chapter 10 tax part 1, chapter 9 tax part 2, chapter 9 tax

partnership

"a syndicate, group, pool, joint venture, or other unincorporated organization" that carries on a business or financial operation or venture. The IRC and Treasury Regulations define a partner simply as a member of a partner-ship.

sec 751

A current distribution that does not bring Sec. 751 into play cannot result in the recognition of a loss by either the partnership or the partner who receives the distribution. Moreover, the partnership usually recognizes no gain on a current distribution (except for Sec. 751 property, defined later in this chapter).

general partner

A general partner's share of nonrecourse liabilities also is determined primarily by his or her profit ratio. On the other hand, because limited partners seldom receive an allocated share of the recourse liabilities, the general partners share all recourse liabilities beyond any amounts the limited partners can claim according to their economic loss potential

limited liability partnership

A variation on the limited partnership is the LLLP. As discussed above, a limited partnership, in addition to having limited partners, has one or more general partners whose personal liability exposure is unlimited. The LLLP is a partnership formed under a state's limited partnership laws but that can elect under the state's laws to provide the general partners with limited liability. Thus, the LLLP is similar to an LLC and becomes potentially useful in states that do not extend LLC status to personal service firms but allow such firms to operate as an LLLP.

non-liquidating distribution

All other distributions, including those that substantially reduce a partner's interest in the partnership, are governed by this

precontribution gain recognition 2 cases cause this

Although a current distribution usually causes gain recognition only if money distributions exceed a partner's basis, a distribution also may trigger recognition of previously unrecognized precontribution gain or loss. A precontribution gain or loss is the difference between the FMV and adjusted basis of property when contributed to the partnership. Two different distribution events may trigger recognition of precontribution gain or loss 1. if a partner contributes property with a precontribution gain or loss, the con-tributing partner must recognize the precontribution gain or loss when the partnership distributes the property to any other partner within seven years of the contribution. The amount of precontribution gain or loss recognized by the contributing partner equals the amount of precontribution gain or loss remaining that would have been allocated to the contributing partner had the property instead been sold for its FMV on the distribu-tion date. The partnership's basis in the property immediately before the distribution and the contributing partner's basis in his or her partnership interest are both increased by any gain recognized or decreased by any loss recognized.

self-employment income

Every partnership must report the net earnings (or loss) for the partnership that constitute self-employment income to the partners. The instructions to Form 1065 contain a worksheet to make such a calculation. The partnership's self-employment income includes both guaranteed payments, partnership ordinary income and loss, and some separately stated items, but generally excludes capital gains and losses, Sec. 1231 gains and losses, Sec. 1245 recapture, interest, dividends, and rentals. The distributive share of self-employment income for each partner is shown on a Schedule K-1 and is included with the partner's other self-employment income in determining his or her self-employment tax liability (Schedule SE, Form 1040). The distributive share of partnership income allocable to a limited partner is not self-employment income.

LIMITATION ON EXCESS BUSINESS LOSSES

For tax years beginning after 2017 and before January 2026, the tax law imposes a limita-tion on excess business losses, applicable to noncorporate taxpayers.48 The IRC defines an excess business loss as the excess of: c The aggregate deductions for the year attributable to trades and businesses, over c The sum of aggregate gross income or gain attributable to such trades or businesses, plus $259,000 ($518,000 for married taxpayers filing jointly).

guarenteed payments

If a partner takes a guaranteed payment, that partner's after-tax cash flow will increase even though the partner's self-employment (SE) tax will increase and the qualified business income deduction (QBI) deduction will decrease. These results occur because the guaran-teed payment is included in SE income, but it is not included in qualified business income

STEP 3: ANALYZE COLUMN 5 TO DETERMINE WHETHER SEC. 751 ASSETS WERE EXCHANGED FOR NON-SEC. 751 ASSETS

If the column 5 total for the Sec. 751 assets section of Table C:10-1 is zero, no Sec. 751 exchange has occurred. The partner simply received an additional amount of one type of Sec. 751 asset in exchange for relinquishing an interest in some other type of Sec. 751 asset. For example, no Sec. 751 exchange occurs if a partner exchanges an interest in substantially appreciated inventory for an interest in unrealized receivables.

QBI formula

In general, the deduction is limited to the lesser of: (1) combined qualified business income (combined QBI) of the taxpayer, or (2) 20% of the excess of taxable income (without regard to the QBI deduction) over any net capital gain (as defined in Sec. 1(h) applicable to preferential tax rates)

limited liability partnership

Initially, professional organizations in certain fields (e.g., public accounting and law) were not permitted to operate as LLCs and therefore remained general partnerships. Subsequently, many states have added LLPs to the list of permissible business forms. The primary difference between a general partnership and an LLP is that, in an LLP, a partner is not liable for damages resulting from failures in the work of other partners or of people supervised by other partners. Under the check-the-box regulations, an LLP can be treated as a partnership or as a corporation. Like an LLC, the default tax classification of an LLP is a partnership. The same tax rules apply to an LLP that apply to a traditional partnership

limited partnership

It must have at least one general partner, who essentially has the same rights and liabilities as any general partner in a general partnership,3 and at least one limited partner

donor retained control

No mechanical test exists to determine whether the donor has retained too much control, but several factors may indicate a problem: - Retention of control over distributions of income can be a problem unless the retention occurs with the agreement of all partners or the retention is for the reasonable needs of the business. - Retention of control over assets that are essential to the partnership's business can indicate too much control by the donor. - Limitation of the donee partner's right to sell or liquidate his or her interest may indi-cate that the donor has not relinquished full control over the interest. - Retention of management control that is inconsistent with normal partnership arrangements can be another sign that the donor retains control. This situation is not considered a fatal problem unless it occurs in conjunction with a significant limit on the donee's ability to sell or liquidate his or her interest.

