At-risk amount

at-risk equals the partners' basis less the partner's share of nonrecourse debt. Qualified nonrecourse real estate financing is included in at-risk basis.

Built in capital losses

for built-in capital losses, the amount of loss that can be recharacterized as capital is limited to the built-in loss at the time the asset was contributed.