Chapter 21
Partnerships
Comprehensive Volume
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1
The Big Picture (slide 1 of 3)
• For 15 years, Maria has owned and operated a seaside
bakery and cafe called The Beachsider.
– Maria would like to expand and has talked to her landlord,
Kyle about it.
• The Beachsider is one of several older buildings on 3
acres of a 10-acre parcel that Kyle inherited 30 years
ago.
– The remaining 7 acres are undeveloped.
• Kyle and Maria talked to Josh, a real estate developer,
and he proposed an expansion to The Beachsider and
upgrades to the other buildings.
The Big Picture (slide 2 of 3)
• The parties agreed to form a partnership to own and
operate The Beachsider and to improve and lease the
other buildings.
• Under the plan, Kyle and Maria will each contribute
½ of the capital needed.
– Kyle’s real estate is valued at about $2 million.
– Maria’s bakery equipment and the cafe furnishings are
valued at about $500,000.
– The improvements will cost about $1.5 million, which
Maria has agreed to contribute to the partnership.
The Big Picture (slide 3 of 3)
• Josh will not contribute any capital to the partnership.
– Instead, he will manage the construction and the operation
of the partnership in exchange for 5% of the capital and
20% of the ongoing profits.
– His capital interest is valued at $200,000.
• What are the tax consequences if the trio forms
Beachside Properties as a partnership to own and
operate the shopping center?
– What issues might arise later in the life of the entity?
• Read the chapter and formulate your response.
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
• For tax purposes, includes:
–
–
–
–
Syndicate
Group
Pool
Joint venture, etc
Entities Taxed as Partnerships
(slide 1 of 4)
• General partnership
– Consists of at least 2 general partners
– 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
Entities Taxed as Partnerships
(slide 2 of 4)
• Limited liability company (LLC)
– Combines the corporate benefit of limited liability
with benefits of partnership taxation
• Unlike corporations, income is subject to tax only once
• Special allocations of income, losses, and cash flow are
available
– Owners are “members,” not partners, but if
properly structured will receive partnership tax
treatment
Entities Taxed as Partnerships
(slide 3 of 4)
• 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
Entities Taxed as Partnerships
(slide 4 of 4)
• Limited liability partnership (LLP)
– An LLP partner is not personally liable for
malpractice committed by other partners
– Popular organizational form for large accounting
firms
• Limited liability limited partnership (LLLP)
– An extension of the limited partnership form
– All partners, whether general or limited, are
accorded limited liability
The Big Picture – Example 1
Types Of Partnerships (slide 1 of 2)
• Return to the facts of The Big Picture on p. 21-1.
• When Beachside Properties is formed, Kyle, Maria,
and Josh must decide which type of partnership to
utilize.
– With a general partnership, Kyle, Maria, and Josh would
each be jointly and severally liable for all entity debts.
– With a limited partnership, one of the partners would be
designated as a general partner and would be liable for all
entity debts.
– Because all 3 partners want to have limited liability, they
decide not to use a general or limited partnership.
The Big Picture – Example 1
Types Of Partnerships (slide 2 of 2)
• They do not consider a limited liability
partnership because that entity form is
typically reserved for service-providing
entities.
• With a limited liability company (or, if their
state permits, a limited liability limited
partnership), each partner’s losses will be
limited to the partner’s contributed capital.
– Therefore, Kyle, Maria, and Josh decide to form
Beachside Properties as an LLC.
