chapter 10

Chapter 10Chapter 10Partnership TaxationPartnership Taxation

Income Tax Fundamentals 2011

Gerald E. Whittenburg Martha Altus-Buller

2011 Cengage Learning

Learning ObjectivesLearning ObjectivesDefine a partnership for tax purposesUnderstand basic tax rules for forming

and operating a partnershipDescribe tax treatment of distributionsDetermine partnership tax years Identify tax treatment of transactions

between partners and partnershipsUnderstand application of at-risk rulesAnalyze pros/cons of limited liability

companies


Nature of Partnership TaxationNature of Partnership Taxation

Partnerships must file an informational tax return called Form 1065◦Partnership itself does not pay tax; rather,

income/expenses ‘flow through’ to partners◦Partnership income taxable to partner, even

if he/she does not receive cash!!

Partnerships must make various elections (depreciation and inventory methods, for example)


What is a Partnership?What is a Partnership?

A partnership is a syndicate, group, pool, joint venture or other unincorporated organization through which any business, financial operation or venture is carried on

Partnerships are legal entities under civil law

In most states they have rights under Uniform Partnership Act


Partnership AgreementPartnership Agreement

Can form general partnership by simple verbal agreement◦ However, prudent to document agreement in

writing

◦ General partners usually take on risk of legal liability for certain partnership actions and debts

◦ Limited liability partnerships (LLPs) or Limited Liability Companies (LLCs) limit some of that exposure

LLPs and LLCs are required to register with state in which they are formed


Partnership FormationPartnership Formation When forming a partnership, individuals

contribute assets to partnership in exchange for a partnership interest

No gain/loss is usually recognized Exceptions include

◦ When services are performed in exchange for partnership interest

◦ When property is contributed with liabilities in excess of basis, then

Recognized Gain = Liabilities Allocable to Others – Adjusted Basis of Property Contributed


Partnership FormationPartnership Formation

Partner’s basis in partnership interest

Cash contributed plus: Basis of property transferred to

partnershipplus: Gain recognized (from prior screen)less: Liabilities allocable to other partnersEquals: Partner’s initial basis in partnership


Example #1 – Example #1 – Partnership FormationPartnership Formation


Example

Anna contributes four wind turbines with a $100,000 fair market value (FMV) for a 50% interest in JSC Partnership. The equipment has an adjusted basis of $45,000 and a $12,000 note against it, Anna also renders legal services valued at $13,000. What is Anna’s basis in the partnership interest? Does she recognize any taxable gain on this transaction?

SolutionSolutionExampleAnna contributes wind turbines with a $100,000 FMV for a 50%

interest in JSC Partnership. The equipment has an adjusted basis of $45,000 and a $12,000 note against it, Anna also renders legal services valued at $13,000. What is Anna’s basis in the partnership interest? Does she recognize any taxable gain on this transaction?

Solution Anna must report $13,000 of ordinary income because of services

performed. The liability (mortgage) allocable to other partners ($6,000) does not exceed the basis of the property contributed, so no gain recognition. Her basis in the partnership interest is calculated as follows: $52,000 = 45,000 + 13,000 - .50(12,000)


Anna’s partnership basis = adjusted basis in equipment + income recognized - liability assumed by other partner

Example #2 – Example #2 – Partnership FormationPartnership Formation


Example

Leisle contributes raw land with a FMV of $2,000,000 for 60% interest in Fuel Cell Tech LLP. The land has a basis of $450,000 and a mortgage of $1,200,000. What is Leisle’s basis in the partnership interest and does she have any taxable gain on this transaction?

SolutionSolutionExample Leisle contributes raw land with a FMV of $2,000,000 for 60%

interest in Fuel Cell Tech LLP. The land has a basis of $450,000 and a mortgage of $1,200,000. What is Leisle’s basis in the partnership interest and does she have any taxable gain on this transaction?

Solution Leisle has contributed property with liabilities assumed by other

partners in excess of basis, so her taxable gain is [($1,200,000 x 40%) - $450,000] = $30,000

Leisle’s basis in her partnership interest equals $0. $450,000 + $30,000 – .40($1,200,000)


Her adjusted basis in raw land + gain recognized - liability assumed by other partners

Changes in Partner’s BasisChanges in Partner’s Basis


Changes occur to partner’s basis due to subsequent activities

Beginning Basis

+ Additional Contributions

+ Share of Net Ordinary Taxable Income

+ Share of Capital Gains/Other Income

- Distributions of Property or Cash

- Share of Net Loss from Operations*

- Share of Capital Losses/Other Deductions

+/- Increase/Decrease in Liabilities

Basis in Partnership Interest

*Note: Can’t take basis below 0 and must comply with at-risk limitations

Example – Example – Basis AdjustmentsBasis Adjustments


Example

Suresh and Kia enter into a partnership, sharing equally in the profits and losses. Suresh contributes land with a $70,000 basis and $150,000 FMV. Subsequent to formation, the partnership incurred liabilities = $130,000 and the partnership income for 2010 totaled $42,000.

What is Suresh’s basis in the partnership interest at year-end?

SolutionSolution

Example

Suresh and Kia enter into a partnership, sharing equally in the profits and losses. Suresh contributes land with a $70,000 basis and $150,000 FMV. Subsequent to formation, the partnership incurred liabilities = $130,000 and the partnership income for 2010 totaled $42,000.

What is Suresh’s basis in the partnership interest at year-end?

