Chapter 21: Partnerships

Partnership Allocation

Partnership agreement can provide that a partner share capital, profits, and losses in different ratios

Substantiality

Partnership allocations must also have "substantial" effect; It has to have a real economical consequence

Liquidating Distribution

Partnership itself liquidates and distributes all its property to the partners, or ongoing partnership redeems interest of one of its partners

Loss Limitations

Partnership losses flow through to partners for use on their tax returns; Only losses that make it through all 3 limits are deductible by a partner

Permitted Taxable Year (Concept Summary 21.2)

Partnership must adopt tax year under first of the following tests that applies: (1) Required taxable year (2) Natural business year (3) 444 taxable yar (4) 52-53 week year

Inside Basis (inside partnership; asset)

Refers to the partnership's adjusted basis for each asset it owns; Each partner "owns" a share of the partnership's inside basis for all of its assets

Outside Basis (outside partnership; interest)

Represents each partner's basis in the partnership interest; All partners should maintain a record of their respective outside bases

Election Out of Subchapter K

Some entities can elect to be excluded from partnership treatment if organized for certain activities; Owners simply report their share of operations on their own tax return; Such elections are not common

Guaranteed Payment

Specifically a payment from the partnership to the partner Under two reasons: (1) partner performs a service for the partnership and (2) the partnership is paying the partner for their use of capital

Measuring Income of Partnership

Step 1: Net ordinary income and expenses related to the trade or business of the partnership Step 2: Segregate and report separately some partnership items

Partnership Taxation

Step 1: Net ordinary income and expenses related to the trade or business of the partnership Step 2: Segregate and report separately some partnership items (if an item of income, expense, gain, or loss might affect any 2 partners' tax liabilities differently, it is separately stated; ie: charitable contributions)

Recourse Debt

The partnership or at least one partner is personally liable; Allocate to partners using a "constructive liquidation scenario"

A partner's basis in partnership interest is adjusted to reflect partnership activity:

This prevents double taxation of partnership income

Partnership Formation

Usually, no gain or loss is recognized by a partner or partnership on the contribution of money or property in exchange for a partnership interest; Gain (loss) is deferred until taxable disposition of: property by partnership, or partnership interest by partner

Nonrecourse Debt Allocation

**Skip Step 1** Step 2: Liability = precontribution gain allocated to contributing partner (704c allocation; when debt is in excess of basis; allocated to the partner who contributed) Step 3: Remaining debt commonly allocated by profit sharing ratios

Holding Period

- Equals basis of contributed property - If partner contributes capital assets and 1231 assets, holding period of partnership interest includes holding period of assets contributed - For other assets including cash, holding period begins on date partnership interest is acquired - If multiple assets are contributed, partnership interest is apportioned and separate holding period applies to each portion

Break-Down of Partnerships:

- Formation - Operations - Routine distributions: either cash or property (non-liquidating) - Liquidating distributions (end of p-ship) - Sale of P-ship interest

Effect of Hot Assets

- Hot assets include: Unrealized receivables and Inventory (which includes partnerships property except money, capital assets, and 1231 assets) - Must allocate sales price of partnership interest between "hot" (ordinary income) assets and "nonhot" (capital gain) components - Selling partner's gain is classified as a capital gain or loss portion and an ordinary income or loss amount related to the hot assets

For existing partnerships, basis depends on how interest was acquired:

- If purchased from another partner, basis = amount paid for the interest - If acquired by gift, basis = donor's basis plus, in certain cases, a portion of the gift tax paid on the transfer - If acquired through inheritance, basis = FMV on date of death

Partnership Liabilities

- Increase in partner's share of liabilities: Treated as a cash contribution to the partnership Increase partner's adjusted basis - Decrease in partner's share of liabilities: Treated as a cash distribution to the partner Decreases partner's adjusted basis

Other transaction between partner and partnership:

- Loan transactions - Rental payments - Sales of property

Examples of Separately Stated Items

- Net short and long-term capital gains and losses, - 1231 gains and losses, - DPAD, - Charitable contributions, - Interest income and other portfolio income, - Expenses related to portfolio income, - Personalty expensed under 179, - Special allocations of income or expense, - AMT preference and adjustment items, - Passive activity items, - Self-Employment income, and - Foreign taxes paid