“Check-The-Box” Regs
• Allows most unincorporated entities to select
their federal tax status
– If 2 or more owners, can choose to be treated as:
• Partnership, or
• Corporation
– Permits some flexibility
• Not all entities have a choice
• e.g., New publicly traded partnerships must be taxed as
corporations
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
Partnership Taxation
(slide 1 of 3)
• 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
Partnership Taxation
(slide 2 of 3)
• Generally, the calculation of partnership
income is a 2-step approach
– 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
– e.g., Charitable contributions
Partnership Taxation
(slide 3 of 3)
• Electing large partnerships can net some items
that would otherwise be separately stated
– Must have at least 100 partners and elect
simplified reporting procedures
– Such partnerships separately report less than a
dozen categories of items to their partners
• e.g., Combine interest, nonqualifying dividends, and
royalty income into one amount, and report the net
amount to partners
Partnership Reporting
• Partnership files Form 1065
– On page 1 of Form 1065, partnership reports ordinary
income or loss from its trade or business activities
– Schedule K accumulates information to be reported to
partners
• Provides ordinary income (loss) and separately stated items in total
– Each partner (and the IRS) receives a Schedule K-1
• Reports each partner’s share of ordinary income (loss) and
separately stated items
Conceptual Basis for
Partnership Taxation (slide 1 of 2)
• Involves 2 legal concepts:
– Aggregate (or conduit) concept—Treats
partnership as a channel with income, expense,
gains, etc. flowing through to partners
• Concept is reflected by the imposition of tax on the
partners, not the partnership
Conceptual Basis for
Partnership Taxation (slide 2 of 2)
• Involves 2 legal concepts (cont’d):
– Entity concept—Treats partners and partnerships
as separate and is reflected by:
• Partnership requirement to file its own information
return
• Treating partners as separate from the partnership in
certain transactions between the two
Partner’s Ownership Interest
• Each owner normally has a:
– Capital interest
• Measured by capital sharing ratio
– Partner’s percentage ownership of capital
– Profits (loss) interest
• Partner’s % allocation of partnership ordinary income
(loss) and separately stated items
• Certain items may be “specially allocated”
– Specified in the partnership agreement
Inside and Outside Bases
• Inside basis
– 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 its assets
• Outside basis
– Represents each partner’s basis in the partnership
interest
– All partners should maintain a record of their
respective outside bases
Basis Issues
(slide 1 of 3)
• Partner’s outside basis is adjusted for income
and losses that flow through from partnership
• This ensures that partnership income is only taxed once
Basis Issues
(slide 2 of 3)
• Partner’s basis is important for determining:
– Deductibility of partnership losses
– Tax treatment of partnership distributions
– Calculating gain or loss on the partner’s
disposition of the partnership interest
Basis Issues
(slide 3 of 3)
• Partner’s capital account balance is usually not
a good measure of a partner’s adjusted basis in
a partnership interest for several reasons
• e.g., Basis includes partner’s share of partnership
liabilities; Capital account does not
Partnership Formation Transaction
Tax Consequences of
Partnership Formation (slide 1 of 2)
• 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
Tax Consequences of
Partnership Formation (slide 2 of 2)
• Partner’s basis in partnership interest = 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
WST Partnership Formation
Example (slide 1 of 2)
• William contributes cash
– Amount
$20,000
• Sarah contributes land
– Basis
– FMV
$ 6,000
$20,000
• Todd contributes equipment
– Basis
– FMV
$22,000
$20,000
WST Partnership Formation
Example (slide 2 of 2)
Gain or loss
Partner Recognized
Basis in
Interest
Partnership’s
Property Basis
William
Sarah
Todd
$20,000
$ 6,000
$22,000
$20,000
$ 6,000
$22,000
$-0$-0$-0-
Neither the partnership nor any of the partners recognizes
gain or loss on the transaction
Exceptions to Tax-Free Treatment on
Partnership Formation (slide 1 of 4)
• Transfers of appreciated stock to investment
partnership
– Gain will be recognized by contributing partner
– Prevents multiple investors from diversifying their
portfolios tax-free
Exceptions to Tax-Free Treatment on
Partnership Formation (slide 2 of 4)
• If transaction is essentially a taxable exchange
of properties, gain will be recognized
– e.g., Individual A contributes land and Individual
B contributes equipment to a new partnership;
shortly thereafter, the partnership distributes the
land to B and the equipment to A; Partnership
liquidates
– IRS will disregard transfer to partnership and treat
as taxable exchange between A & B
Exceptions to Tax-Free Treatment on
Partnership Formation (slide 3 of 4)
• Disguised Sale
– e.g., Partner contributes property to a partnership;
Shortly thereafter, partner receives a distribution
from the partnership
• Distribution may be viewed as a purchase of the
property by the partnership
Exceptions to Tax-Free Treatment on
Partnership Formation (slide 4 of 4)
• 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 services are not deductible by the partnership, they
must be capitalized to an asset account
Profits Interest Received in Exchange
for Services (slide 1 of 2)
• When a partner receives an interest in the
partnership’s future profits in exchange for
services
– The partner is not typically required to recognize
any income when is received
• Even if the partner is fully vested in the partnership
interest
– The amount of the partnership’s future profits
cannot typically be determined, and no liquidation
rights exist
• So, there is no current value to the interest
Profits Interest Received in Exchange
