Tax II Exam 2 Vocab + Review/Discussion Questions

Under what circumstances is it possible for partners to recognize gain when contributing property to partnerships? [20]

Partners have the potential of recognizing gain on the contribution of property when the property contributed is secured by debt. In determining whether gain must be recognized, the partner must assess the cash deemed to have received from the partnership distribution compared with the tax basis of the partner's partnership interest prior to the deemed distribution. This happens if the assumption of the partner's liabilities is in excess of the partner's basis of the contributed property. If the cash deemed to have received exceeds the tax basis immediately before the deemed distribution, then a gain must be recognized. This circumstance occurs due to the negative basis created for the partner, which is not allowed under partnership tax law.

In what situations do partners need to know the tax basis in their partnership interests? [20]

Partners should always keep track of the tax basis in their partnership interest because certain situations require partners to actually know their tax basis. These situations occur when a partner sells her/his partnership interest or when a partner receives a distribution from the partnership. Tracking the tax basis in the partnership interest helps the partner determine the amount of gain or loss that must be reported on the partner's tax return.

In what order are the loss limitation rules applied to limit partners' losses from partnerships? [20]

The order of the hurdles a partner must pass through for the loss limitation rules are (1) tax basis loss limitation, (2) at-risk loss limitation, (3) passive activity loss limitation, and excess business loss limitation. As the losses exceed the limitation in the tax basis, at-risk, and passive activity loss hurdles, the suspended losses will be carried forward indefinitely within each group until enough basis or income is generated to cover these losses. Excess business losses are treated by partners as net operating losses to be carried forward and utilized to the extent allowable in future years.

In general, what effect does an operating distribution have on the partnership?

The partnership does not generally recognize gain or loss for tax purposes when making an operating distribution. This contrasts with the tax treatment of corporate distributions in which the corporation recognizes gain or loss on distributions of property other than cash.

What is the rationale for requiring partners to defer most gains and all losses when they contribute property to a partnership? [20]

The rationale for requiring partners to defer most gains and losses when contributing property to a partnership is twofold. First, the IRS desires that entrepreneurs have a way to start their own business without having to pay any taxes upfront. Second, the partners are considered as still owning the property they have contributed to the partnership. While they don't own the property outright, each partner has a small percentage of the property contributed in her/his partnership interest she/he exchanged for. This second reasoning helps further support the idea that partnerships follow the aggregate concept.

What types of business entities are taxed as flow-through entities? [20]

The two main business entities that are taxed as flow-through entities are partnerships and S corporations. Partnerships are taxed under Subchapter K and consist of general partnerships, limited partnerships, and limited liability companies (LLC). S corporations are taxed under Subchapter S. Both these types of business entities are treated as flow-through entities and are taxed accordingly.

What is a partnership's ordinary business income (loss) and how is it calculated? [20]

Through the course of business, partnerships create income or losses. Some of these items are considered to affect a specific partner or groups of partners differently. Thus, these separately-stated items must be reported on a partner-by-partner basis. Then, after adjusting the partnership's business income (loss) for these separately-stated items, the partnership reports the remaining amount of business income (loss) to ordinary business income (loss). The total amount will be allocated to each partner according to the special allocation rules agreed upon or else based upon the profit sharing ratios of the partnership.

Under what conditions will a partner recognize loss in a liquidating distribution?

When a distribution includes only cash, unrealized receivables, and inventory and the partner's basis in his partnership interest is greater than the sum of the bases of the distributed assets, the partner will recognize a loss on a liquidating distribution. The partner treats the loss as a capital loss.

How do partners who purchase a partnership interest determine the tax basis and holding period of their partnership interests? [20]

When a partner purchases a partnership interest, the initial tax basis for the partner is determined by taking the cost basis of the interest the partner purchased and adding to this basis any debt allocated to the partner's interest. The holding period for this purchased interest will begin on the date that the partner purchased the partnership interest.