Effect of Liquidating Distribution

- No gain or loss is recognized by partnership - Partner reduces basis in partnership interest by basis in property received at each level using Ordering Rules - Partner's entire basis in interest will be absorbed by distributed assets

Exchange for Services

- Receipt of fully vested partnership interest in exchange for services rendered to partnership receipt of the partnership interest is generally taxable to the partner - Partnership may deduct the amount included in the service partner's income if the services are of a deductible nature (if the service are not deductible, they must be capitalized to an asset account)

For Tax Purposes, includes:

- Syndicate - Group - Pool - Joint venture, etc.

Ordering Rules

When the inside basis of distributed assets exceeds the distributed partner's outside basis, assets are deemed distributed in the following order: 1) Cash 2) Unrealized receivables and inventory 3) All other assets ** Basis is allocated to assets within a category based on adjusted basis to partnership

Nonliquidating Distribution

A nonliquidating distribution is any distribution from a continuing partnership to a continuing partner Two types of distributions: (1) Draw - distribution of partner's share of current or accumulated profits (2) Partial liquidation - reduces partner's interest in partnership capital but does not liquidate partner's interest

Partners as Employees

A partner usually does not qualify as an employee for tax purposes resulting in the following tax consequences: - A partner receiving guaranteed payments from the partnership is not subject to tax withholding - The partnership cannot deducted payments for a partner's fringe benefits - A general partner's distributive share of ordinary partnership income and guaranteed payments for services are generally subject to the Federal self-employment tax

Basis Limitation

A partner's basis in the partnership interest can NEVER be negative

Distributions from a Partnership

A payment from a partnership to a partner is not necessarily treated as a distribution; A partner may pay interest or rent to a partner, make a guaranteed payment, or purchase property from a partner

"Check-the-Box" Regs

Allows most incorporated entities to select their federal tax status; If 2 or more owners, can choose to be treated as a partnership or a corporation; Permits some flexibility (not all entities have a choice)

Limited Liability Partnership (LLP; very popular)

An LLP partner is not personally liable for malpractice committed by other partners; Popular organizational form for large accounting firms

Partnership Definition

An association of two or more persons to carry on a trade or business; Contribute money, property, labor; Expect to share in profit and losses

Limited Liability Limited Partnership (LLLP)

An extension of the limited partnership form; All partners, whether general or limited, are accorded limited liability

LLC Partnership (don't focus on as much)

Combines the corporate benefit of limited liability with benefits of partnership taxation (income is subject to tax only once and special allocations are available); Owners are "member," not partners, but if properly structured will receive partnership tax treatment

New publicly traded partnerships must be taxed as...

Corporations.

Aggregate Concept

Each partner owns a specific share of each item of partnership income, gain, loss, or deduction; Character is determined at partnership level; Taxation is determined at partner level

Exceptions to Liquidating Distribution Rules:

Gain is recognized if: - Cash distributed exceeds partner's basis - Precontribution gain exceptions - Disproportionate distribution Loss is recognized only if: - Assets received include only cash, unrealized receivables and inventory, AND - Outside basis exceeds partnership's inside basis in distributed property

Transfers of appreciated stock to investment partnership:

Gain will be recognized by contributing partner; Prevents multiple investors from diversifying their portfolios on a tax-free basis

If transaction is essentially a taxable exchange of property...

Gain will be recognized.