for Services (slide 2 of 2)
• However, receipt of the profits interest
might be currently taxable if
– The future income of the partnership is
assured,
– Partnership interest is sold within two years
of receipt, or
– The interest relates to a limited partnership
interest in a publicly traded partnership
Tax Issues Relative to Contributed Property
(slide 1 of 4)
• Contributions of depreciable property and
intangible assets
– Partnership “steps into shoes” of contributing
partner
• Continues the same cost recovery and amortization
calculations
• Cannot expense contributed depreciable property under
§179
Tax Issues Relative to Contributed Property
(slide 2 of 4)
• Gain or loss is ordinary when partnership
disposes of:
– Contributed unrealized receivables
– Contributed property that was inventory in
contributor’s hands, if disposed of within 5 years
of contribution
• Inventory includes all tangible property except capital
assets and real or depreciable business assets
Tax Issues Relative to Contributed Property
(slide 3 of 4)
• If contributed property is disposed of at a loss
and the property had a ‘‘built-in’’ capital loss
on the contribution date
– Loss is treated as a capital loss if disposed of
within 5 years of the contribution
– Capital loss is limited to amount of ‘‘built-in’’ loss
on date of contribution
Tax Issues Relative to Contributed Property
(slide 4 of 4)
• Special allocations must be made relative to
contributed property that is appreciated or
depreciated
– The partnership’s income and losses must be
allocated under § 704(c) to ensure that the inherent
gain or loss is not shifted away from the
contributing partner
– Discussed later in the chapter
The Big Picture – Example 13
Contributions To The Partnership (slide 1 of 2)
• Return to the facts of The Big Picture on p. 21-1.
• Kyle’s and Maria’s capital contributions to the newly formed
LLC are as follows
– Kyle contributes real estate, basis $600,000, FMV $2 million.
– Maria contributes bakery equipment, basis $0, FMV $500,000.
• No tax consequences on formation of Beachside Properties,
LLC for the LLC, Kyle, or Maria.
– Kyle does not recognize his $1.4 million realized gain.
– Maria does not recognize her $500,000 realized gain.
• Kyle takes a substituted basis of $600,000 for his interest.
• Maria takes a substituted basis of $1.5 million ($1.5 million
for contributed cash + $0 for contributed property).
The Big Picture – Example 13
Contributions To The Partnership (slide 2 of 2)
• Beachside Properties has the following adjusted basis in the
contributed property.
– A carryover basis of $600,000 for the real estate contributed by Kyle.
– A carryover basis of $0 for the property contributed by Maria.
• To the extent that the buildings and other land improvements
are depreciable, the LLC ‘‘steps into Kyle’s shoes’’ in
calculating depreciation deductions.
• When Josh vests in his 5% capital interest in the LLC in
exchange for services, the $200,000 is taxable to him.
– Beachside Properties will probably capitalize this amount because it
relates to construction
• Josh’s 20% interest in future profits will be taxed to him as
profits are earned by the partnership.
Elections Made by Partnership
(slide 1 of 2)
• Inventory method
• Accounting method
– Cash, accrual or hybrid
•
•
•
•
Depreciation method
Tax year
Organizational cost amortization
Start-up expense amortization
Elections Made by Partnership
(slide 2 of 2)
• Optional basis adjustment (§754)
• §179 deduction
• Nonrecognition treatment for involuntary
conversions
• Election out of partnership rules
Organizational Costs
(slide 1 of 2)
• Partnership may elect to deduct up to $5,000
of organization costs in year business begins
– Deductible amount must be reduced by
organization costs that exceed $50,000
– Remaining amounts are amortizable over 180
months beginning with month the partnership
begins business
Organizational Costs
(slide 2 of 2)
• Organizational costs include costs:
– Incident to creation of the partnership, chargeable to a
capital account, and of a character that, if incident to the
creation of a partnership with an ascertainable life, would
be amortized over that life
• Includes accounting fees and legal fees connected with the
partnership’s formation
• Costs incurred for the following items are not
organization costs:
–
–
–
–
Acquiring and transferring assets to the partnership
Admitting and removing partners, other than at formation
Negotiating operating contracts
Syndication costs
Start-up Costs
(slide 1 of 2)
• Start-up costs—include operating costs incurred after
entity is formed but before it begins business
including:
–
–
–
–
Marketing surveys prior to conducting business
Pre-operating advertising expenses
Costs of establishing an accounting system
Costs incurred to train employees before business begins,
and
– Salaries paid to executives and employees before the start
of business
Start-up Costs
(slide 2 of 2)
• Partnership may elect to deduct up to $5,000
of start-up costs in the year it begins business
– Deductible amount must be reduced by start-up
costs in excess of $50,000
– Costs that are not deductible under this provision
are amortizable over 180 months beginning with
the month in which the partnership begins business
Method of Accounting
(slide 1 of 2)
• New partnership may adopt cash, accrual or
hybrid method
– Cash method cannot be adopted if partnership:
• Has one or more C corporation partners
• Is a tax shelter
Method of Accounting
(slide 2 of 2)
• C Corp partner does not preclude use of cash
method if:
– Partnership meets the $5 million or less gross
receipts test
– C corp partner(s) is a qualified personal service
corp, or
– Partnership is engaged in farming business
Required Taxable Year
• Partnership must adopt tax year under first of
the following tests that applies:
Least Aggregate Deferral – Example 15
(slide 1 of 2)
• Crimson, Inc., and Indigo, Inc., are equal partners in the CI
Partnership.
