Tax-chapter 19

Allocation of Items

Allocation of recognized built-in gains and losses - required. Special allocations (for example, of depreciation or capital gains) - allocation must have "substantial economic effect" "economic effect" - allocation has a direct effect on distributions in possible future liquidation. "substantial" - essentially ensures the allocation is not done primarily for purposes of tax reduction.

Outside basis def

- refers to a partner's tax basis in their partnership interest - used mainly in computation of gain or loss from partnership distributions and sale of partnership interest

Outside Basis Computations: Special basis rules

1. Losses may not reduce basis below zero. Instead, they remain suspended until more basis is acquired, for example, through contributions or income. 2. Basis is reduced by the amount of any losses suspended under the at-risk or passive loss rules. 3. No separate adjustment to basis is generally made for guaranteed payments received by a partner from his P/S. The reason: Guaranteed payments are included in the partner's income, which would increase his basis, but they are accompanied by a cash distribution, which simultaneously reduces basis. - any increase (or decrease) in partner's share of liabilities of partnership is treated as contribution (or distribution) of money and increase( or decreases) partner's outside basis in partnership interest

Disguised Sales under the Seven-year Rule

Contributing partner receives distribution within seven years of contribution (directly reciprocal) - All or part of remaining precontribution gain, but not loss, is recognized by contributing partner - Gain limited to FMV - contributing partner's outside basis before distribution - Hard and fast rule, not just a presumption - HI-TECH TRANSACTIONS -- MANY Distribution of contributed property to another partner within seven years (indirectly reciprocal) - Remaining net precontribution gain or loss is recognized PROBABLY NONE - Character is determined as if partnership sold property to distributee partner

Taxation at ownership level

Ordinary (nonseparately stated) Income - Exclusions and Cost of Goods Sold = Gross Income from Business Operations - Operating Expenses = Code Sec. 702(a)(8) Ordinary Business Income (Reported on page 1 of Form 1065 and on line 1 of Schedule K)

Outside Basis Computations: holding period

depends on type of property contributed by partner - Investment or business prop: Carries over from property contributed. - Other property (e.g., receivables and inventory): Begins on day after contribution. - Services: Begins on day after contribution. [Note that an outside basis can have a split holding period if multiple assets are contributed.]

Separately Stated Items

- Items other than partnership operating income and expenses must be separately stated. The reason for showing these items separately is that their ultimate tax treatment may vary from partner to partner.  - Separately stated items are first computed at the partnership level (same computation method as with individuals).  - Next, each partner's distributive share of each separately stated item is reported on his Schedule K-1 of the partnership return. - Finally, the K-1 is sent to each partner who transfers his distributive share of ordinary business income (loss) and each separately stated item listed from the K-1 to the appropriate section of the partner's return. For example, a distributive share of charitable contributions reported on the K-1 is transferred to Schedule A of Form 1040 if the partner is an individual. There, it is subject to certain AGI limitations of the partner, which will differ from that of the other partners. ANY BARRIERS?

Formation of Partnerships—Contributions in General

- No gain or loss. Generally, Code Sec. 721 requires that no gain or loss is recognized if property is transferred to a partnership in exchange for a partnership interest. - It does not matter whether the transfer is during partnership formation or after the partnership had already been formed. - Similar nonrecognition rules govern corporate shareholders in a Code Sec. 351 contribution, except Code Sec. 351 has an 80% control requirement. NO 351 TYPE REQUIREMENT - CONSIDER - Mandatory nonrecognition. Notwithstanding the exceptions in the following slide, nonrecognition treatment for qualified transactions under Code Sec. 721 is mandatory, not elective for partners. Similarly, nonrecognition treatment under Code Sec. 351 is mandatory for corporate shareholders.

Partner's Year of Inclusion

- Partner's distributive share reported in partner's taxable year in which the partnership year ends - Planning opportunity??? - Guaranteed payments follow same rule, no matter when actually paid - Change in ownership - can use either the proration method or closing-of-the-books method to allocate income among owners - Certain cash-basis expense items of a partnership, such as interest, taxes, and payment for the use of services or property, are , in effect, placed on the accrual basis.