Special Allocations [20]

allocations of income, gain/loss, expenses, etc that are allocated to the owners of an entity in a manner NOT in proportion with the owner's interests in the entity

Capital Account [20]

an account reflecting a partner's share of the equity in a partnership -- maintained using tax accounting methods or other methods including GAAP at the discretion of the partnership

Capital Interest [20]

an economic right attached to a partnership interest giving a partner the right to receive cash or property in the event the partnership liquidated (synonymous with liquidation value of PI)

Partnership Interest [20]

an intangible asset reflecting the economic rights a partner has with respect to a partnership -- including capital interests and profit interests

Partnership Interest [21]

an intangible asset reflecting the economic rights a partner has with respect to a partnership, including the right to receive assets in liquidation of the partnership (capital interest) and the right to be allocated future profits/losses (profits interest)

Profits Interest [20]

an interest in a partnership giving a partner the right to a share in future profits but not the right to share in the current value of a partnership's assets -- generally not taxable in the year they are received

At-Risk Amount [20]

an investor's risk of loss in a worst-case scenario -- in a PS, an amount generally equal to a partner's tax basis exclusive of the partner's share of non recourse debt

Outside Basis [21]

an partners tax basis in the interests in a partnership or LLC

Unrealized Receivables [21]

any rights to receive payment for: 1. goods delivered or to be delivered 2. services rendered or to be rendered also includes other assets to the extent they would produce ordinary income if sold for their fair market value (FMV)

Non-Recourse Debt [20]

debt for which no partner bears any economic risk of loss

Recourse Debt [20]

debt held by a partnership for which at least one partner has economic risk of loss

Excess Business Loss [20]

excess of aggregate business deductions for the year over aggregate business gross income or gain of an individual taxpayer plus a threshold amount depending on filing status

Start-Up Costs [20]

expenses that would be classified as business expenses except that the expenses are incurred before the business begins

Inventory Item [21]

for sale of PI purposes, classic inventory defined as property held for sale to customers in the ordinary course of business, but also assets that are not capital assets or section 1231 assets, which would produce ordinary income if sold by the partnership

Separately Stated Items [20]

income, expenses, gains/losses, credits and other items that are excluded from a partnership's operating income/loss and disclosed to partners in a PS separately because their tax effects may be different for each partner

Flow-Through Entities [20]

legal entities that do not pay income tax -- income and losses from flow-through entities are allocated to their owners

Qualified Non-Recourse Financing [20]

non-recourse debt secured by real property from a commercial lender unrelated to the borrower

Tax Capital Accounts [20]

partner's capital accounts initially determined using the tax basis of contributed property and maintained using tax accounting income and expense recognition principles.

Sec 704 Capital Accounts [20]

partner's capital accounts reflect the fair market value of property contributed to and distributed property from partnerships

Operating Distributions [21]

payments from an entity to its owners that represent a distribution of entity profits -- the partner continues their interests in the partnership after the distribution

Guaranteed Payments [20]

payments made to partners or LLC members that are guaranteed because they are not contingent on partnership profits or losses -- economically similar to shareholder salary payments

Self-Employment Taxes [20]

social security and medicare taxed paid by the self-employed on a taxpayer's net earnings from self-employment

Passive Activity Loss (PAL) Rules [20]

tax rules designed to limit taxpayer's ability to deduct losses from activities in which they don't materially participate against income from other sources

At-Risk Rules [20]

tax rules limiting the losses flowing through to partners to their amount "at risk" in the partnership

Liquidation Value [20]

the amount a partner would receive if the partnership were to sell all its assets, pay its debts, and distribute its remaining assets to the partners in exchange for their partnership interests

Carryover Basis [21]

the basis of an asset the transferee takes in property received in a nontaxable exchange --the basis transfers from transferor to the transferee

Built-in-Loss [20]

the difference between the FMV and the AB of property owned by an entity when the FMV<AB

Built-in-Gain [20]

the difference between the FMV and the AB of property owned by an entity when the FMV>AB

Form 1065 [20]

the form partnerships file annually with the IRD to report partnership ordinary income/loss and separately stated items for the year

Subchapter K [20]

the portion of the internal revenue code dealing with partnerships tax law

Inside Basis [20]

the tax basis of an entity's assets and liabilities

Inside Basis [21]

the tax basis of the entity's assets and liabilities

Entity Approach [20]

the theory of taxing partnerships that treats partnerships as entities separate from partners

Hot Assets [21]

unrealized receivables or inventory items that give rise to ordinary gains and losses -- exact definition depends on whether it is in reference to dispositions of a PI or distributions

Under what circumstances can partners with passive losses from partnerships deduct their passive losses? [20]

A partner may deduct the passive losses she/he has generated from a partnership under three circumstances. First, a passive loss is not deductible until the taxpayer generates current year passive income in the activity producing the loss. Second, a passive loss is not deductible until the taxpayer generates current year passive income from another passive activity the taxpayer is involved with. Last, a passive loss will not be deductible unless the taxpayer sells the activity that has produced the passive loss. In this case, the taxpayer will report a gain or loss on the sale and can use the passive loss to offset this or any other source of income (i.e., active income, portfolio income, or other passive income).