STEP 1: DIVIDE THE ASSETS INTO SEC. 751 ASSETS AND NON-SEC. 751 ASSETS

STEP 1: DIVIDE THE ASSETS INTO SEC. 751 ASSETS AND NON-SEC. 751 ASSETS

other partnership elections

Sec. 703(b) requires that the partnership make all elections that can affect the computation of taxable income derived from the partnership.27 The three elections reserved to the individual partners relate to income from the discharge of indebtedness, deduction and recapture of certain mining exploration expenditures, and the choice between deducting or crediting foreign income taxes. Other than these elections, the partnership makes all elections at the entity level. Accordingly, the partnership elects its overall accounting method, which can differ from the methods used by its partners. The partnership also elects its inventory and de-preciation methods

Allocations Related to Contributed Property.

Section 704(c), however, requires precontribution gains or losses to be allocated to the contributing partner. Thus, the precontribution gain of $6,000 in Example C:9-22 would be allocated to Elizabeth. In addition, income and deductions reported with respect to contributed property must be allocated to take into account the difference between the property's basis and FMV at the time of contribution.

effects of operations

Section 705 mandates a basis increase for additional contributions made by the partner to the partnership plus the partner's distributive share for the current and prior tax years of the following items: -Partnership taxable income (both separately stated items and partnership ordinary income) - Tax-exempt income of the partnership Basis is decreased (but not below zero) by distributions from the partnership to the partner plus the partner's distributive share for the current and prior tax years of the follow-ing items: -Partnership losses (both separately stated items and partnership ordinary loss) -Expenditures that are not deductible for tax purposes and that are not capital expenditures

Increases and Decreases in Liabilities.

Two changes in a partner's liabilities are considered contributions of cash by the partner to the partnership.38 The first is an increase in the partner's share of partnership liabilities. This increase can arise from either an increase in the partner's profit or loss interests or from an increase in total partnership liabilities.Accordingly, if a partnership incurs a large debt, the partners' bases in their partnership interests increase. The second way to increase a partner's basis is to have the partner assume partnership liabilities in his or her individual capacity. Conversely, two liability changes are treated as distributions of cash from the partner-ship to the partner. These changes are a decrease in a partner's share of partnership liabili-ties and a decrease in the partner's individual liabilities resulting from the partnership's assumption of the partner's liability. Often, both an increase and a decrease in a partner's basis for his or her interest can result from a single transaction. The framework below illustrates the steps used to calculate the partner's basis in his or her partnership in

sec 731

Under Sec. 731, partners who receive distributions recognize a gain if they receive money distributions that exceed their basis in the partner-ship. For distribution purposes, money includes cash, deemed cash from reductions in a partner's share of liabilities, and the fair market value (FMV) of marketable securities

partnership distibrutions

When a partnership makes current (nonliquidating) distributions, the distributions gen-erally are nontaxable to the partners because they represent the receipt of earnings that already have been taxed to the partners and that have increased the partners' bases in their partnership interests. Because they are a return of capital, these distributions reduce a partner's basis in his or her partnership interest. If a cash distribution is so large, however, that it exceeds a partner's basis in his or her partnership interest, the partner recognizes gain equal to the amount of the excess.

sale of property- gain property

When gain is recognized on the sale of a capital asset between a partnership and a related partner, Sec. 707(b)(2) requires that the gain be ordinary (and not capital gain) if the property will not be a capital asset to its new owner. Sales or exchanges resulting in the application of Sec. 707(b)(2) include transfers between (1) a partnership and a person who owns, directly or indirectly, more than 50% of the partnership's capital or profits interests, or (2) two partnerships in which the same persons own, directly or indirectly, more than 50% of the capital or profits interests. This provision prevents related parties from increasing the depreciable basis of assets (and thereby reducing future ordinary income) at the cost of recognizing only a current capital gain.

general partnership

exists any time two or more partners join together and do not specifically provide that one or more of the partners is a limited partner (as defined below). In a general partnership, each partner has the right to. participate in the management of the partnership. However, a general partnership is flexible enough to allow its business affairs to be managed by a single partner chosen by the general partners. In a general partnership, each partner has unlimited liability for all partnership debts.

liquidating distribution

is a single distribution, or one of a planned series of distributions, that terminates a partner's entire interest in the partnership.

at-risk basis

is essentially the same amount as the regular partner-ship basis with the exception that liabilities increase the at-risk basis only if the partner is at risk for such an amount. The at-risk rules apply to individuals and closely held C corpora-tions. Partners that are widely held C corporations are not subject to these rules.

nonrecourse loan

is one in which the lender may sell property used as security if the loan is not paid, but no partner is liable for any deficiency. In short, the lender has no recourse against the borrower for additional amounts. Nonrecourse debts most commonly occur in connection with the financing of real property that is expected to substantially increase in value over the life of the loan.

at-risk rules

which limit loss deductions to the partner's at-risk basis.

separately stated items

-Net short-term capital gains and losses -Net long-term capital gains and losses - Net Sec. 1231 gains and losses - Unrecaptured Sec. 1250 gains -Sec. 179 expense - Charitable contributions -Dividends and interest income - Taxes paid or accrued to a foreign country or to a U.S. possession -Tax-exempt or partially tax-exempt interest - Investment income and expenses - Any items subject to special allocations (discussed below) - Any other item provided by Treasury Regulations and tax form instructions As a general rule, an item must be separately stated if the income tax liability of any partner that would result from treating the item separately is different from the liability that would result if that item were included in partnership ordinary income

nonrecognition of gain or loss

-Section 721 governs the formation of a partnership. In most cases, a partner who contributes property in exchange for a partnership interest recognizes no gain or loss on the transaction. Likewise, the partnership recognizes no gain or loss on the contribution of property. The partner's basis for his or her partnership interest and the partnership's basis for the property are both the same as basis of the property transferred