Liabilities Assumed by Partnership

- Partner's share of liabilities increases their outside basis in the partnership - Partner's share of debt is also added to amount realized if partnership interest is sold, creating a "wash" - Accounts payable (and accrued expenses) of cash-basis contributors are not "liabilities" for purposes of calculating outside basis

Taxable Year of the Partnership

The following rules govern tax years of partnerships: - Majority Interest Taxable Year. Partnerships are generally required to elect the same taxable year as their partners who represent a majority (>50%) interest on the first day of the partnership's first tax year. Code Sec. 706(b). calculation - Principal Partners' Common Tax Year. If there is no majority interest taxable year, the partnership must use the same year as that of the principal partners, i.e., those owning five percent or more interest in either profits or capital. For this to be possible, all of the principal partners must have the same year end. - Least Aggregate Deferral. If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership generally must use the least aggregate deferral rules. Under the least aggregate deferral rules, the following deferral calculation is made for each year-end any partner has: partner's interest in profits × months of deferral. For each possible year end, the deferral calculations for all of the partners are aggregated. The year-end with the lowest aggregate is the one that must be used, unless a natural business year-end can be established (for seasonal businesses). - CAN I GAME THIS RULE? - Natural Business Year. A partnership that can show it has a natural business year can use that as its taxable year, no matter what year it would have under the majority interest, principal partners, or least aggregate deferral methods.

Organization and Syndication Costs

(1) Amortizable expenditures. Organizational expenses qualify for amortization (and reduce Code Sec. 702(a)(8) income) if: (a) = incurred incidental to formation of the partnership. (e.g., legal fees for drafting the partnership agreement, cost of state filings, cost of required notice publications and organizational meeting costs.) and (b) = incurred before the end of the tax year in which the partnership commences business. At the election of the partnership, a deduction is allowed for the taxable year in which the partnership begins business in an amount equal to the lesser of (a) actual organizational expenses, or (b) $5,000 (reduced dollar-for-dollar by the amount by which such organizational costs exceed $50,000). The remainder of such organizational costs are allowed as a deduction ratably over the 180-month period beginning with the month in which the partnership begins business. (2) Nonamortizable expenditures. Organizational expenses DO NOT qualify for amortization if related to issuing and marketing partnership interests. Examples are prospectus preparation costs and commissions on sales of limited partnership interests. These are written off when the partnership is terminated.

Limited Liability Limited Partnership [LLLP].

- An LLLP is a limited partnership in which the general partners are not liable for the negligence or misconduct of the other general partners.

Limited Liability Partnership [LLP].

- An LLP is a general partnership in which the general partners are not liable for any malpractice committed by the other general partners.

Limited Partnership [LP].

- An LP is comprised of at least one general partner and often many limited partners. - Limited partners may not participate in the management of the LP, and their risks of loss are restricted to their equity investments in the LP.

Outside Basis Computation

+ Basis in contributed property +/- Share of P/S's ordinary business income (i.e., earned income/loss, both active and passive) +/- Share of "separately stated items" (including tax-exempt income/nondeductible expenses) + Income recognized by partner on services contributed + Gain recognized by partner on excess debt relief + Share of debt assumption (See ¶19,551 for more details about allocation of liabilities.) - Share of P/S losses - Debt of the partner that is assumed by the partnership - Basis of property distributions, including cash = Partner's outside basis of partnership interest -> DIFFERENT FOR DIFFERENT PARTNERS

General Partnership [GP].

- A GP has two or more general partners who is personally liable for partnership debts - a general partner can be bankrupted by a malpractice judgment brought against the partnership, even though the partner was not personally involved in the malpractice.

Limited Liability Company [LLC].

- An LLC is a state-registered association generally taxed as a partnership if it "checks the box" to be treated as a partnership. LLC members, like corporate shareholders, are not personally liable for the debts of the LLC. - Unlike limited partners, LLC members may participate in management without risking personal liability. - However, guaranteed payments to members are subject to self-employment tax, along with the members' share of ordinary income or loss from the LLC. - Advantages: single level of taxation, limited liability of members, inclusion of members' share of LLC debt in members' outside basis

Definition of Partnership.

- An unincorporated association with two or more persons who associate for a profit motive. - For income tax purposes, partnerships are generally treated as pass-through entities, i.e., the partnership pays no taxes, and partnership income (loss) and separately stated items are allocated to each partner according to the partnership's profit sharing agreement. - The partners receive separate K-1 schedules from the partnership. Each K-1 reports each partner's share of the partnership net profit and separately reported income and expense items. Partners report these items on their own tax returns, even if no cash or property has been distributed to them.

Guaranteed Payments

- Can be for services or use of capital - Ordinary income to partner, ordinary deduction to partnership - Income to the partner in partner's tax year containing the end of partnership year in which guaranteed payment is deducted - Deducted by partnership on page one of Form 1065, income reported to partner on Sch. K-1.