Under what circumstances will a partner recognize a loss from an operating distribution?

A partner never recognizes loss from operating distributions.

What is a tax basis capital account, and what type of tax-related information does it provide? [20]

A tax basis capital account is an equity account that is created for each partner of the partnership. This account is measured using the tax accounting rules. The account reflects tax basis of any capital contributions (i.e., property and cash), capital distributions, and future earnings and losses allocated to that partner. Additionally, a tax basis capital account can provide more tax-related information for each partner. For instance, each partner's share of inside basis of the partnership's assets can be calculated by adding the partner's share of debt to her/his capital account.

What is a flow-through entity, and what effect does this designation have on how business entities and their owners are taxed? [20]

Flow-through entities are entities that are not taxed on the entity level; rather, these entities are taxed on the owner's level. These types of entities conduct a regular business; however, the income earned and deductions allowed are passed to the owners of these flow-through entities. The owners are then taxed on the amount allocated to them. Thus, flow-through entities provide a way for income and deductions to be taxed only once instead of twice

How do general and limited partners treat their share of ordinary business income for self-employment tax purposes? [20]

In determining how different partners treat their share of ordinary business income, the IRS assesses the involvement the partner has in the partnership. General partners are considered to be actively involved in the management of the partnership. Thus, the general partner's share of ordinary business income is treated as trade or business income and is subject to self-employment tax. Conversely, limited partners are generally not actively involved with managing the partnership. The limited partner's share of ordinary business income is treated as investment income and not subject to self-employment tax. Both types of partners must treat guaranteed payments as income relating to self-employment; however, the treatment of ordinary business income for purposes of self-employment tax depends on the type of partner.

Under what circumstances will a partner recognize a gain from an operating distribution?

In general, partners do not recognize gain or loss from operating distributions. However, when the partnership distributes money that exceeds a partner's basis in her partnership interest, she will recognize a gain equal to the excess. In this situation, the partner is unable to adjust the basis in property distributed in order to defer the gain.

Is the character of partnership income/gains and expenses/losses determined at the partnership or partner level? Why? [20]

In keeping with the entity concept, the character of all income/gains and expenses/losses is determined at the partnership level. Despite the chance that specific items would change character depending upon the partner who holds them, Congress has decided to unify the character of all items by looking at the character from the partnership's perspective. Thus, partnerships are required to file a form 1065 return along with all partners' K-1s to help properly report the amounts and character of various items that show up on the individual partner's return.

Under what conditions will a partner recognize gain in a liquidating distribution?

In the situation in which a partnership distributes only money and the amount exceeds the partner's basis in her partnership interest, she will recognize a gain equal to the excess. In this situation, the partner is unable to adjust the basis in property distributed in order to defer the gain.

What happens to partnership losses allocated to partners in excess of the tax basis in their partnership interests? [20]

Losses that are allocated to partners that exceed the partner's tax basis cannot be used during the current taxable year. The excess loss will be suspended and carried forward indefinitely until the partner has sufficient basis to utilize the losses. A partner would be able to increase her/his tax basis by (1) making a capital contribution, (2) guaranteeing more partnership debt, or (3) helping the partnership become more profitable. Once the partner's tax basis is positive, the losses previously suspended can be used.

What distinguishes operating from liquidating distributions?

Operating or current distributions are made to partners whose interests in the partnership continue after the distribution. Liquidating distributions terminate a partner's interest in the partnership.

What items will decrease a partner's basis in her partnership interest? [20]

The following items will decrease a partner's basis and must be adjusted for on an annual basis in the order given. These items will be adjusted after all the increases to a partner's basis have been taken into effect. 1. Actual and deemed cash distributions from the partnership 2. Partner's share of non-deductible expenses (fines, penalties, etc.) 3. Partner's share of ordinary business losses and 4. Partner's share of separately-stated expenses/loss items

What items will increase a partner's basis in her partnership interest? [20]

The following items will increase a partner's basis and must be adjusted for on an annual basis in the order given. 1. Actual and deemed cash contributions to the partnership 2. Partner's share of ordinary business income 3. Partner's share of separately-stated income/gain items and 4. Partner's share of tax-exempt income