The partner is considered at risk for his or her share of nonrecourse real estate financing if all of the following requirements are met:

-The financing is secured by real estate used in the partnership's real estate activity. -The debt is not convertible to any kind of equity interest in the partnership. - The financing is from a qualified person or from any federal, state, or local government, or is guaranteed by any federal, state, or local government. A qualified person is an unrelated party who is in the trade or business of lending money (e.g., bank, financial institution, or mortgage broker).

passive losses

. Generally, losses of an individual partner from a passive activity cannot be used to offset either active in-come or portfolio income. However, passive losses carry over to future years where they can offset passive income in those years. Moreover, passive losses are allowed in full when a taxpayer disposes of the entire interest in the passive activity. Passive losses generated by a passive rental activity in which an individual partner is an active participant can be de-ducted up to a maximum of $25,000 per year. This deduction phases out by 50% of the amount of the partner's adjusted gross income (AGI) that exceeds $100,000, so that no deduction is allowed if the partner has AGI of $150,000 or more. (The phase-out begins at $200,000 for low-income housing or rehabilitation credits.) Losses disallowed under the phase-out are deductible to the extent of passive income. A passive activity is any trade or business in which the taxpayer does not materially participate. A taxpayer who owns a limited partnership interest in any activity generally fails the material participation test. Accordingly, losses from most limited partnership interests can be used only to offset income from passive activities even if the limited partner has sufficient Sec. 704(d) and at-risk basis. Although passive activity limitations may greatly affect the taxable income or loss re-ported by a partner, they have no unusual effect on basis. Basis is reduced (but not below zero) by the partner's distributive share of losses whether or not the losses are limited under the passive loss rules.47 When the suspended passive losses later become deductible, the partner's basis in the partnership interest is not affected.

EXCHANGE OF SEC. 751 ASSETS AND OTHER PROPERTY

A current distribution receives treatment under Sec. 751 only if the partnership has Sec. 751 assets and an exchange of Sec. 751 property for non-Sec. 751 property occurs. Accordingly, if a partnership does not have both Sec. 751 property and other property, the rules discussed above for simple current distributions control the taxation of the dis-tribution. Similarly, a distribution that is proportionate to all partners or (1) consists of only the partner's share of either Sec. 751 property or non-Sec. 751 property and (2) does not reduce the partner's interest in other property is not affected by the Sec. 751 rules. However, any portion of the distribution that represents an exchange of Sec. 751 prop-KEY POINT Steps 2 and 3 try to identify whether a disproportionate dis-tribution of Sec. 751 assets has taken place. In Table C:10-1, if the column 5 total for Sec. 751 assets is zero, Sec. 751 is not applicable. But as the table illustrates, Anne received $10,000 more than her share of the partnership cash without receiving any of her $10,000 share of Sec. 751 assets. erty for non-Sec. 751 property must be isolated and is not treated as a distribution at all. Instead, it is treated as a sale between the partnership and the partner, and any gain or loss realized on the sale transaction is fully recognized.10 The character of the recognized gain or loss depends on the character of the property deemed sold. For the party deemed the seller of the Sec. 751 assets, the gain or loss is ordinary income or loss. Analyzing the transaction to determine what property was involved in the Sec. 751 transaction is best accomplished by using an orderly, step-by-step approach

limited partner

A limited partner normally is not liable to pay partnership debts beyond the original contribution (which already is reflected in his or her basis in the partnership interest) and any additional amount the partner has pledged to contribute.

guaranteed payment

A partner who provides services to the partnership in an ongoing relationship might be compensated like any other employee. Section 707(c) provides for this kind of payment and labels it a guaranteed payment. The term guaranteed payment also includes certain payments made to a partner for the use of invested capital. These payments are similar to interest. Both types of guaranteed payments must be determined without regard to the partnership's income.

partner's basis

A partner's basis in his or her partnership interest is a crucial element in partnership taxa-tion. When a partner makes a contribution to a partnership or purchases a partnership interest, he or she establishes a beginning basis. Because partners can be personally liable for partnership debts, a partner's basis in his or her partnership interest is increased by his or her share of any partnership liabilities. Accordingly, the partner's basis fluctuates as the partnership borrows and repays loans or increases and decreases its accounts payable.

basis for partnership interest - beginning basis

A partner's beginning basis for a partnership interest received for a contribution of property or services has been discussed. However, a partner also can acquire a partner-ship interest by methods other than contributing property or services to the partner-ship. If a person purchases the partnership interest from an existing partner, the new partner's basis is the price paid for the partnership interest, including assumption of partnership liabilities. If a person inherits the partnership interest, the heir's basis is the FMV of the partnership interest on the decedent's date of death or, if elected by the executor, the alternate valuation date but not less than liabilities assumed. If a person receives the partnership interest as a gift, the donee's basis generally equals the donor's basis (including the donor's ratable share of partnership liabilities) plus the portion of any gift tax paid by the donor that relates to appreciation attaching to the gift property. In summary, the usual rules for the method of acquisition dictate the beginning basis for a partnership interest.