Sale of Partnership Interest

Generally, results in gain or loss recognition by selling partner Gain (loss) = amount realized less partner's basis in partnership interest Partnership liabilities assumed by purchasing partner

Limited Partnership

Has at least one general partner (one or more limited partners); Only general partner(s) are personally liable to creditors (limited partners' loss is limited to equity investment)

Separately Stated Items

If an item of income, expense, gain, or loss might affect any 2 partners' tax liabilities differently, it is separately stated; Fall under the "aggregate" concept

Proportionate Nonliquidating Distributions

In general, neither partner nor partnership recognizes gain or loss on proportionate nonliquidating distributions Partner recognizes gain to extent cash received exceeds partner's adjusted basis (outside basis) in partnership interest

Partnership is not a Taxable Entity (flow through entity)

Income taxed to owners, not entity; Partners report their share of partnership income or loss on their own tax return

Adjustments to Basis

Initial Basis + Partner's subsequent contributions to partnership + Partner's share of partnership: Debt increase Income items Exempt income items Depletion adjustment - Distributions and withdrawals from partnership - Partner's share of partnership: Debt decreases Nondeductible expenses Deductions and losses

Slide 58 Example:

Josh is getting one guaranteed payment from services Maria is getting two guaranteed payments from services and capital Kyle is getting one guaranteed payment from capital

Slide 59 Example:

Josh receives $5,000/month for services; Maria receives $10,000/month for services and capital; Kyle receives $5,000/month for capital Guaranteed Payments = 12 months x $5K x 4 payments = $240,000 **Beachside may deduct these payments

Treatment of Guaranteed Payments

May be deducted or capitalized by partnership depending on the nature of the payment; Deductible by partnership if meets "ordinary and necessary business expense" test; May create partnership loss; Includable in income of partner at time partnership deducts

Precontribution Gain or Loss

Must be allocated to partners taking into account the difference between basis and FMV of property on date of contribution

Partnership's Income and Losses

Must be allocated under Section 704(c) to ensure that the inherent gain or loss is not shifted away from contributing partner (can't hide from your losses)

Property Distributions

No gain recognized on a property distribution If inside basis of property distributed exceeds partner's outside basis in partnership interest, distributed asset takes substituted basis Assets are deemed distributed and basis applied in a certain order

Sale of Property

No loss is recognized on the sale of property between a partnership and a partner who owns > 50% of partnership capital or profits If property is subsequently at a gain, the disallowed loss reduces gain recognized

Nonrecourse Debt

No partner is personally liable; Allocate to partners using a three-tiered allocation

Disguised Sale

Partner contributes property to a partnership; shortly thereafter, partner receives a distribution from the partnership; Distribution may be viewed as a payment for the purchase of the property by the partnership

General Partnership (most basic and the worst)

Partners are jointly and severally liable; Creditors can collect from both partnership and partners' personal assets; General partner's assets are at risk for malpractice of other partners even though not personally involved

Legal Concepts:

(1) Aggregate Concept - Treats partnerships as a channel with income, credits, deductions, etc. flowing through to partnerships; Reflected by the impositions of tax on the partners, not the partnership (2) Entity Concept - Treats partners and partnerships as separate and is reflected by: partnership requirement to file its own information return and treating partners as separate from the partnership in certain transactions between the two

Economic Effect Test Requires:

(1) An allocation must be reflected in a partner's capital account, (2) When partner's interest is liquidated, partner must receive assets with FMV = the positive balance in the capital account, and (3) A partner with a negative capital account must restore that account upon liquidation (this can best be envisioned as a contribution of cash to the partnership equal to the negative balance)

Each owner normally has a:

(1) Capital interest - measured by capital sharing ratio (partner's % of ownership of capital) (2) Profits (loss) interest - partner's % allocation of partnership ordinary income (loss) and separately stated items; certain items may be "specially allocated" (3) Specified in the partnership agreement

If a payment is treated as a distribution, it will fall into one of two categories:

(1) Liquidating distributions (2) Nonliquidating distributions ** Depends on whether the partner remains a partner in the partnership after the distribution

Distributions from a partnership may be either:

(1) Proportionate - partner receives his or her share of certain ordinary income-producing assets (2) Disproportionate - partner's share of certain ordinary income-producing assets increases or decreases

Three different loss limitations apply:

(1) Section 704d - basis in partnership interest (2) Section 465 - at risk limitation (3) Section 469 - passive loss limitation ** limitations are applied successively to amounts which are deductible at all prior levels

For new partnerships, partner's basis usually equals:

(Adjusted basis of property contributed) + (FMV of any service performed by partner in exchange for partnership interest)