"Check the Box" Regulations allow an entity to choose what type of tax entity it will be

- Default classification - More than one owner - Partnership One owner - Sole Proprietorship - Incorporated entity - must be a tax corporation, but can elect S corporation status to get "flow-through" status

Partnership Ordinary Business Income (Loss)

- Earned income from operations generally follows the same rules as for individuals (i.e., all income from whatever source derived, unless specifically excluded) - It is offset by cost of goods sold and operating expenses to produce Partnership Ordinary Business Income (Loss). (Line 22, page 1 of Form 1065)

Disguised Sales—General Rules

- If a contribution of property by a partner to a P/S followed by a distribution by the P/S to the partner is a disguised sale, then it is treated as if the partner sold a fraction of the contributed property to an unrelated 3rd party. The fraction treated as sold is equal to the amount of cash and FMV of property distributed divided by the FMV of the property contributed. - The partnership's basis in the property contributed will be the sum of (1) the FMV of the fraction of the property "sold" to the partnership, plus (2) the basis of the fraction of the property still treated as a contribution. - The partner's basis in the partnership interest will be the basis of the fraction of the property still considered to be contributed, rather than sold.

Contributions of Property - Special Situations

- Precontribution Gain/Loss - To the extent recognized by the partnership on a later sale, allocated to the contributing partner THIS IS A WOW (exp 19.2) - Accounts Receivable - Gain or loss recognized on collection or disposition is ordinary TO WHOM (excess collected may be allocated according to partnership agreement) (19.21) - Inventory - Gain/loss on disposition within five years will be ordinary (> 5 years, gain would be capital) - Capital Loss Property - precontribution loss recognized on disposition within five years will be capital loss (>5 years, loss would be ordinary) - Depreciable Property - Depreciation method, recovery period, and recapture potential carry over

Contribution of Encumbered Property

- When a partnership assumes the debt of a contributing partner, the partner relieved of debt is treated as having received a distribution of money from the partnership in the amount of the debt relief. Code Sec. 752(b). - That assumption of debt by the partnership is shared by ALL partners, in accordance with their ownership %'s. The term "ALL partners" includes the partner relieved of the debt. In essence, the partner is relieved of 100% of the debt, then assumes his pro rata share of that same debt assumed by the P/S. The amount of partnership debt assumed by a partner is treated as a cash contribution by the partner to the partnership. - The partner's "net" debt relief (total debt relief minus pro rata additional debt burden) is non-taxable to the relieved partner to the extent of his basis in the partnership. - Any net debt relief in excess of basis is capital gain (i.e., same effect as if the amount of excess net debt relief were a cash distribution.) The capital gain is short-term or long-term depending on the holding period of the partnership interest. (look at exhibit 1, 19-25)

Limitation on Losses—At-Risk Rules

A partner's distributive share of partnership losses and deductions from both business and investment activities are "at-risk." Code Sec. 465(b)(1) and (2). Such losses are allowed only to the extent of the partner's at-risk amount at the end of the partnership's tax year. (a) The at-risk amount is generally the partner's outside basis  defined at Code Sec. 704(d). (i) Nonrecourse loans from "non-qualified" lenders are  generally excluded from the at-risk basis amount but  included in the Code Sec. 704(d) outside basis. (b) If a partnership has more than one "activity," then the at-risk rules  must be applied to each activity separately (i.e., each activity must  have its own "at-risk" basis). Code Sec. 465(c)(2)(A) and (3)(A).

Passive Activity Loss (PAL) Rules

As with the at-risk rules, the PAL rules are applied on a partner-by-partner basis, not at the partnership level. However, unlike the at-risk rules, the PAL rules apply only to business income and losses for which the partner does not actively participate. PALs are deductible to the extent of income from all passive activities in the aggregate. "Portfolio income" (interest, dividends, annuities, royalties not derived from the ordinary course of business and gains or losses from assets that produce such income, less related expenses) are not considered as arising from a passive activity. Code Sec. 469(e)(1). Partnership ordinary loss is generally passive to a partner unless the partner materially participates in the partnership activity.

Partner-Partnership Transactions

Attribution - From entities (proportionate attribution) - From family members (siblings, spouse, ancestors, lineal descendants) Transactions - Is transaction in capacity as a partner? - Denial of loss deduction - Sales between a partner and a >50% owned partnership (or two > 50% owned partnerships). - Disallowed loss can reduce later gain, if any on sale by purchaser - Sale of capital assets to or from controlled partnerships - Ordinary gain unless the property is a capital asset in the hands of the transferee - Ordinary gain if the property is depreciable by the transfee - Installment sales - Sale of the property within two years of purchase will accelerate unpaid installments and associated gain - Payee on cash basis and payer on accrual basis - Expense of payer is not deductible until income is recognized by payee

Operation of the Partnership—Cash-Basis Reporting

Cash method. The cash method is not available to partnerships with corporate partners whose three year average of gross receipts for the periods ending with each of the prior three years is more than $5,000,000. The cash method may be used by partnerships with C corporation partners if the partnership's three-year average annual gross receipts are $5 million or less in all preceding years. The determination is made annually. Accrual Method. Once the three-year average annual gross receipts exceeds $5 million, a partnership with a C corporation partner must use the accrual basis thereafter.