– Crimson uses the calendar year, and Indigo uses a fiscal year ending
August 31.
• Neither Crimson nor Indigo is a majority partner as neither
owns more than 50%.
• Although Crimson and Indigo are both principal partners, they
do not have the same tax year.
• Therefore, the general rules indicate that the partnership’s
required tax year must be determined by the “least aggregate
deferral rule.”
• The following computations support August 31 as CI’s tax
year.
Least Aggregate Deferral Example 15
(slide 2 of 2)
Alternative Tax Years
• Other alternatives may be available if:
– Establish to IRS’s satisfaction that a business
purpose exists for another tax year
• e.g., Natural business year at end of peak season
– Choose tax year with no more than 3 month
deferral
• Partnership must maintain with the IRS a prepaid, noninterest-bearing deposit of estimated deferred taxes
– • Elect a 52- to 53-week taxable year
Measuring Income of Partnership
• Calculation of partnership income is a
2-step approach
– 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
Separately Stated Items
(slide 1 of 2)
• If an item of income, expense, gain or loss
might affect any 2 partners’ tax liabilities
differently, it is separately stated
Separately Stated Items
(slide 2 of 2)
• Separately stated items fall under the
“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
Examples of Separately Stated Items
(slide 1 of 2)
• Net short and long-term capital gains and
losses
• §1231 gains and losses
• Domestic production activities deduction
• Charitable contributions
• Interest income and other portfolio income
• Expenses related to portfolio income
Examples of Separately Stated Items
(slide 2 of 2)
•
•
•
•
•
•
Personalty expensed under §179
Special allocations of income or expense
AMT preference and adjustment items
Passive activity items
Self-employment income
Foreign taxes paid
The Big Picture – Example 16
Income Measurement & Reporting
(slide 1 of 4)
The Big Picture – Example 16
Income Measurement & Reporting
(slide 2 of 4)
• The LLC experienced a $250,000 net loss from
operations last year, its first year of business.
• In addition, as discussed later, Beachside paid
$240,000 to its members as guaranteed payments.
• Beachside will determine its ordinary income or loss
for the year, along with its separately stated items.
• In addition, Beachside will report additional
information the partners might need to prepare their
individual income tax returns.
The Big Picture – Example 16
Income Measurement & Reporting (slide 3 of 4)
• Beachside is not a allowed a deduction for last year’s
$250,000 NOL
– This item was passed through to the LLC members in the
previous year.
• The LLC is not allowed a deduction for payment of
Kyle’s medical expenses.
– This payment is probably handled as a distribution to Kyle,
who may report it as a medical expense on his Schedule A
in determining his itemized deductions.
The Big Picture – Example 16
Income Measurement & Reporting (slide 4 of 4)
• Similarly, the LLC cannot deduct the distribution to
Maria.
– Distributions are discussed later in the Chapter.
• The AMT adjustment is not a separate component of
the LLC’s income
– It must be reported by Beachside’s members so that they
can properly calculate any AMT liability.