Section 444 Election and Required Payments

A partnership can elect to use a tax year other than a required year by filing an election under Sec. 444. This election is made by filing Form 8716 (Election to Have a Tax Year Other Than a Required Tax Year) by the earlier of the fifteenth day of the fifth month following the month that includes the first day of the tax year for which the election is effective or the due date (without regard to extension) of the income tax return resulting from the Sec. 444 election. In addition, a copy of Form 8716 must be attached to the partnership's Form 1065 for the first tax year for which the Sec. 444 election is made. A partnership making a Sec. 444 election must make a required payment annually under Sec. 7519. The required payment has the effect of remitting a deposit equal to the tax (at the highest individual tax rate plus one percentage point) on the partnership's de-ferred income. A partnership can obtain a refund if past payments exceed the tentative payment due on the deferred income for the current year. Similar refunds are available if the partner-ship terminates a Sec. 444 election or liquidates. The required payments are not deduct-ible by the partnership and are not passed through to a partner. The required payments are in the nature of a refundable deposit. The Sec. 7519 required payment is due on or before May 15 of the calendar year fol-lowing the calendar year in which the election year begins. The partnership remits the required payment with Form 8752 (Required Payment or Refund Under Section 7519) along with a computational worksheet, which is illustrated in the instructions to Form 1065. Refunds of excess required payments also are obtained by filing Form 8752.

Partnership Ordinary Income

All taxable items of income, gain, loss, or deduction that do not have to be separately stated are combined into a total called partnership ordinary income or loss. This ordi-nary income amount sometimes is incorrectly referred to as partnership taxable income. Partnership taxable income is the sum of all taxable items among the separately stated items plus the partnership ordinary income or loss. Therefore, partnership taxable income often is substantially greater than partnership ordinary income.

schedule M3

A partnership must file Schedule M-3 in lieu of Schedule M-1 if any one of the following conditions holds: - The amount of total assets reported in Schedule L of Form 1065 (Balance Sheet per Books) equals or exceeds $10 million. -The amount of adjusted total assets equals or exceeds $10 million, where adjusted total assets equal the Schedule L amount plus the following items that appear in Schedule M-2 of Form 1065: (1) capital distributions made during the year, (2) net book loss for the year, and (3) other adjustments. - Total receipts equal or exceed $35 million. - A reportable entity partner owns at least a 50% interest in the partnership on any day of the tax year, where a reportable entity partner is one that had to file its own Schedule M-3.

PARTNER'S DISTRIBUTIVE SHARE

Once the partnership determines separately stated income, gain, loss, deduction, or credit items, and partnership ordinary income or loss, the partnership must allocate the totals among the partners. Each partner must report and pay taxes on his or her distributive share. Under Sec. 704(b), the partner's distributive share normally is determined by the terms of the partnership agreement or, if the partnership agreement is silent, by the part-ner's overall interest in the partnership as determined by taking into account all facts and circumstances. Note that the term distributive share is misleading because it has nothing to do with the amount actually distributed to a partner. A partner's distributive share is the portion of partnership taxable and nontaxable income that the partner has agreed to report for tax purposes. Actual distributions in a given year may be more or less than the partner's distributive share.

sec 737

Second, under Sec. 737, property distributions to a partner may cause the partner to recognize his or her remaining precontribution gain if the FMV of the distributed prop-erty exceeds the partner's basis in his or her partnership interest before the distribution. The gain recognized under Sec. 737 is the lesser of the remaining precontribution net gain or the excess of the FMV of the distributed property over the adjusted basis of the partnership interest immediately before the property distribution (but after reduction for any money distributed at the same time)

section 444

Section 444 provides an election that permits a partnership to use a year-end that results in a deferral of the lesser of the current deferral period or three months. The de-ferral period is the time from the beginning of the partnership's fiscal year to the close of the first required tax year ending within such year (i.e., usually December 31). The Sec. 444 election is available to both new partnerships making an initial tax year election or existing partnerships that are changing tax years. A partnership that satisfies the Sec. 706 requirements described above or has established a business purpose for its choice of a year-end (i.e., natural business year) does not need a Sec. 444 election.

sec 751 asset defined

Section 751 assets include unrealized receivables and inventory. These two categories en-compass all property likely to produce ordinary income when sold or collected. Each of these categories must be carefully defined before further discussion of Sec. 751

STEP 5: DETERMINE THE IMPACT OF THE CURRENT DISTRIBUTION.

The last step in analyzing the distribution's effect on the partner is to determine the impact of the portion of the distribution that is not a Sec. 751 exchange. This distribution is treated exactly like any other nonliquidating distribution

irs audit procedures

For partnership years beginning after 2017, a partner must treat an item in his or her tax return in a manner that is consistent with the way the item is treated at the partnership level. Any adjustment to items of income, gain, loss, deduction, or credit of a partnership will be determined, assessed, and collected at the partnership level. Each partnership must designate a partner or other person as the partnership representative. This person will have the sole authority to act on behalf of the partnership, and the partnership and partners will be bound by the actions of the designated representative. Partnerships with 100 or fewer partners may elect out of these procedures if the partnership follows certain procedures and notifies the partners that it made such an election.

partnership taxable income

Although the partnership is not a taxable entity, the IRC requires that the partnership calculate partnership taxable income for various computational reasons, such as adjusting the partners' basis in their partnership interests. Partnership taxable income for partner-ships that are not electing large partnerships is calculated in much the same way as the taxable income of individuals, with a few differences mandated by the IRC. First, taxable income is divided into separately stated items and ordinary income or loss. Section 703(a) specifies a list of deductions available to individuals but that cannot be claimed by a partnership. The forbidden deductions include income taxes paid or accrued to a foreign country or U.S. possession, charitable contributions, oil and gas depletion, and net oper-ating loss (NOL) carryovers. The first three items must be separately stated and may or may not be deductible by the partner. Because all losses are allocated to the partners for deduction on their tax returns, the partnership itself never has an NOL carryover. Instead, a partner may have an NOL if his or her deductible share of partnership losses exceeds his or her other business income. These NOLs are used at the partner level without any further regard for the partnership entity.