Solution$70,000 + .50($130,000) + .50($42,000) = $156,000

Beginning balance + 50% liabilities + 50% net income


Partnership Income ReportingPartnership Income Reporting

Partnerships do not pay tax ◦ All information flows through to be reported by the partners◦ Tax return is due by 15th of 4th month following close of

partnership tax year

Must report each element of income and expense separately on Form 1065 (Partnership Tax Return)◦ Schedule K-1 shows allocable partnership

income/expenses for each partner, based upon the individual ownership percentage Ordinary income/loss Special income/deduction items such as charitable deductions,

interest, capital gains/losses


Partnership Income ReportingPartnership Income Reporting

Income and expenses flow through to individual’s tax return

On the individual partner’s tax return the deductible losses from partnership activities are limited to basis in partnership interest ◦ Cannot reduce basis below zero

◦ Carry forward any unused losses to subsequent years (when there may be additional basis with which to absorb loss!)


Current Distributions Current Distributions

Partnerships may make distributions of money or other property to partners◦A current distribution is one that does not

completely terminate a partner’s interest◦No gain recognized by partner, unless

partner’s basis in partnership has reached zero Then, only the portion of the current distribution

that is in excess of partner’s basis is taxed


Guaranteed PaymentsGuaranteed Payments

Amount that a partner receives for services rendered or use of partner’s capital is called a guaranteed payment◦Guaranteed payments are made regardless

of income/loss situation of partnership◦Guaranteed payments are subtracted before

partnership taxable income/loss is allocated to partners

◦Guaranteed payments are taxable ordinary income to partner and deductible by partnership


Tax Years & PartnershipsTax Years & Partnerships

IRS establishes rigid rules pertaining to tax years as follows:o Unless it can show bona fide business purpose for

adopting another fiscal year-end, the partnership must adopt the same tax year as the majority of the partners

o If this is not possible, it must adopt same tax year as majority of the principal partners

o If neither of these work, partnership must use the least aggregate deferral method (see major tax service for more information)


Transactions Between Transactions Between Partners & Partnerships Partners & Partnerships

Generally, transactions between partners and the partnership are not regarded as related party transactions

However, if a partner with more than 50% direct or indirect ownership* sells assets to the partnership (or two partnerships with > 50% ownership by same partner)◦ And a gain results: it is taxed as ordinary income

◦ And a loss results: the loss is disallowed and any gain on future sale of asset by the partnership is reduced by the deferred loss

*Note: Indirect ownership means “through spouse, siblings, lineal descendants and ancestors”


At-Risk LimitationsAt-Risk Limitations Partners cannot deduct losses from activities in

excess of their investment° Losses limited to amounts at risk (AAR) in those activities

Definitions◦ A “nonrecourse liability” is a debt for which the borrower

is not personally liable and doesn’t count towards AAR

◦ “Encumbered property” is the property pledged for a liability and the adjusted basis is includable in AAR if partner is personally liable for repayment of debt

Taxpayers are at-risk for an amount equal to Cash and property contributed to partnership

+ Liabilities on encumbered properties (recourse debt)

+ Liabilities for which taxpayer is personally liable (recourse debt)

+ Retained profits in activity2011 Cengage Learning

At-Risk LimitationsAt-Risk Limitations

Taxpayer allowed a loss deduction allocable to business activity to the extent of:◦Income received or accrued from activity

without regard to amount at risk or

◦Taxpayer’s amount at risk at the end of the tax year


At-Risk Rules &At-Risk Rules &Real EstateReal Estate

Real estate acquired before 1987 is not subject to at-risk rules

For real estate acquired after 1986, the amount of “qualified nonrecourse financing” is considered to be the amount at risk◦This is defined as debt secured by real

estate and borrowed from person who regularly engages in the lending of money

◦Does not apply to financing from seller or promoter


Example Example Real Estate & At-RiskReal Estate & At-Risk

Example

Jolene invests in real estate and gives $200,000 cash as a down payment; she also borrows $800,000 which is secured by a bank mortgage on the property. What is Jolene’s amount at risk? Would this answer change if she had obtained the mortgage from the seller?


SolutionSolution

Example

Jolene invests in real estate and gives $200,000 cash as a down payment; she also borrows $800,000 which is secured by a bank mortgage on the property. What is Jolene’s amount at risk? Would this answer change if she had obtained the mortgage from the seller?

Solution

Jolene has $1,000,000 at risk in this real estate investment. If the mortgage had been obtained from the seller, her amount at risk would be limited to the down payment of $200,000.


Limited Liability Companies Limited Liability Companies

Limited Liability Companies (LLCs) have attributes of both partnerships and corporations

Advantages of LLCs are numerous

◦ Taxable income/loss passes through to owners

◦ No general partner requirement

◦ Owners can participate in management

◦ Owners have limited liability

◦ LLC ownership interest is not a security

◦ Tax attributes pass through to owners

◦ Offer greater tax flexibility than S corporations (single member LLCs are very common)


Limited Liability CompaniesLimited Liability Companies

Disadvantages of LLCs◦ Because of newness, limited amount of case law

dealing with limited liability companies

◦ States are not uniform in treatment of LLCs, so potential for confusion if LLC is operating in more than one state

Note: LLCs are quickly becoming a major form

of business organization in the U.S.


That’s AllThat’s All


chapter 10

Education

partnership agreement

general partnership

jsc partnership

partnership tax years

certain partnership

uniform partnership

cengage learning

basis of property