The Big Picture – Example 17
Income Measurement & Reporting (slide 1 of 2)
The Big Picture – Example 17
Income Measurement & Reporting (slide 2 of 2)
The Big Picture – Example 18
Income Measurement & Reporting
The Big Picture – Example 19
Income Measurement & Reporting
• Continue with the facts in Examples 16 and 17, but
now consider the book-tax reconciliation.
– Beachside Properties, LLC, must prepare the Analysis of
Income (Loss) and Schedule M–1 on Form 1065, page 5.
– In preparing these schedules, the LLC combines the
ordinary income of $180,000, guaranteed payments of
$240,000, and the four separately stated income and
deduction amounts in Example 17 to arrive at “net income”
of $730,000.
– This amount is shown on line 1 of the Analysis of Income
(Loss) and is the amount to which book income is
reconciled on Schedule M–1, line 9.
Partnership Allocations
(slide 1 of 4)
• Partnership agreement can provide that a
partner share capital, profits, and losses in
different ratios
– e.g., Partnership agreement may provide that a
partner has a 30% capital sharing ratio, yet be
allocated 40% of the profits and 20% of the losses
– Such special allocations are permissible if certain
rules are followed
• e.g., Economic effect test
Partnership Allocations
(slide 2 of 4)
• The economic effect test requires that:
– An allocation must be reflected in a partner’s
capital account
– When partner’s interest is liquidated, partner must
receive assets with FMV = the positive balance in
the capital account
– 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
Partnership Allocations
(slide 3 of 4)
• Substantiality
– Partnership allocations must also have
“substantial” effect
• In general, an allocation does not meet the “substantial”
test unless it has economic consequences in addition to
tax consequences that might benefit a subset of the
partners
Partnership Allocations
(slide 4 of 4)
• Precontribution gain or loss
– Must be allocated to partners taking into account the
difference between basis and FMV of property on date of
contribution
• For nondepreciable property this means any built-in gain or loss
must be allocated to the contributing partner when disposed of by
partnership in taxable transaction
• For depreciable property, allocations related to the built-in loss can
be made only to the contributing partner
– For allocations to other partners, the partnership’s basis in the loss
property is treated as being the fair market value of the property at the
contribution date
The Big Picture – Example 23
Precontribution Gain or Loss (slide 1 of 2)
• Return to the facts of The Big Picture on p. 21-1.
• When Beachside Properties, LLC, was formed
– Kyle contributed land (value of $800,000 and basis of $600,000) and
buildings (value of $1,200,000 and basis of $0).
– Maria contributed equip. & furnishings with FMV $500,000, basis $0.
• For § 704(b) book accounting purposes, Beachside records the
land and other properties at their FMV.
– For tax purposes, the LLC takes carryover bases in the properties.
• The LLC must keep track of the differences between the basis
in each property and the value at the contribution date.
– If any property is sold, gain must be allocated to contributing partner to
extent of previously unrecognized built-in gain.
The Big Picture – Example 23
Precontribution Gain or Loss (slide 2 of 2)
• For example, if Beachside sells the land contributed by Kyle for $1.1
million, the gain would be calculated and allocated as follows:
Amount realized
Less: Adjusted basis
Gain realized
Built-in gain to Kyle
Remaining gain (allocated
proportionately)
§ 704(b)
$1,100,000
800,000
$ 300,000
–0–
___Tax_
$1,100,000
600,000
$500,000
200,000
$ 300,000
$ 300,000
• For tax purposes,
– Kyle would recognize $320,000 of the gain [($300,000 X 40%) +
$200,000]
– Maria would recognize $120,000 ($300,000 X 40%), and
– Josh would recognize $60,000 ($300,000 X 20%).
The Big Picture – Example 24
Schedule K-1 (slide 1 of 3)
• Consider the facts of Examples 16 and 17.
• Maria is a 40% owner.
– She will receive a Schedule K–1 showing her 40%
share of ordinary income and separately stated
items from Beachside Properties.
– On her Form 1040, Maria includes
•
•
•
•
•
$72,000 of ordinary income
$2,400 charitable contributions
$4,800 short-term capital gain
$120,000 passive rental income
$1,600 qualified dividend income
The Big Picture – Example 24
Schedule K-1 (slide 2 of 3)
• Consider the facts of Examples 16 and 17.
– On the first page of Form 1040, Maria lists her
$840 share of tax-exempt interest.
– She must also consider the $120,000 guaranteed
payment she received.
– In determining her AMT liability (if any), Maria
takes into account a $7,290 positive adjustment.