capital ownership

Because each partner reports and pays taxes on a distributive share of partnership in-come, a family partnership is an excellent way to spread income among family members and minimize the family's tax bill. However, to accomplish this tax minimization goal, the IRS must accept the family members as real partners. The question of whether someone is a partner in a family partnership is often litigated, but safe-harbor rules under Sec. 704(e) provide a clear answer if three tests are met: the partnership interest must be a capital interest, capital must be a material income-producing factor in the partnership's business activity, and the family member must be the true owner of the interest. A capital interest gives the partner the right to receive assets if the partnership liq-uidates immediately upon the partner's acquisition of the interest. Capital is a material income-producing factor if the partnership derives substantial portions of gross income from the use of capital. For example, capital is a material income-producing factor if the business has substantial inventory or significant investment in plant or equipment. Capital is seldom considered a material income-producing factor in a service business.

Loss Limitation Pertaining to Outside Basis

Each partner is allocated his or her distributive share of ordinary income or loss and separately stated income, gain, loss, or deduction items each year. The partner always reports income and gain items in his or her current tax year, and these items increase the partner's basis in the partnership interest. However, the partner may not be able to use his or her full distributive share of losses because Sec. 704(d) limits a partner's loss deduction to the amount of his or her basis in the partnership interest (outside basis) before the loss. All positive basis adjustments for the year and all reductions for actual or deemed distributions must be made before determining the amount of the deductible loss.

qualified business income deduction

For tax years beginning after 2017, the tax law allows a deduction for a percentage of qualified business income (sometimes referred to as the "pass-through deduction"). The deduction reduces taxable income (instead of adjusted gross income), but taxpayers can take the deduction regardless of whether they claim the standard deduction or itemized deductions. The deduction pertains to the taxpayer's qualified business income from a partnership, S corporation, or sole proprietorship, as well as to a percentage of the taxpayer's qualified REIT and publicly traded partnership income. The purpose of the deduction is to bring the tax rates on these types of businesses somewhat in line with the tax rate applicable to corporations. In general, the deduction is limited to the lesser of: (1) combined qualified business income (combined QBI) of the taxpayer, or (2) 20% of the excess of taxable income (without regard to the QBI deduction) over any net capital gain (as defined in Sec. 1(h) applicable to preferential tax rates). Qualified business income (QBI) is defined as the net amount of items of income, gain, deduction, and loss effectively connected to a U.S trade or business, plus 20% of qualified REIT dividends and 20% of qualified publicly traded partnership income. Excluded from this definition are investment-related items such as capital gains and losses, dividends, and interest income, as well as any employee compen-sation and guaranteed payments that the taxpayer receives from the entity

Limitation on Net Business Interest.

For tax years beginning after 2017, the tax law limits the deductibility of business interest in a given year to the sum of the following amounts: -Business interest income -30% of adjusted taxable income (but not less than zero) -Floor plan financing interest for vehicles Adjusted taxable income for this purpose means taxable income computed without regard to: - Income, gain, deduction, or loss not allocable to a trade or business - Business interest or business interest income (i.e., amounts allocable to a trade or business) -Any NOL (carryover) deduction -The qualified business income deduction - For years beginning before January 1, 2022, any deduction allowable for depreciation, amortization, or depletion - Any other adjustments provided by the Treasury Department

special loss limitations

Four sets of rules limit the loss from a partnership interest that a partner may deduct. The Sec. 704(d) rules explained above limit losses to the partner's basis in the partnership interest. Three other rules establish more stringent limits. The at-risk rules limit losses to an amount called at-risk basis; the passive activity loss or credit limitation rules disallow most net passive activity losses; and the limitation on excess business losses applies if ag-gregate deductions exceed certain thresholds.

varying interest rule

If a partner's ownership interest changes during the partnership tax year, the income or loss allocation takes into account the partner's varying interest.32 This varying interest rule applies for changes occurring to a partner's interest as a result of buying an additional interest in the partnership, selling part (but not all) of a partnership interest, giving or being given a partnership interest, or admitting a new partner. Treasury Regulations prescribe two basic methods for applying the varying interest rule: (1) the interim closing method, whereby the partnership closes its books at the time of the variation and allocates items accordingly or (2) an elective proration method, whereby the partnership prorates items on either a calendar day, semi-monthly, or monthly convention.33

estimated taxes

If the partnership is not an electing large partnership, it pays no income taxes and makes no estimated tax payments. However, the partners must make estimated tax payments based on their separate tax positions including their distributive shares of partnership income or loss for the current year. Thus, the partners are not making separate estimated tax payments for their partnership income but rather are including the effects of the partnership's results in the calculation of their normal estimated tax payments.

combined QBI

In general, the deduction is limited to the lesser of: (1) combined qualified business income (combined QBI) of the taxpayer, or (2) 20% of the excess of taxable income (without regard to the QBI deduction) over any net capital gain (as defined in Sec. 1(h) applicable to preferential tax rates)

basis effects of distributions

In general, the partner's basis for property distributed by the partnership carries over from the partnership. The partner's basis in the partnership interest is reduced by the amount of money received and by the partner's basis in the distributed property

inventory

Inventory is equally surprising in its breadth. Inventory for purposes of Sec. 751 includes three major types of property: 1. Items held for sale in the normal course of partnership business 2. Any other property that, if sold by the partnership, would not be considered a capital asset or Sec. 1231 property 3. Any other property held by the partnership that, if held by the selling or distributee partner, would be property of the two types listed above In short, cash, capital assets, and Sec. 1231 assets are the only properties that are not inventory. For purposes of calculating the impact of Sec. 751 on distributions, inventory is consid-ered a Sec. 751 asset only if the inventory is substantially appreciated. (This substantially appreciated rule does not apply to sales of partnership interests, discussed later in this chap-ter.) The test to determine whether inventory is substantially appreciated (and therefore fall-ing under Sec. 751) is purely mechanical. Inventory is substantially appreciated if its FMV exceeds 120% of its adjusted basis to the partnership. For purposes of testing whether the inventory is substantially appreciated (but only for that purpose), inventory also includes unrealized receivables. The inclusion of unrealized receivables in the definition of inventory increases the likelihood that the inventory will be substantially appreciated.

