Partnership Taxation

Which of the following are ordinary income and which are separately stated items?

Revenues $120,000 Interest income 6,000 Gain on sale of securities 8,000 Salaries 36,000 Guaranteed payments 10,000 Rent expense 21,000 Depreciation expense 18,000 Charitable contributions 3,000 Legend: Ordinary Income, Separately Stated Items

When a partner's share of partnership liabilities increases, that partner's basis in the partnership

Increases by the partner's share of the increase. A partner's share of partnership liabilities represents an amount "at risk" that is part of the partner's basis in the partnership, so when the liabilities increase, the partner's basis increases by the partner's share.

When a partnership is created, the partners normally make contributions of cash or property

-When a partner contributes cash, their basis is increased by the amount paid -When a partner contributes property, their basis in the partnership interest is increased by the partner's tax basis in the contributed asset (FMV is ignored)

Partner's Basis increases for

-contributions of assets by the partner to the partnership -borrowings and other debts incurred by the partnership -allocation of partnership income to the partner

The deduction for a partner's share of ordinary business loss from a P/S is subject to basis, at-risk, and passive activity limitations.

At-risk rules prevent partners from deducting losses greater than their personal liability in the P/S

For tax purposes, no deduction is generally allowed for costs incurred to organize a partnership (P/S) or promote the sale of an interest in that P/S.

However, a P/S may elect to immediately deduct up to $5,000 of organizational costs and amortize the remainder ratably over 180 months beginning in the month the entity begins business. The $5,000 immediate deduction must be reduced by the amount of organizational expenses exceeding $50,000.

If built-in gain property is disposed of by the partnership, special allocation rules apply to prevent the contributing partner from shifting any pre-contribution gain to the other partners. The lesser of the recognized gain or the built-in gain is allocated to the contributing partner, thus ensuring the partner only defers the gain instead of permanently evading it. Any remaining gain is allocated among all the partners. Finley will be allocated $47,000 of the gain from the sale.

P/S's recognized gain ($141k - $80k) = $61k Built-in gain allocated to Finley ($120k - $80k) = (40k) Balance allocated to all partners $21k Finley's share of balance ($21k x 1/3) = $7k Finley's total allocated gain ($40k + $7k) = $47k

Nonliquidating Distributions

Since a partner's basis cannot be reduced below zero, a distribution in which the asset's basis exceeds the partner's basis must be handled specially: -Cash distributions - the excess of the cash distribution over the partner's basis is reported as a gain on the partner's individual tax return -Property distributions - the basis of the distributed asset in the hands of the partner is reduced to equal the partner's basis in the partnership prior to the distribution (no gain or loss on property distributions)

Tax-exempt income and nondeductible expenses are also separately stated on the partner's Schedule K-1

Since such items affect the partner's basis. Examples of items that are included in the partnership ordinary income are sales, depreciation, supplies and salaries

Each partner has an outside tax basis for their interest in a partnership (P/S) that is used to determine the deductibility of paP/S losses and the treatment of distributions. The beginning basis is equal to the partner's initial contributions (eg, cash, property) to the P/S.

Skinner's basis is $13,000, as calculated below: Cash contributed $5,000 + Basis of land contributed 12,000 − Mortgage assumed by P/S (10,000) + Share of mortgage assumed (20% × $10,000) = 2,000 + Share of P/S liabilities (20% × $20,000) = 4,000 Ending basis $13,000

A partnership may elect to immediately deduct up to $5,000 of organizational costs (ie, costs incidental to the creation of the partnership) and amortize the remainder ratably over 180 months beginning in the month the entity begins business.

The $5,000 deduction must be reduced by the amount of organizational expenses exceeding $50,000. Syndication costs must be capitalized. Example, if an partnership spent $15,260 on organizational costs: Immediate deduction $5,000 Amortization [($15,260 − $5,000) × 9/180]*513 Total $5,513 *Operations began April 1, so 9 months of amortization allowed

When a partner contributes property in exchange for a partnership interest, the partner's basis is increased by the property's adjusted tax basis at the time of the contribution.