– If any amounts had been specially allocated to
Maria, the allocation would be reflected in the
amount shown on her Schedule K–1.
The Big Picture – Example 24
Schedule K-1 (slide 3 of 3)
• Consider the facts of Examples 16 and 17.
• In her personal tax return, Maria combines the
partnership’s amounts with similar items from
sources other than Beachside.
– For example, if Maria has a $3,000 long-term capital loss
from a stock transaction, the overall net short-term capital
gain calculated on Schedule D of her 1040 is $1,800.
• For each LLC item, the sum of the allocated amounts
on Josh’s, Kyle’s, and Maria’s K–1s will equal the
totals on Beachside Properties’ Schedule K.
Basis of Partnership Interest
(slide 1 of 3)
• For new partnerships, partner’s basis usually
equals:
– Adjusted basis of property contributed, plus
– FMV of any services performed by partner in
exchange for partnership interest
Basis of Partnership Interest
(slide 2 of 3)
• 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 (or alternate valuation date)
Basis of Partnership Interest
(slide 3 of 3)
• A partner’s basis in partnership interest is
adjusted to reflect partnership activity
– This prevents double taxation of partnership
income
Basis Example
(slide 1 of 2)
•
•
•
•
Pam is a 30% partner in the PDQ partnership
Pam’s beginning basis is $20,000
PDQ reports current income of $50,000
Pam sells her interest for $35,000 at the end of
the year
Basis Example
(slide 2 of 2)
With Basis
Adjustment
$ 35,000
Without Basis
Adjustment
$35,000
Selling Price(A)
Less: Basis in interest
Beginning basis
20,000
20,000
Share of current income
15,000
- 0- .
Ending basis (B)
35,000
20,000
Taxable gain (A)-(B)
$ -0$15,000
–If no basis adjustment, Pam's $15,000 share of partnership
income is taxed twice: as ordinary income and as gain on
sale of interest
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
Basis Limitation
• A partner’s basis in the partnership interest can
never be negative
Partnership Liabilities
• Affect partner’s adjusted basis
– Increase in partner’s share of liabilities
• Treated as a cash contribution to the partnership
• Increases partner’s adjusted basis
– Decrease in partner’s share of liabilities
• Treated as a cash distribution to the partner
• Decreases partner’s adjusted basis
Allocation of Partnership Liabilities
• Two types of partnership debt
– Recourse debt—The partnership or at least one
partner is personally liable
• Allocate to partners using a “Constructive Liquidation
Scenario”
– Nonrecourse debt—No partner is personally liable
• Allocate to partners using a three-tiered allocation
Constructive Liquidation Scenario
•
•
•
•
1.
2.
3.
4.
Partnership assets deemed to be worthless
Assets deemed sold at $0; losses determined
Losses allocated to partners under partnership agreement
Partners with negative capital accounts deemed to
contribute cash to restore negative balance to 0
• 5. Deemed contributed cash would repay partnership debt
• 6. Partnership deemed to liquidate
• - Partner’s share of recourse debt = Cash contribution
used to repay debt (Step 5)
Nonrecourse Debt Allocation
• Three step allocation:
– 1. “Minimum Gain” allocated under regulations
• Minimum gain is basically gain which would arise on
foreclosure of property
– 2. Liability = precontribution gain allocated to
contributing partner
– 3. Remaining debt commonly allocated by profit
sharing ratios (other allocation methods could
be used)
The Big Picture – Example 30
Basis In Partnership Interest (slide 1 of 4)
• Return to the facts of The Big Picture on p. 21-1.
• How is Maria’s basis affected by the income and
deductions of Beachside Properties, LLC?
• Assume the following:
– At the beginning of the tax year (Beachside’s second year
of operations), Maria’s basis in her LLC interest was $1.6
million.
• Includes her $200,000 share of the LLC’s $500,000 of nonrecourse
debt.
– At the end of the year, Beachside had $600,000 of debt,
which was again treated as nonrecourse to all the LLC
members.
The Big Picture – Example 30
Basis In Partnership Interest (slide 2 of 4)
• During the year, Maria contributes to the LLC:
– Cash $100,000, and
– Additional property, basis $0, FMV $50,000.
• On December 31, the LLC distributes $20,000
cash to her.
• Maria’s share of Beachside’s income, gain,
and deductions is as described in Example 24.