How does the amount of debt allocated to a partner affect the amount of gain a partner recognizes when contributing property secured by debt? [20]

A partner that contributes property secured by debt is not only contributing the property to the partnership but also the debt. The partner's tax basis in his or her partnership interest would be increased by the basis of the assets contributed. Next, the property's debt is allocated to each partner according to who is ultimately responsible for it or by each partner's profit-sharing ratio. The basis of the contributed assets plus the allocation of debt would represent the partner's tax basis in the partnership immediately before the deemed distribution of cash as a result of the relief of debt attached to the contributed property. If the partner is not allocated enough debt, the partner's outside basis will become negative and a gain must be recognized. Thus, a partner can only avoid gain by being allocated enough of the partnership debt to keep her/his basis at least above zero.

How do partners measure the amount they have at risk in the partnership? [20]

A partner will measure her/his partnership at-risk amount by looking at what items affect the partner's economic risk of loss. In most cases, items included in the at-risk amount would include cash contributed, tax basis of property contributed, recourse debt, qualified nonrecourse debt, and any other adjustments to the partner's tax basis excluding nonrecourse debt. Nonrecourse debt is considered a part of the tax basis but not a part of the at-risk basis since the partner does not have an economic risk of loss for this type of debt.

Why does a partner's tax basis in her partnership interest need to be adjusted annually? [20]

A partner's tax basis needs to be adjusted annually for the following three reasons. First, a partner does not want to double count any income/gain from the partnership when she/he sells her/his partnership interest or receive a distribution from the partnership. Second, the IRS does not want partners to double count any expenses/losses from the partnership in a similar situation from above. Last, partners want to make sure they adjust for tax-exempt income and non-deductible expenses, so these items will not ultimately be taxed or deducted at the time of selling a partnership interest or receiving a distribution from the partnership.

Distinguish between a capital interest and a profits interest, and explain how partners and partnerships treat each when exchanging them for services provided. [20]

A partnership interest can be broken down into two distinct rights: (1) capital interest and (2) profits interest. To become a partner in a partnership, you will receive at least one of these rights. A capital interest is the right to receive a share of the partnership assets at liquidation. A profits interest is the right to share in the future earnings and losses of the partnership. While these rights are given to most partners that contribute cash or property, special rules exist when these rights are given to partners in exchange for services. When a partner receives a capital interest in exchange for services rendered to the partnership, the partner must treat the liquidation value of the capital interest as ordinary income. Further, the tax basis for the partner will be equivalent to the amount of ordinary income recognized. The holding period for this tax basis will begin on the date the capital interest is received. From the partnership's perspective, the partnership can deduct or capitalize the value of the capital interest depending upon the type of services rendered. This is determined on a fact and circumstance basis. Additionally, the amount deducted by the partnership is allocated to the non-service partners as consideration for effectively transferring a portion of their capital interest to the service partner. When a partner receives a profits interest in exchange for services rendered to the partnership, the partner has no immediate tax impact because the profits interest has no liquidation value at the time the interest is received. Thus, the non-service partners will not receive any deductions for adding the additional partner to the partnership. As the partnership makes future profits and losses, the service partner will be allocated her/his portion of these losses according to the profit sharing ratios. The debt allocated to non-service partners must also be redistributed with the additional service partner receiving her/his portion of debt. Therefore, the initial tax basis of a service partner with only a profits interest will either be zero or the portion of debt the partner is allocated (if any).

What is a partnership interest, and what specific economic rights or entitlements are included with it? [20]

A partnership interest is an equity interest in a partnership. This interest is created through a transfer or sale of cash, property, or services in exchange for an equity interest in the partnership. A partnership interest gives each partner certain rights or entitlements. The two main economic rights are a capital interest and profit interest in the partnership. A capital interest is the right for a partner to receive a share of the partnership assets during liquidation. A profit interest is the right or obligation for a partner to receive a share of the future income or losses of the partnership.