What is a disguised sale?

Code Sec. 707(a)(2)(B) and Reg. §1.707-3 provide that any contribution and distribution of property (other than a capital interest) between partner and partnership (P/S) within 2 years of each other is presumed to be a disguised sale. The burden is on the taxpayers to prove otherwise. Chance of audit issue

Inside Basis Computations

Code Sec. 763 provides that the basis of property received by a partnership will be Partner's basis in contributed property + Gain recognized by a partner on contributions of property (such as when other property is received by the partner). = Partnership's inside basis in property THEORY Note that gain recognized by a partner on excess debt relief (i.e., debt relief - debt assumption - basis in assets contributed) does not increase the partnership's inside basis in the contributed assets, even though it DOES increase the outside basis of the contributing partner in her partnership interest (to zero).

Operation of the Partnership—Separately Stated Items

Items that must be separately stated include the following: Code Sec. 1231 gain and loss Code Sec. 1250 depreciation recapture (Code Sec. 1250, unlike Code Sec. 1245, must be separately stated because corporate partners may be subject to an additional recapture adjustment under Code Sec. 291) Capital gains and losses Dividends eligible for a corporate dividend-received deduction "Qualified" dividends eligible for the 0/15/20% tax rates Tax-exempt income and related expense Investment income and related expense Passive income and losses from rental and other nonoperating activities Recovery items (e.g., tax refunds, recovery of bad debts) Distributions of unrealized receivables or inventory that have substantially appreciated Tax credits Charitable contributions Foreign income taxes paid or accrued Depletion on oil and gas wells Other nonbusiness expenses

Losses in Excess of Partner's Basis

Partner's share of loss is deductible only up to the amount of the partner's basis in the partnership - Excess can be carried over indefinitely - Carryover can be used when more basis is acquired (upon a contribution, recognition of partnership income, etc.) - Carryover is lost if interest sold - Classification of deferred losses - Proportionate to the losses incurred in year carryovers were generated. - Allocation of recourse liabilities - Partner's share is amount partner would have to pay in a hypothetical liquidation - Allocation of nonrecourse liabilities - Partner's share of minimum gain, remaining precontribution gain, and excess nonrecourse liabilities

Partnership Ordinary Business Income (Loss)

The following items are included in the Partnership Ordinary Business Income (Loss) computation because they always get ordinary (nonseparately stated) treatment: - Code Sec. 1245 depreciation recapture - Cost of goods sold - Depreciation and other operating expenses - Amortization of organizational expenditures

Formation of Partnerships—Contributions in General

Three exceptions to nonrecognition. Gain is recognized in either event below: - Services. A partner's contribution of services in exchange for a partnership (P/S) interest creates ordinary income to the partner (P). - Disguised sale. A partner's contribution of property to a P/S followed by a P/S's distribution of property (other than a partnership interest) to a partner within 2 years is presumed by IRS to be a disguised sale.  - Excess of P's net debt relief over P's basis. Excess net debt relief enjoyed by a partner over their basis in their partnership interest is treated as capital gain. Similar treatment holds for corporations. Recall that a shareholder relieved of debt by a corporation has taxable boot if the debt relief exceeds that shareholder's basis in contributed property. - No 80% control requirement. The 80% control requirement for corporate shareholders is not required of partners contributing property to a P/S.  - Partner's outside basis increases with P/S debt assumption. A partner's outside basis increases by his pro rata share of a P/S's increase in both recourse and non-recourse debt. The debt may include debt transferred by a contributing partner. (In contrast, a corporate shareholder's stock basis is not affected by corporate debt assumption.)  - Partner's outside basis decreases with debt relief. Debt transferred by a contributing partner to the P/S results in debt relief to the contributing partner. The partner must reduce his basis in the P/S by the amount of debt relief. (Similarly, shareholders must reduce their basis in stock for the amount of their debt assumed by the corporation.)

Limitation on Losses—At-Risk Rules

What about alimony paid, charitable contributions and other non- business/non-investment expenses? Prop. Reg. 1.465-13 addresses this question by providing that, " ...allowable deductions allocable to an [passive] activity are those otherwise allowable deductions incurred in a trade or business or for the production of income from the activity." (In other words, alimony and charitable contributions paid by a partnership are generally NOT subject to the at-risk rules since they do not ordinarily serve a business or investment purpose to the passive activity incurring these expenses. However, facts and circumstances govern "purpose".)

Inside Basis Def

refers to adjusted basis of assets of partnership