The Big Picture – Example 30
Basis In Partnership Interest (slide 3 of 4)
•
Maria’s basis at year-end calculated using the ordering rules shown in Figure 21.3.
is as follows:
Beginning basis
Contributions, including increase in share of liabilities:
Share of net increase in LLC liabilities
[40% X ($600,000 - $500,000)]
Cash contribution to LLC capital
Maria’s basis in noncash capital contribution
Share of LLC income items:
Ordinary LLC income
LLC’s net passive income from rental real estate
Tax-exempt income
Short-term capital gain
Qualified dividend income
Distributions and withdrawals:
Capital withdrawal
Share of LLC deduction items:
Charitable contribution
Ending basis
$1,600,000
40,000
100,000
–0–
72,000
120,000
840
4,800
1,600
(20,000)
(2,400)
$1,916,840
The Big Picture – Example 30
Basis In Partnership Interest (slide 4 of 4)
• As will be explained later in the Chapter,
Maria could withdraw cash from the LLC up
to the amount of her basis without paying tax
on the distribution.
• Maria’s basis does not appear on the LLC’s tax
return or on her Schedule K–1.
– All partners are responsible for maintaining their
own basis calculations.
The Big Picture – Example 31
Partner’s Capital Account
• Maria’s Schedule K–1 will show her capital account rollforward from the
prior year to the current year.
• Assume that her capital account is calculated on a tax basis and that the
beginning capital account balance was $1.4 million.
• The reconciliation shown on Schedule K–1 will be as follows:
Beginning capital account
$1,400,000
Capital contributed during the year
100,000
Current-year increase (decrease)
196,840
Withdrawals and distributions
(20,000)
Ending capital account
$1,676,840
• Although this will not always be the case, Maria’s ending capital account
balance differs from her ending basis by the amount of her $240,000 share
of the LLC’s nonrecourse debt.
Loss Limitations
(slide 1 of 2)
• Partnership losses flow through to partners for
use on their tax returns
– Amount and nature of losses that may be used by
partners may be limited
– Three different loss limitations apply
• Only losses that make it through all three limits are
deductible by a partner
Loss Limitations
(slide 2 of 2)
Section
704(d)
465
469
Description
Basis in partnership interest
At-risk limitation
Passive loss limitation
• Limitations are applied successively to
amounts which are deductible at all prior
levels
Loss Limitation Example 32
(slide 1 of 2)
Megan's basis in interest
$50,000
At-risk amount
$35,000
Passive income, other sources
$25,000
Share of partnership losses (passive)
$60,000
Loss Limitation Example 32
(slide 2 of 2)
Provisions Deductible loss
§704(d)
$ 50,000
§465
35,000
§469
25,000*
Suspended loss
$ 10,000
15,000
10,000
*Amount deducted on tax return: $25,000
-passes all three loss limitations
Guaranteed Payments
• Payment to partner for use of capital or for
services provided to partnership
– May not be determined by reference to partnership
income
– Usually expressed as a fixed dollar amount or as a
% of capital
Treatment of Guaranteed Payments
(slide 1 of 2)
• 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
Treatment of Guaranteed Payments
(slide 2 of 2)
• Includable in income of partner at time
partnership deducts
– Treated as if received on last day of partnership tax
year
– Character is ordinary income to recipient partner
The Big Picture – Example 36
Guaranteed Payments (slide 1 of 2)
• Return to the facts of The Big Picture as
updated in Example 17.
– Assume that Josh was elected as managing
member of Beachside Properties, LLC
• He works 1,000 hours per year in the business.
– Maria works 1,000 hours per year in the café.
– After transferring his land to Beachside, Kyle has
generally not been involved in the LLC’s
operations.
The Big Picture – Example 36
Guaranteed Payments (slide 2 of 2)
• Kyle and Josh each receive a guaranteed payment of
$5,000 per month from the LLC.
– Josh’s payment is for services, and Kyle’s is for use of his
land.
• Maria receives a guaranteed payment of $10,000 per
month.
– $5,000 is for services, and
– $5,000 is for the use of her $2 million of capital.
• The guaranteed payments total $240,000 for the year
(12 months × $5,000 × 4 payments).
– Beachside may deduct these payments.
The Big Picture – Example 37
Reporting Guaranteed Payments (slide 1 of 2)
• Continue with the facts of Examples 17 and 36.