tax impact of guaranteed payment

Like salary or interest income, guaranteed payments are ordinary income to the recipient. The guaranteed payment must be included in income for the recipient partner's tax year during which the partnership year ends and the partnership deducts or capitalizes the payments.

determining the guaranteed payment

Sometimes the determination of the guaranteed payment is quite simple. For example, some guaranteed payments are expressed as specific amounts (e.g., $20,000 per year), with the partner also receiving his or her normal distributive share. In this case, the partnership deducts the guaranteed payment in arriving at partnership ordinary income and then allocates the resulting ordinary income based on the partners' profit sharing percentages. Other times, the guaranteed payment is expressed as a guaranteed minimum. However, these guaranteed minimum arrangements make it difficult to distinguish the partner's distributive share and guaranteed payments because no guaranteed payment occurs under this arrangement unless the partner's distributive share is less than his or her guaranteed minimum. If the distributive share is less than the guaranteed minimum, the guaranteed payment is the difference between the distributive share and the guaranteed minimum.

SPECIAL ALLOCATIONS

Special allocations are unique to partnerships (and LLCs treated as partnerships). They allow tremendous flexibility in sharing specific items of income and loss among the part-ners. Special allocations can provide a specified partner with more or less of an item of income, gain, loss, or deduction than would be available using the partner's regular dis-tributive share. Special allocations fall into two categories. First, Sec. 704 requires certain special allocations with respect to contributed property. Second, other special allocations are allowed as long as they meet the tests set forth in Treasury Regulations for having sub-stantial economic effect. If the special allocation fails the substantial economic effect test, it is disregarded, and the income, gain, loss, or deduction is allocated according to the partner's interest in the partnership as expressed in the actual operations and activities.

PASSIVE ACTIVITY LIMITATIONS

Subsequent to enacting the at-risk rules, Congress added still a third set of limitations to losses a partner may deduct: the passive activity loss and credit limitations of Sec. 469. Under these rules, income falls into one of three categories: (1) amounts derived from passive activities; (2) active income such as salary, bonuses, and income from businesses in which the taxpayer materially participates; and (3) portfolio income such as dividends, interest, and capital gains from investments other than passive activities.

costs of organizing

The costs of organizing a partnership are capital expenditures. However, under Sec. 709, the partnership can elect to deduct the first $5,000 of these expenditures in the tax year it begins business. As a limit, the partnership must reduce the $5,000 by the amount by which cumulative organizational expenditures exceed $50,000, although the $5,000 can-not be reduced below zero. The partnership can amortize the remaining organizational expenditures over an 180-month period beginning in the month it begins business. A partnership is deemed to have made the Sec. 709 election for the tax year the partnership begins business.23 If the partnership chooses to forgo the deemed election, it can elect to capitalize the expenditures (without amortization) on a timely filed tax return for the tax year the partnership begins business. Either election, to amortize or capitalize, is irrevocable and applies to all organizational expenditures of the partnership.

partnership tax year

The partnership's selection of a tax year is critical because it determines when each partner reports his or her share of partnership income or loss. Under Sec. 706(a), each partner's tax return includes his or her share of partnership income, gain, loss, deduction, or credit items for any taxable year of the partnership ending within or with the partner's tax year.

TIMING OF LOSS RECOGNITION

The loss limitation rules provide a unique opportunity for tax planning. For example, if a partner knows that his or her distributive share of active losses from a partnership for a tax year will exceed the Sec. 704 basis limitation for deducting losses, he or she should carefully examine the tax situation for the current and upcoming tax years. Substantial current personal income may make immediate use of the loss desirable. Current income may be taxed at a higher marginal tax rate than will future income because of, for exam-ple, an extraordinarily good current year, an expected retirement, or a decrease in future years' tax rates. If the partner chooses to use the loss in the current year, he or she can make additional contributions just before year-end (perhaps even from funds the partner borrows, as long as the additional benefit exceeds the cost of the funds). Alternatively, one partner may convince the other partners to have the partnership incur additional li-abilities so that each partner's basis increases. This last strategy should be exercised with caution unless a business reason (rather than solely a tax reason) exists for the borrowing

TRANSACTIONS BETWEEN A PARTNER AND THE PARTNERSHIP

The partner and the partnership are treated as separate entities for many transactions. Section 707(b) restricts sales of property between the partner and partnership by disal-lowing certain losses and converting certain capital gains into ordinary income. Section 707(c) permits a partnership to make guaranteed payments for capital and services to a partner that are separate from the partner's distributive share. Each of these rules is ex-plored below.