How do partners determine whether they are passive participants in partnerships when applying the passive activity loss limitation rules? [20]

According to the Code, a partner is considered to be a passive participant if the activity conducted is a trade or business and the partner does not materially participate in the activity. The IRS has made it clear that those participants in rental activities and limited partners within a partnership are automatically considered to be passive participants. Further, regulations help clarify whether a partner would be considered a material participant. If the partner meets any of the conditions below, then the partner would be a material participant and the activity would not be considered a passive activity to the partner. 1. The individual participates in the activity more than 500 hours during the year. 2. The individual's activity constitutes substantially all of the participation in such activity by individuals. 3. The individual participates more than 100 hours during the year and the individual's participation is not less than any other individual's participation in the activity. 4. The activity qualifies as a "significant participation activity" (individual participates for more than 100 hours during the year) and the aggregate of all other "significant participation activities" is greater than 500 hours for the year. 5. The individual materially participated in the activity for any 5 of the preceding 10 taxable years. 6. The activity involves personal services in health, law, accounting, architecture, and so on, and the individual materially participated for any three preceding years. 7. Taking into account all the facts and circumstances, the individual participates on a regular, continuous, and substantial basis during the year.

What is inside basis and outside basis, and why are they relevant for taxing partnerships and partners? [20]

An inside basis, in relation to partnerships, is the basis the partnership takes in the assets that the partnership holds. An outside basis, in relation to partnerships, is the tax basis each partner has in the partnership. The inside basis is necessary to compute the gain/loss recognized on all property sold by the partnership. The outside basis is necessary to compute the gain/loss recognized on the partnership interest when sold. For tax purposes, the inside basis is similar to the basis the partner had in the property prior to contribution. On the other hand, the outside basis corresponds not only to the contributed property, but also to the debt and income/losses of the partnership that have been allocated to the individual partners.

What challenges do LLCs face when deciding whether to treat their members' shares of ordinary business income as self-employment income? [20]

Before a string of relatively recent Tax Court decisions, only Proposed Reg. §1402(a)-2 provided guidance on this matter; however, the regulation was never finalized leaving LLCs without any authoritative guidance to help resolve this issue. The proposed regulation provided that if an LLC member is involved in the operations of the LLC, the member should treat the ordinary business income as self-employment income. The regulation listed the following three criteria that would demonstrate active involvement in the LLC: (1) personal liability for the debt of the LLC as an LLC member, (2) authority to contract on behalf of the LLC, or (3) more than 500 hours participating in the LLC's trade or business during the taxable year. If any one of these requirements were met, then the LLC member would be more associated as a general partner and should account for their share ordinary business income as self-employment income. The recent Tax Court decisions providing authoritative guidance in this area are consistent with the spirit of the Proposed Regulation issued years earlier by the IRS. These decisions provide that LLC members with either management control or that provide significant services to the LLC should treat their share of ordinary business income as self-employment income (see Renkemeyer, Campbell & Weaver, LLP, et al. v. Commissioner, 136 TC 137 (2011), Riether, 919 F.Supp.2d 1140 (D. N.M. 2012), and Castigliola T.C. Memo. 2017-62.) With these decisions to consult, LLCs and their advisors should face less uncertainty than in the past when deciding how to treat an LLC member's share of ordinary business income for self-employment tax purposes.

What are guaranteed payments and how do partnerships and partners treat them for income and self-employment tax purposes? [20]

Guaranteed payments are similar to cash salary payments for services provided. Fixed payments made to a partner in the capacity as a partner no matter the profit (loss) of the partnership for that tax year are known as guaranteed payments. Thus, on the partnership level, they are treated like a salary payment to an unrelated party. The partnership deducts the guaranteed payment in computing the partnership's ordinary business income (loss). On the partner level, the partner that receives a guaranteed payment must account for the guaranteed payment as a separately-stated item that is taxed as ordinary income. Further, the partner must include the amount of the guaranteed payment in computing self-employment income for tax purposes. This reporting requirement is required no matter if the partner is a general partner, limited partner, or LLC member.

If a partner's outside basis is less than the partnership's inside basis in distributed assets, how does the partner determine his basis of the distributed assets in an operating distribution?

If only money is distributed, the partner recognizes gain equal to the difference between the money distributed and the basis in the partnership interest. If the partnership distributes money and hot assets only, the partner defers gain recognition by reducing the basis of the hot assets distributed. The partner first allocates basis to the assets received equal to the partnership basis (allocating to money first). Then, the partner allocates the required decrease (difference between the partnership's basis in the distributed assets and the partner's outside basis) to the assets with unrealized depreciation. Finally, the partner allocates any remaining required decrease to the distributed assets in proportion to their adjusted bases. If the partnership distributes other property in addition to money and hot assets, the partner defers gain by reducing the basis in the other property distributed. The partner first assigns basis to the distributed assets equal to the partnership basis. The partner then allocates the required decrease to property other than money, inventory and unrealized receivables to the extent of the unrealized depreciation in the assets. Finally, the partner allocates any remaining required decrease to the other property in proportion to the assets' adjusted bases.

