chapter 10 partnership taxation

Income Tax Fundamentals 2010 Gerald E. Whittenburg

Martha Altus-Buller

2010 Cengage Learning

Tax year must be the same tax year as 50% of partners

If majority of partners’ tax years are different, must use tax year of ‘principal partners’ Principal partner defined as partner with at least

5% share in profits or capital If principal partners have different tax years,

partnership generally required to use least aggregate deferral method

Note: Partnerships don’t pay tax as an entity


Partnerships/S-Corporations may elect to adopt a different fiscal tax year from the one prescribed on previous slide, but only

° If entity can demonstrate that natural business cycle easily conforms to fiscal year other than calendar year Such as golf course (natural cycle in Denver ends in

October)

Note: S-Corporations don’t pay tax as an entity


Even though S-Corporations and partnerships don’t pay tax, the entity must make an estimated payment if choosing to use a fiscal year-end different from calendar year-end◦ Estimated taxes are calculated as

Estimated deferral period taxable income x

(Highest individual tax rate + 1%)

◦ Estimate deferral period taxable income by using average monthly income from preceding fiscal year


ExampleSan Juan River Expeditions Inc., an S-Corp,

has taxable income of $360,000 for the year ended 9/30/09 with a three-month deferral period. The company made a $15,000 payment last year. What’s their current required tax payment?


ExampleSan Juan River Expeditions Inc., an S-Corp, has taxable income of

$360,000 for the year ended 9/30/09 with a three-month deferral period. The company made a $15,000 payment last year. What’s their current required tax payment?

SolutionThe required tax payment = (Estimated taxable income in deferral period x 36%) - prior year’s tax payment

Deferral period is 3 months (October – December)[($360,000/12) x 3 months] = $90,000 ($90,000 x 36%) = $32,400

($32,400 - 15,000) = $17,400 estimated tax payment due in current year


A Personal Service Corporation (PSC) is a corporation with shareholder-employee(s) whom provide a personal service, such as architects or dentists

Generally must adopt calendar year However, can adopt a fiscal year if

◦ Can prove business purpose or◦ Fiscal year results in a deferral period of less than 3

months and Shareholders’ salaries for deferral period are proportionate to

salaries received during rest of the period or

Corporation limits its salaries deduction


See next slide

Purpose is to keep the PSC from deducting one year’s salary in first nine months

If salaries don’t remain constant, the PSC can only deduct pro rata amount◦ Based on a required formula


If taxpayer has a short year (other than first/last year of operation), tax is calculated based on following example:

° In 2009, Flo-Mex changes from a calendar year to tax year ending 9/30. For the short period 1/1/09 – 9/30/09, Flo-Mex’s taxable income = $20,000. Calculate tax for the short period

Annualize TI $20,000 x 12/9 = 26,667

Tax on annualized TI $26,667 x 15%* = 4,000

Allocate tax to short period $4,000 x 9/12 = $3,000

Individual taxpayers rarely change tax years

*Chapter 1, page 1-3


Partnerships must file an informational tax return ◦ Form 1065◦ But partnership itself does not pay tax ◦ 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)


A partnership is a syndicate, group, pool, joint venture or other unincorporated organization through which any business, financial operation or venture is carried on◦ Simply co-owning property does not constitute a

partnership Note: many co-owners of real estate choose to

operate as a limited partnership or limited liability company


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 partnerships or Limited Liability

Companies (LLCs) limit some of that exposure• Limited partnerships or LLCs are required

to register with state in which they are formed


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


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



ExampleAnna contributes equipment 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 mortgage 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?

ExampleAnna contributes equipment 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 mortgage 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 equals $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 Leisle contributes 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?

Example #2Leisle contributes 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 land + gain recognized - liability assumed by other partners


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 $

- 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 Suresh and Kia enter into a partnership, sharing

equally in the profits and losses. Suresh contributed land with a $70,000 basis and $150,000 FMV . Subsequent to formation, the partnership incurred liabilities = $130,000 and the partnership income for 2009 totaled $42,000. What is Suresh’s basis in the partnership interest at year-end?

Example Suresh and Kia enter into a partnership, sharing equally in

the profits and losses. Suresh contributed land with a $70,000 basis and $150,000 FMV . Subsequent to formation, the partnership incurred liabilities = $130,000 and the partnership income for 2009 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


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


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 basis to absorb loss!)


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


Amount that a partner receives for services rendered 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


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

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

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


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”


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◦ “Encumbered property” is the property pledged for a liability

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 activity


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


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

For real estate acquired after 1986, the “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


ExampleJolene buys a real estate investment 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?


ExampleJolene buys a real estate investment 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?

SolutionJolene 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 (LLCs) are a cross between a partnership and a corporation◦ Treated generally as a partnership for tax purposes◦ Each owner has limited liability (similar to a corporation)

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


Disadvantages◦ 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 operating in more than one state

Note: Limited Liability Companies quickly becoming a major form of business organization in the U.S.


chapter 10 partnership taxation

Documents

different fiscal tax

short year

estimated tax payment

income tax fundamentals

year of operation

different tax years

cengage learningsee

current required tax