The adjusted tax basis is the property's cost less accumulated depreciation. The fair market value of the property is irrelevant.

in a distribution when Partner's basis (outside basis) > Asset's basis (inside basis)

The amount of basis used for the distributed property other than cash: (1) Nonliquidating distribution (lower of inside or outside basis) - Asset (2) Liquidating distribution (outside basis) - partner

In a distribution when Partner's basis (outside basis) < Asset's basis (inside basis)

The amount of basis used for the distributed property other than cash: (1) Nonliquidating distribution (lower of inside or outside basis) - Partner (2) Liquidating distribution (outside basis) - Partner

Partner's basis is adjusted each accounting period for the partner's share of partnership profits (losses), changes in partnership liabilities, additional contributions made, and distributions received.

The basis may never fall below zero. Nonrecourse liabilities (eg, secured by collateral) provide basis for distributions but generally do not provide basis for deducting losses since the partners do not bear the risk for the loss. Therefore, the at-risk basis excludes P/S nonrecourse debt.

In general, a liquidating distribution is a nontaxable return of partner capital. Liquidating distributions reduce a partner's basis in the partnership to zero, and the distributed property assumes the partner's basis in the partnership.

The partner's basis is first reduced by distributed cash and then by distributed hot assets, and any remaining basis is assigned to other property. Depreciation recapture is considered a hot asset

Nonliquidating partnership distributions reduce a partner's basis in the partnership first by cash and then by the partnership's basis in distributed property (but not below zero).

The partnership's property basis carries over to the partner limited to the partner's basis after accounting for cash distributions.

There are two tax bases for partnerships (P/S): the inside and outside bases. Inside basis is a P/S's basis in its assets, and outside basis is the partners' basis in the P/S. Because of certain transactions, these two bases may not be the same. However, to eliminate the basis disparity when a P/S interest is sold, a P/S generally may make an irrevocable Section 754 election.

The purpose of this election is to align the new partner's basis in their P/S interest with their share of basis in the P/S assets. When making this election, the P/S must adjust its inside basis in P/S assets so the new partner's share of inside basis equals their outside basis (ie, purchase price).

For tax purposes, no deduction is generally allowed for costs incurred to organize a partnership or promote the sale of an interest in the partnership. However, a partnership may elect to immediately deduct up to $5,000 of organization costs.

The remaining costs are amortized, using the straight-line method, ratably over 180 months beginning in the month the entity's business begins.

For tax purposes, a partnership terminates when

no part of its business, financial operations, or venture is carried on by any of its partners in the form of a partnership.

When there is no majority of partners with the same tax year,

the least aggregate deferral method must be applied and the required partnership tax year will be the partner tax year which results in the lowest number of weighted combined months of income deferral.

Basis is generally equal to the amount at risk

unless a reason is given as to why the partner is not at risk for such amount

The most important concept in partnership tax law is that of a partner's basis

which generally equals the amount the partner has "at risk" in the partnership

Outside basis

A partner's basis in his or her partnership interest.

Cadwallader has had a 30% interest in C&C Associates, a partnership, since 20X9. In 20X14 the partnership is liquidated. The partnership's only assets at the time of liquidation are $50,000 in cash and land with a fair market value of $60,000 and a basis of $65,000. C&C Associates has no liabilities. Cadwallader's adjusted basis for her partnership interest is $34,500 and she receives $30,000 cash in liquidation of her entire interest. What amount and type of loss should Cadwallader recognize on her 20X14 tax return?

A. $4,500 ordinary loss (17%) B. $4,500 long-term capital loss (47%) C. $4,500 short-term capital loss (7%) D. $0 (27%) Since Cadwallader is receiving a total of $30,000 in cash in total liquidation of her partnership interest with a basis of $34,500, she will recognize a loss of the difference of $4,500. The loss would be ordinary to the extent that it related to inventory or receivables, neither of which are assets of the partnership, and capital loss for the remainder. Because the holding period is from 20X9 to 20X14, it will be a long-term capital loss.