How does a partner determine his basis in distributed assets when the partnership distributes other property in addition to money and hot assets?

If the partner's basis in the partnership interest is greater than the basis of the distributed assets, the partner defers loss recognition by increasing the basis of the other property distributed. The required increase equals the difference between the partner's outside basis and the partnership bases in the distributed assets. The partner first assigns a basis to the distributed assets equal to the partnership's basis. The partner then allocates the required increase to the other property with unrealized appreciation. Finally, the partner allocates any remaining required increase to the other property in proportion to their fair market values. When the partnership distributes other property in addition to money, inventory, and unrealized receivables and the partner's basis in the partnership interest is less than the basis of the distributed assets, the partner defers gain by reducing the basis in the other property distributed. The partner first assigns basis to the distributed assets equal to the partnership basis. The partner then allocates the required decrease to property other than money, inventory and unrealized receivables to the extent of the unrealized depreciation in the assets. Finally, the partner allocates any remaining required decrease to the other property in proportion to the assets' adjusted bases.

Describe how a partner determines his basis in distributed assets in cases in which a partnership distributes only money, inventory, and/or unrealized receivables in a liquidating distribution.

If the partner's basis in the partnership interest is greater than the basis of the distributed assets, the partner is unable to defer loss without changing the character of the loss. Therefore, the partner assigns a basis to the money, inventory, and unrealized receivables equal to the partnership's basis in the distributed assets. The partner recognizes a capital loss equal to the remaining outside basis after the distributed assets have been assigned a carryover basis. If the partner's basis in the partnership interest is less than the basis of the distributed assets, the partner defers gain recognition by reducing the basis of the hot assets distributed. The required decrease is equal to the difference between the partnership's basis in the distributed assets and the partner's outside basis. The partner allocates the required decrease to assets with unrealized depreciation first to eliminate existing losses in the distributed assets. Then the partner allocates any remaining required decrease to the distributed assets in proportion to their adjusted bases.

How much flexibility do partnerships have in allocating partnership items to partners? [20]

Partnerships have a great deal of flexibility in determining how to allocate partnership items to partners, both separately-stated and non-separately stated items. The determining factors must be (1) the partners agree upon the allocations and (2) the allocations either have substantial economic effect or are in accordance with the partners' interests in the partnership. The second factor is put into place to make sure the allocations are being accomplished for a business objective and not just to reduce or avoid taxes. While both of these items need to be met for a special allocation of a partnership item, certain items have mandatory allocations to specific partners. For example, contributed property built-in gain (loss) must be allocated to the partner who contributed the property when the property is sold. Any additional gain (loss) will be allocated according to the partnership agreement. Overall, if the partnership has no mandatory allocations or does not specify and meet the requirements for special allocations, the partnership will allocate partnership income and losses according to the capital or profit and/or loss interests of each partner.

What is recourse and nonrecourse debt, and how is each generally allocated to partners? [20]

Recourse debt is debt for which partners are considered to have an economic risk of loss. Partners are legally liable for recourse debt and must satisfy this type of debt personally if the partnership cannot. An example of recourse debt is accounts payable owed by a general partnership. Nonrecourse debt is debt for which no partners are considered to have an economic risk of loss because nonrecourse debt is typically secured by real property. An example of nonrecourse debt is a mortgage on a building. In regards to a partnership's debt, recourse debt is allocated to those partners that have the ultimate responsibility of paying the debt. The debt is allocated to the partners that have an economic risk of loss. On the other hand, nonrecourse debt is generally allocated to the partners according to their profit sharing ratios. Despite the partners not being legally liable for some debt, all debt is allocated to adjust the outside basis of the partners.