HOLDING PERIOD AND CHARACTER OF DISTRIBUTED PROPERTY

The partner's holding period for property distributed as a current distribution includes the partnership's holding period for such property. The length of time the partner owns the partnership interest is irrelevant when determining the holding period for the distributed prop-erty. Thus, if a new partner receives a distribution of property the partnership held for two years before he or she became a partner, the new partner's holding period for the distributed property is deemed to begin when the partnership purchased the property (i.e., two years ago) rather than on the more recent date when the partner purchases the partnership interest.

partnership agreement

The partnership agreement may describe a partner's distributive share by indicating the partner's profits and loss interest, or it may indicate separate profits and loss interests. For example, the partnership agreement may state that a partner has a 10% interest in both partnership profits and losses or a partner has only a 10% interest in partnership profits (i.e., profits interest) but has a 30% interest in partnership losses (i.e., loss interest). If the partnership agreement states only one interest percentage, it is used to allo-cate both partnership profit and loss. If the partnership agreement states profit and loss percentages separately, the partnership's taxable income for the year is first totaled to determine whether a net profit or net loss has occurred. Then the appropriate percentage (either profit or loss) applies to each class of income for the year.

REPORTING TO THE IRS AND THE PARTNERS

The partnership must file a Form 1065 (U.S. Return of Partnership Income) with the IRS by the fifteenth day of the third month after the end of the partnership tax year. (See Appendix B for a completed Form 1065.) The IRS, however, allows an automatic six-month extension of time to file Form 1065. To obtain the extension, the partnership must file Form 7004 (Application for Automatic Extension of Time to File Certain Business Income Tax, Information, and Other Returns) on or before the partnership's normal filing date.59 The IRS imposes penalties for failure to file a timely or complete partnership return. Because the partnership is only a conduit, Form 1065 is an information return and is not accompanied by any tax payment.60 Included on the front page of Form 1065 are the ordinary items of income, gain, loss, and deduction that are not separately stated. Schedule K of Form 1065 reports both a summary of the ordinary income items and all the partnership's separately stated items. Schedule K-1, which the partnership must prepare for each partner, reflects a particular partner's distributive share of partnership ordinary income or loss, separately state items, and his or her special allocations. The partner's Schedule K-1 is notification of his or her share of partnership items for use in calculating income taxes and self-employment taxes.

706 restrictions

The partnership must use the same tax year as the one or more majority partners who have an aggregate interest in partnership profits and capital exceeding 50%. This rule must be used only if these majority partners have a common tax year and have had this tax year for the shorter of the three preceding years or the partnership's period of existence. If the tax year of the partner(s) owning a majority interest cannot be used, the partnership must use the tax year of all its principal partners (or the tax year to which all of its principal partners are concurrently changing). A principal partner is defined as one who owns a 5% or more interest in capital or profits. If the principal partners do not have a common tax year, the partnership must use the tax year that allows the least aggregate deferral. The least aggregate deferral test provided in Treasury Regulations25 requires that, for each possible tax year-end, each partner's ownership percentage be multiplied by the number of months the partner would defer income (number of months from partnership year-end to partner year-end). The number arrived at for each partner is totaled across all partners. The same procedure is followed for each alternative tax year, and the partnership must use the tax year that produces the smallest total.

partnership profits and losses

The partnership, however, must file Form 1065 (U.S. Partnership Return of Income), an infor-mation return that provides the IRS with information about partnership earnings as well as how the earnings are allocated among the partners. The partnership must elect a tax year and accounting methods to calculate its earnings. (Appendix B includes a completed partnership tax return that shows a Form 1065 and Schedule K-1 for a partner along with a set of supporting facts. Each partner receives a Schedule K-1 from the partnership, which informs the part-ner of the amount and character of his or her share of partnership items. The partner then combines his or her partnership earnings and losses with all other items of income or loss for the tax year, computes the amount of taxable income, and calculates the tax liability. Partnership income is taxed at the applicable tax rate for its partners, which can range from 10% to 37% (in 2020) for partners who are individuals, trusts, or es-tates. Corporate partners pay tax on partnership income at a 21% tax rate. One of the major advantages of the partnership form of doing business is that partner-ship losses are allocated among the partners. If the loss limitation rules (explained later in this chapter) do not apply, these losses offset the partners' other income, resulting in immediate tax savings for the partners. The immediate tax saving available to the partner contrasts sharply with the net operating loss (NOL) carryforwards that may result from a C corporation's operations. Another major advantage is that the partners may be eligible for the qualified business income deduction (discussed later in this chapter).

STEP 2: DEVELOP A SCHEDULE, SUCH AS THE ONE IN TABLE C:10-1, TO DETERMINE WHETHER THE PARTNER EXCHANGED SEC. 751 ASSETS FOR NON-SEC. 751 ASSETS OR VICE VERSA.

This schedule must be based on the FMV of all the partnership's assets. To make the determination, compare the partner's interest in the partnership's assets before the distribution with his or her interest in the assets after the distribution. This part of the analysis assumes a hypothetical nontaxable pro rata distribution equal to the partner's decreased interest in the assets. We can see whether the partner exchanged Sec. 751 assets for non-Sec. 751 assets by comparing the hypothetical distribution with the actual distribution. 1. Column 1 represents the partner's interest (valued at FMV) in each asset before the distribution. 2. Column 2 represents the partner's interest (valued at FMV) in each asset after the distribution. 3. Column 3 shows a hypothetical proportionate distribution that would have occurred had the partner's ownership interest been reduced by the partner taking a pro rata share of each asset. (As such, the proportionate distribution would be nontaxable.) 4. Column 4 shows the amounts actually distributed. 5. Column 5 shows the difference between the hypothetical and actual distributions. This column indicates whether a Sec. 751 exchange has occurred (see Step 3).