Basis in received assets

Basis is assets when partnership distribution to partner

Albert Eckstein files his tax return using a calendar year and is a partner in Angel Partnership, which has a tax year ending September 30. Angel Partnership made Albert guaranteed payments of $3,000 monthly in calendar 20X13, and increased it to $3,500 for calendar 20X14. What amount of Angel Partnership guaranteed payments will Albert report on his 20X14 tax return? A. None B. $40,500 C. Depends on partnership income D. $42,000

Explanation Choice B (Correct) and Choices C, D (Incorrect): While functionally similar to a salary, guaranteed payments paid to a partner are not treated like a salary paid to an employee but, instead, are recognized in accordance with the partnership's tax year. For the partnership's year ending 9/30/X14, Eckstein would have received $3,000 per month for October through December of 20X13, or $9,000 in total, and $3,500 month for the 9 months from January through September of 20X14, or $31,500 in total for a combined amount of $40,500.

A partnership can use a tax year other than the normally required year if it either

(1) provides a valid business purpose for the alternate tax year (ski resort ends May 31st) (2) makes a Section 444 election - no business reason needed, but no more than 3 months' income deferral allowed.

Guaranteed payments to a partner

- Like a salary in an S corp - Included in gross income, taxable as ordinary income - Subject to self employment tax - Deductible to partnership as ordinary expense (but not a separately stated item) - Not based on partnership income - Should be for services provided by partner or use of capital - Does not directly reduce a parter's basis

A partnership is an association between two or more persons to operate a business as co-owners for profit. Characteristics include:

-File an information tax return, form 1065 -tax year generally must be the same as the partners, or a majority of partners -accounting is similar to S-Corps -Informal creation since all partners have unlimited liability (everything is "at risk"

Gains and Losses

-Losses in excess of basis are not deductible -Cash distributions in excess of basis results in gain -Contributed asset subject to higher liability results in gain -if an asset distribution exceeds basis, the basis of the distributed asset will be adjusted

Guaranteed payments

-Not based on partnership income or loss -Can be for services or special use of partner's capital -Deduction when computing P/S ordinary income -Separately stated item on partner's/recipient's K-1 -Taxable to the recipient partner as ordinary income -Does not directly affect partner's tax basis

Partner's basis decreases for

-distributions of assets from the partnership to the partner -allocation of partnership losses to the partner -repayments and other reductions of debts of the partnership

The holding period of a partnership interest acquired in exchange for a contributed property:

-for capital assets or section 1231 (assets held less than one-year) assets: includes period held by the partner -for all other property: when partnership interest acquired

Morse is a 50% partner in Ecco Partnership. Morse's tax basis in Ecco on January 2 was $4,000. Ecco did not have unrealized receivables, appreciated inventory, or properties that had been contributed by its partners. On December 31, Ecco made an $11,000 nonliquidating cash distribution to Morse. For the year, Ecco reported $10,000 of ordinary business income. What is the amount of the net capital gain realized by Morse from the cash distribution? A. $0 B. $2,000 C. $7,000 D. $11,000

A cash nonliquidating distribution is taxable only to the extent it exceeds the partner's basis. Because the partnership interest is considered a capital asset to the partner, the excess is treated as a capital gain. The taxpayer's basis before the distribution is $9,000 ($4,000 beginning basis + $5,000 one-half of partnership income). The $11,000 distribution reduces basis to zero and the resulting excess of $2,000 ($11,000 − $9,000) is taxed as a capital gain.

A partner can deduct a loss up to his or her adjusted basis in the partnership. A partner's basis increases for contributions of assets by the partner to the partnership, borrowings and other debts incurred by the partnership, and allocation of partnership income (distributive share) to the partner.

A partner's basis decreases as a result of distributions of assets from the partnership to the partner, allocation of partnership losses (distributive share) to the partner, and repayments and other reductions of debts of the partnership.

Organizational and start-tup costs

A partnership may deduct up to $5,000 of organization expenditures and up to $5,000 of start-up costs of the tax year in which the partnership begins business. Any remaining expenditures are deducted ratably over the 180-month period beginning with the month in which the partnership begins business. The $5,000 amount is reduced by the amount by which the organizational expenditures or start-up costs exceed $50,000, respectively.

If a partner contributes property subject to a liability assumed by the partnership (P/S), the contribution is reduced by the liability. Basis is increased by a partner's pro rata share of P/S liabilities.

