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Chapter 10Chapter 10Partnership TaxationPartnership Taxation
Income Tax Fundamentals 2012
Gerald E. Whittenburg Martha Altus-Buller
2012 Cengage Learning
Learning ObjectivesLearning Objectives
Define a partnership for tax purposes Understand basic tax rules for forming and
operating a partnership, as well as partnership income reporting
Describe tax treatment of distributions Determine partnership tax years Identify tax treatment of transactions between
partners and partnerships Understand application of at-risk rules Analyze pros/cons of limited liability companies
2012 Cengage Learning
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)
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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
Partnerships are legal entities under civil law
In most states they have rights under Uniform Partnership Act
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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
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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
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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
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Example #1 – Example #1 – Partnership FormationPartnership Formation
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ExampleAnna 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)
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Anna’s partnership basis = adjusted basis in equipment + income recognized - liability assumed by other partner
Example #2 – Example #2 – Partnership FormationPartnership Formation
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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)
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Her adjusted basis in raw land + gain recognized - liability assumed by other partners
Changes in Partner’s BasisChanges in Partner’s Basis
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Changes occur to partner’s basis due to subsequent activitiesBeginning 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
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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 2011 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 2011 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
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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 the 15th of the 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
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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!)
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Banks and online payments networks (like
PayPal) are required to send 1099-Ks to all
merchants with more than $20,000 of sales and
more than 200 transactionsThe partnership, LLC or corporation will report
this income on Line 1 of their tax return
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1099-K Reporting Merchant 1099-K Reporting Merchant Card and Third-Party PaymentsCard and Third-Party Payments
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
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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
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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)
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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”
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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 activity
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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
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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
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Example Example Real Estate & At-RiskReal Estate & At-Risk
ExampleJolene 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?
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SolutionSolution
ExampleJolene 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?
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.
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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)
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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.
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That’s AllThat’s All2012 Cengage Learning