Substantial Economic Effect

To distinguish transactions affecting only taxes from those affecting the partner's eco-nomic position, Treasury Regulations look at whether the allocation has an economic effect and whether the economic effect is substantial. Under the Sec. 704 regulations, the allocation has economic effect if it meets all three of the following conditions: -The allocation results in the appropriate increase or decrease in the partner's capital account. -The proceeds of any liquidation occurring at any time in the partnership's life cycle are distributed in accordance with positive capital account balances. -Partners must make up negative balances in their capital accounts upon the liquidation of the partnership, and these contributions are used to pay partnership debts or are allocated to partners having positive capital account balances.

STEP 4: DETERMINE THE GAIN OR LOSS ON THE SEC. 751 DEEMED SALE

We must assume that the exchange occurring in Step 3 above was a sale of the exchanged prop-erty between the partnership and the partner. This step follows logically from the premise that the partner "bargained" to receive the amounts actually distributed rather than a pro-portionate distribution. She sold her interest in some assets to receive more than her pro-portionate interest in other assets. As with any sale, the gain (or loss) equals the difference between the FMV of the property received and the adjusted basis of the property given up. Note that, up to this point, we have been dealing only in terms of the FMV, so the adjusted basis of property given up must be determined as if the hypothetical distribution actually had occurred.

Minor Donees

When income splitting is the goal of a family, the appropriate donee for the partnership interest is often a minor. With the problem of donor-retained controls in mind, gifts to minors should be made with great attention to detail. Further, net unearned income of a child under age 18 is taxed to the child under the "kiddie tax" rules using special rates based on the estate and trust income tax rates. This provision removes much of the incentive to transfer family partnership interests to young children, but gifting partnership interests to minors age 18 or older still can reap significant tax advantages, although in some situations the kiddie tax also applies to children ages 18 through 23

limited liability company

With the advent of LLCs, businesses have the opportunity to be treated as a partnership for tax purposes while having limited liability protection for every owner. State law provides this limited liability. Unique tax rules for LLCs have not been developed. Instead, the check-the-box regulations (discussed in Chapter C:2) permit each LLC to choose whether to be treated as a partnership or taxed as a corporation. If an LLC is considered a partnership for tax purposes, the same tax rules apply to the LLC that apply to a traditional partnership. Chapter C:10 further discusses the tax treatment of LLCs.

sales of property-loss property

Without restrictions, a controlling partner could sell property to the partnership to recognize a loss for tax purposes while retaining a substantial interest in the property through ownership of a partnership interest. Congress closed the door to such loss recognition with the Sec. 707(b) rules. The rules for partnership loss transactions are quite similar to the Sec. 267 related party rules discussed in Chapter C:3. Under Sec. 707(b)(1), no loss can be deducted on the sale or exchange of property between a partnership and a person who directly or indirectly owns more than 50% of the partnership's capital or profits interests. Indirect ownership includes ownership by related parties such as members of the partner's family.49 Similarly, losses are disallowed on sales or exchanges of property between two partnerships in which the same persons own, directly or indirectly, more than 50% of the capital or profits interests. If the seller is disallowed a loss under Sec. 707(b)(1), the purchaser can reduce any subsequent gain realized on a sale of the property by the previ-ously disallowed loss.

unrealized receivables

includes a much broader spectrum of property than the name implies. Unrealized receivables are certain rights to payments to be received by a partnership to the extent they are not already included in income under the partnership's accounting methods. They include rights to payments for services performed or to be performed as well as rights to payment for goods delivered or to be delivered (other than capital assets). A common example of unrealized receivables is the accounts receivable of a cash method partnership. In addition to rights to receive payments for goods and services, the term unrealized receivables includes most potential ordinary income recapture items. A primary example of this type of unrealized receivable is the potential Sec. 1245 or 1250 recapture on the partner-ship's depreciable property, which is the amount of depreciation that would be recaptured as ordinary income under Sec. 1245 or 1250 if the partnership sold property at its FMV The definition of unrealized receivables is not limited to Sec. 1245 and 1250 deprecia-tion recapture. Among the other recapture provisions creating unrealized receivables are Sec. 617(d) (mining property), Sec. 1252 (farmland), and Sec. 1254 (oil, gas, and geo-thermal property). Assets covered by Sec. 1278 (market discount bonds) and Sec. 1283 (short-term obligations) generate unrealized receivables to the extent the partnership would recognize ordinary income if it sold the asset. This type of unrealized receivable is deemed to have a zero basis.

recourse loan

is the usual kind of loan for which the borrower remains liable until the loan is paid. If the recourse loan is secured and the borrower fails to make payments as scheduled, the lender can sell the property used as security. If the sales proceeds are insufficient to repay a recourse loan, the borrower must make up the difference. Under Treasury Regulations, a recourse loan is one for which any partner or a related party will bear an economic loss if the partnership cannot pay the debt.

exceptions to tax year

the partnership has a business purpose for using some tax year other than the year prescribed by these rules, the IRS may approve use of another tax year. Revenue Procedure 2002-3926 states that an acceptable business purpose for using a different tax year is to end the partnership's tax year at the end of the partnership's natural business year. This revenue procedure explains that a business having a peak period and a nonpeak period completes its natural business year at the end of its peak season (or shortly thereafter). For example, a ski lodge has a natural business year that ends in early spring. Partnerships that do not have a peak period cannot use the natural business year exception

The second requirement for a special allocation

to be accepted under Treasury Regulations is that the economic effect must be substantial, which requires that a reason-able possibility exists that the allocation will substantially affect the dollar amounts to be received by the partners independent of tax consequences.36 Moreover, allocations that involve shifting of tax benefits will not pass the substantiality test. Shifting occurs when the following two conditions are present: -The net change in the partner's capital accounts will be the same for a normal allocation and the special allocation. -The total tax liability of the partners will be less with the special allocation than with a normal allocation.