Basis can never fall below zero. Suspended losses are carried forward. Nonrecourse liabilities (eg, secured by collateral) provide basis for distributions but generally do not provide basis for deducting losses since the partners do not bear the risk for the loss. Therefore, the at-risk basis excludes P/S nonrecourse debt.

Nonliquidating partnership distributions reduce a partner's outside basis (but not below $0) first by cash, and then by the lesser of the property's carryover basis or the partner's remaining outside basis.

Cash distributions exceeding a partner's basis in the partnership is a taxable capital gain; however, distributed property generally is nontaxable.

Contribution of assets by partners

Cash or property -tax-free exchange (no 80%/control rule) -carryover basis -carryover holding period Services -taxable at FMV or capital interest received (ie, generally the FMV of services provided)

Cadwallader has had a 30% interest in C&C Associates, a partnership, since 20X9. In 20X14 the partnership is liquidated. The partnership's only assets at the time of liquidation are $50,000 in cash and land with a fair market value of $60,000 and a basis of $65,000. C&C Associates has no liabilities. Cadwallader's adjusted basis for her partnership interest is $34,500 and she receives $30,000 cash in liquidation of her entire interest. What amount and type of loss should Cadwallader recognize on her 20X14 tax return? A. $4,500 ordinary loss B. $4,500 long-term capital loss C. $4,500 short-term capital loss D. $0

Choice B (Correct) and Choices C, D (Incorrect): Since Cadwallader is receiving a total of $30,000 in cash in total liquidation of her partnership interest with a basis of $34,500, she will recognize a loss of the difference of $4,500. The loss would be ordinary to the extent that it related to inventory or receivables, neither of which are assets of the partnership, and capital loss for the remainder. Because the holding period is from 20X9 to 20X14, it will be a long-term capital loss.

On March 17, 20X4, Packer became a partner in Cats & Dogs Co., an already formed partnership. Packer does not have property to contribute and thus contributes services in exchange for his 5% profits and capital interest in Cats & Dogs. Cats & Dogs net assets are as follows: Basis January 1, 20X4 $150,000 March 17, 20X4 $150,000 December 31, 20X4 $150,000 Fair Market Value January 1, 20X4 $150,000 March 17, 20X4 $170,000 December 31, 20X4 $175,000 On Packer's 20X4 tax return, what amount must Packer include as ordinary income from transfer of partnership interest? A. $0 (19%) B. $7,500 (27%) C. $8,500 (42%) D. $8,750 (10%)

Choice C (Correct): When a partner renders services in exchange for a partnership capital interest, the partner will recognize ordinary income in an amount equal to the value of the partnership capital interest as of the date on which the services are provided. Thus, Packer will recognize ordinary income as of March 17 of 5% x $170,000 or $8,500.

The Code generally requires tax elections affecting the calculation of the P/S ordinary business income or loss to be made at the P/S level, not by individual partners (Choices C and D). Common elections made by the P/S include selecting the tax year, inventory valuation method, and cost recovery (ie, depreciation) method.

For example, a P/S may elect to use any method of depreciation that is approved by the IRS in calculating the P/S ordinary business or loss. Special elections related to depreciation (ie, Section 179 immediate expensing) are still made the P/S level but allocated to individual partners as separately reported items.

The capital account is different than the partner's adjusted basis

For example, the capital account does not include a partner's share of the partnership liabilities, whereas basis does.

Partnerships and S corporations share some characteristics (eg, both can be formed with nontaxable exchanges, both are pass-through entities, and most owners do not pay self-employment tax on the entities' earnings).

However, general partners who actively participate in partnerships are subject to self-employment tax.

Distributions reduce a partner's basis in the partnership (but not below zero). Basis is first reduced by cash distributions to determine any gain. Next, basis is reduced by the partnership's adjusted basis in distributed property.

If the partnership's adjusted basis exceeds the partner's basis (after cash distributions), the partner does not recognize a gain. Instead, the partner's property basis is limited to the remaining basis in the partnership interest.

Example: if a partner gets a 20% interest by contributing an asset with an FMV of $10,000, a carryover basis of $4,000 and subject to a mortgage of $6,000, which the partnership assumes.