What are some common separately stated items, and why must they be separately stated to the partners? [20]

Separately-stated items must be taken out of ordinary income (loss) because these items either (1) relate only to a specific partner in the partnership or (2) the item is taxed differently for each partner depending upon the entity of the partner and the partner's current tax situation. The following is a partial list of items that are separately stated on a partnership return. 1. Short-term capital gains (losses) 2. Long-term capital gains (losses) 3. Section 1231 gains (losses) 4. Charitable contributions 5. Dividends 6. Interest income 7. Guaranteed payments 8. Net earnings (losses) from self-employment 9. Tax-exempt income 10. Net rental real estate income (loss) 11. Investment interest expense 12. Section 179 deductions

Compare and contrast the aggregate and entity concepts for taxing partnerships and their partners. [20]

The aggregate concept treats partnerships more like a conglomeration of individual owners. Each partnership is viewed as an aggregation of the partners' separate interests in the assets and liabilities of the partnership. For example, each partner, rather than the partnership, pays tax on their individual share of partnership income. The entity concept treats partnerships more like a corporation. Each partnership is an entity separate from its partners. For example, the partnership decides on which tax method to use and which tax elections to make rather than the individual partners.

What hurdles (or limitations) must partners overcome before they can ultimately deduct partnership losses on their tax returns? [20]

While a partnership can create an ordinary business loss, the individual partners potentially will not be able to deduct the entire amount in the year of the loss. The partner must potentially overcome four loss limitation rules before the deduction is available. If the loss does not pass any of the limitations, then the loss is suspended indefinitely under that specific hurdle. The four loss limitations are (1) the tax basis limitation, (2) the at-risk loss limitation, (3) the passive activity loss limitation, and (4) the excess business loss limitation. First, a partner is not able to take any losses that exceed the tax basis of the partner, the partner's outside basis. This limitation prevents partners from taking losses beyond their investment or basis in their partnership interests. Second, a partner cannot take any losses that exceed the at-risk amount for the partner. The at-risk amount is generally the same as the partner's tax basis, except that it excludes the partner's share of nonrecourse debt. This limit still includes recourse debt and qualified nonrecourse debt. In the case of a passive participant in a partnership, losses cannot be taken if the loss exceeds the amount of passive income reported by the partner. Passive losses such as losses from rental activities or losses allocated to a limited partner can only be offset with passive income and gains. Finally, losses remaining after overcoming the prior three hurdles are limited to the sum of the partner's aggregate business gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a tax year is $500,000 for married taxpayers filing jointly and $250,000 for other taxpayers.

What are the basic tax-filing requirements imposed on partnerships? [20]

While a partnership does not pay taxes, the IRS still requires all partnerships to file an information return to the IRS - Form 1065 (U.S. Return of Partnership Income). This form must be filed by the 15th day of the 3rd month of the partnership's year end. For calendar year end partnerships, the form must be filed by March 15th. An extension is available to file by the due date of the original return and provides the partnership an additional six months to file Form 1065. The extension must be filed on Form 7004. The tax return that must be filed by all partnerships consists of a detailed calculation of the partnerships ordinary business income (loss) on page 1 of Form 1065. On page 3 of Form 1065, Schedule K must be filled out which lists the ordinary business income (loss) along with any separately-stated items. This schedule is an aggregate of each partner's share of items both separately-stated and non-separately stated. In addition, each partner's proportion of the above items is reported on a Schedule K-1. A Schedule K-1 for every partner must be filed with Form 1065, and each individual partner will receive her/his own Schedule K-1 from the partnership.

In what sense is the at-risk loss limitation rule more restrictive than the tax-basis loss limitation rule? [20]

While the at-risk loss limitation and tax basis loss limitation are basically the same, one difference exists between the two different hurdles a partner must overcome when faced with losses. The at-risk loss limitation only accounts for those items that the partner is at risk for. The major item that is not included under the at-risk calculation but is included in the tax basis is nonrecourse debt. As a note, qualified nonrecourse debt is still considered to be part of the partner's at-risk calculation.

Liquidating Distributions [21]

a distribution that terminates an owner's interest in the partnership/entity

Service Partner [20]

a partner who receives a partnership interest by contributing services rather than cash or property

Nonservice Partner [20]

a partner who receives a partnership interest in exchange for property rather than services

Outside Basis [20]

a partner's interest in a partnership

Limited Partnership [20]

a partnership with at least one general partner with unlimited liability for the entity's debts and atlas one limited partner with liability limited to the partner's investment in the partnership

General Partnership [20]

a partnership with partners who all have unlimited liability with respect to the liabilities of the entity

Ordinary Business Income (Loss) [20]

a partnership's remaining income or loss after separately stated items are removed

Schedule K [20]

a schedule filed with a partnership's annual tax return listing its ordinary income (loss) and it separately stated items

Limited Liability Company (LLC) [20]

a type of flow-through entity for federal tax purposes -- owners have limited liability for debts and liabilities -- generally taxed as partnerships for federal income tax purposes