Initial Basis = $4,000 +Partner share of liabilities = $1,200 (6k x 20%) -Liabilities contributed to partnership = ($6,000) Ending Outside Basis = ($800). However, since basis cannot be negative, the partner has an $800 gain and basis is $0 (note that the gain is a 'capital gain')

Separately Stated Items

PISS CTN CT -Passive Activities -Investment Income (dividends & interest) -Section 179 depreciation election -Section 1231 gains/losses -Capital gains & Losses -Tax credits -Non-Deductible Expenses -Charitable Contributions -Dividends & Investment interest -Tax-Exempt Income (note that interest expense is not a separately stated item)

In the absence of an election, a partnership generally is required to adopt the same tax year as that of one or more partners holding a majority of partnership interests. For example, if a partnership has a corporate partner that has a 51% partnership interest and a January 31 year end, then absent an election, the partnership also must adopt a January 31 year end.

Partnership year-end options (1) Default Year end must be the same as that used by a majority of partners (2) Section 444 election for different year end -No valid business reason needed -Deferral must not exceed 3 months (3) Business purpose for different year end -Must provide valid business reason (eg, ski resort's season ends in May) -Deferral may exceed 3 months

Inside basis

Partnership's basis in its assets

Partnership distributions reduce (see exhibit) a partner's outside basis (but not below $0) in the following order: Cash: To determine gain if cash distributions exceed the partner's basis.

Property: No gain/loss is recognized. However, the partner's basis in the property is adjusted to the lesser of the partner's remaining basis in the partnership or the property's carryover basis from the partnership, and any gain/loss will be recognized upon selling the property.

A partner's basis never declines below $0

This is also knows as "ending Outside Basis". Very important to know

Partnership Information Tax Return Form 1065

Total income (loss) Less: Deductions Ordinary Business Income (loss) Interest due BBA AAR imputed underpayment Other Taxes Total Balance Due Less: Payments Amount owed / overpayment

Because a P/S is a flow-through entity, it cannot claim a net operating loss (NOL).

Without an NOL, there can be no NOL carryover

When a partner acquires a partnership interest from another partner, the acquiring (transferee) partner's beginning basis is equal to the

amount paid to the selling (transferor) partner plus the new partner's share of partnership debt.

Distributions reduce a partner's basis in the partnership

but are not taxable unless cash distributions exceed the partner's basis.

-If the asset being contributed is subject to a liability, the partner's net contribution is reduced b/c of the contributed liability,

but then each partner's basis is increased by their individual shares of the liability the partnership has assumed

A partners' outside basis includes

cash or property contributed at carryover basis plus the partner's share of partnership income

In a liquidating distribution hwhen both cash and property is distributed

do cash first, the remainder is allocated to property

When a partner renders service to the partnership in exchange for an interest int he business

the partner reports ordinary income equal to the FMV of the partnership interest being granted, and the partner's basis is increased by the same amount

Liquidating Distriutions

the partner's basis in the partnership must be reduced to $0 in all cases. The difference between cash and property distributions as follows: (1) Cash, inventory and unrealized receivable distributions (b) the total distributed to a partner is compared to his/her basis before the distribution and any excess is a loss on the partner's individual tax return (a) only cash (and marketable securities) is used to determine a gain (2) Property distributions - the asset's basis is always equal to the partner's basis in the partnership before the distribution, so no gain or loss is recognized

A partner's basis is not identical to the partner's capital in the business since a partner's basis includes

the partner's share of partnership liabilities to creditors and the partner's capital account does not

Because guaranteed payments to partners represent ordinary business expenses of the partnership, they are included in the determination of the ordinary income of the partnership

they must also, however, be separately stated on the Schedule K-1 of each partner receiving such payments, so that the partner will include the income received on their individual tax return

A partnership is generally required to adopt the same tax year as that of the partners.

thus if the partners are all individuals that report income using calendar years, the partnership itself should have a December 31 year-end. If no majority, the tax year of the principal partners is used. if no principal, the year with the lest aggregate deferral is used, which means the year that defers the least amount of partners' income for the least amount of time