• Beachside’s ordinary income was $420,000 before the
guaranteed payments were deducted.
– After the deduction, Beachside’s ordinary income is $180,000.
• As owners of 40% profits interests, Kyle and Maria are each
allocated $72,000 of the LLC’s $180,000 of ordinary income
as well as their shares of the LLC’s separately stated items.
The Big Picture – Example 37
Reporting Guaranteed Payments (slide 2 of 2)
• In addition, Kyle will report as income his guaranteed payment
of $60,000, and Maria will report the $120,000 guaranteed
payment she received.
• As the owner of a 20% profits interest, Josh will report his
$36,000 share of Beachside’s ordinary income (as well as his
share of the other separately stated items).
– In addition, Josh will report as income the $60,000 guaranteed payment
he received.
Other Transactions Between Partner and
Partnership (slide 1 of 2)
• May be treated as if partner were an outsider,
for example:
– Loan transactions
– Rental payments
– Sales of property
Other Transactions Between Partner and
Partnership (slide 2 of 2)
• Timing of deduction for payment by an accrual
basis partnership to a cash basis partner
depends on whether payment is:
– Guaranteed payment
• Included in partner’s income on last day of partnership
year when accrued (even if not paid until the next year)
– Payment to partner treated as an outsider
• Deduction cannot be claimed until partner includes the
amount in income
Sales 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 sold at a gain, the
disallowed loss reduces gain recognized
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 deduct 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
The Big Picture – Example 38
Self-employment Tax Of Partners
(slide 1 of 2)
• Return to the facts of The Big Picture in Examples 36 and 37.
• If Beachside follows the Proposed Regulations, the members’
distributive shares and guaranteed payments will be treated as
follows:
The Big Picture – Example 38
Self-employment Tax Of Partners
(slide 2 of 2)
• * Under the Proposed Regulations, Maria’s
distributive share is not SE income.
– She is not personally liable for the LLC’s debt, and
she is not authorized to contract on behalf of the
LLC.
– Even though she works for the LLC more than 500
hours per year, another LLC member (Kyle) has
the same rights as Maria.
• Because Kyle would be classified as a limited partner, Maria is also
classified as such.
Distributions from a Partnership
(slide 1 of 4)
• A payment from a partnership to a partner is not
necessarily treated as a distribution
– e.g., Partnership may pay interest or rent to a partner, make
a guaranteed payment, or purchase property from a partner
• If a payment is treated as a distribution, it will fall
into one of two categories:
– Liquidating distributions
– Nonliquidating distributions
• Depends on whether the partner remains a partner in
the partnership after the distribution
Distributions from a Partnership
(slide 2 of 4)
• A liquidating distribution occurs when either:
– Partnership itself liquidates and distributes all its
property to the partners, or
– Ongoing partnership redeems interest of one of its
partners
• e.g., Partner retires
Distributions from a Partnership
(slide 3 of 4)
• A nonliquidating distribution is any
distribution from a continuing partnership to a
continuing partner
– Two types of nonliquidating distributions
• Draw
– Distribution of partner’s share of current or accumulated
profits
• Partial liquidation
– Reduces partner’s interest in partnership capital but does not
liquidate partner’s interest
Distributions from a Partnership
(slide 4 of 4)
• Distributions from a partnership may be either:
– Proportionate—Partner receives his or her share of
certain ordinary income-producing assets
– Disproportionate—Partner’s share of certain
ordinary income-producing assets increases or
decreases
Proportionate Nonliquidating Distributions
(slide 1 of 3)
• In general, neither partner nor partnership
recognizes gain or loss on proportionate
nonliquidating distributions
– Partner usually takes a carryover basis in assets
distributed
– Basis in partnership interest is reduced by amount
of cash and basis of property distributed
Proportionate Nonliquidating Distributions
(slide 2 of 3)
– Partner recognizes gain to extent cash received
exceeds partner’s adjusted basis (outside basis) in
partnership interest
• Reduction in partner’s share of partnership debt is
treated as a distribution of cash
– First reduces partner’s basis in partnership
– Any reduction in excess of partner’s basis in partnership results
in taxable gain to the partner
– Partner cannot recognize loss on a proportionate
nonliquidating distribution
Proportionate Nonliquidating Distributions
(slide 3 of 3)
• Property distributions
– In general, 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
Ordering Rules
• 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
Proportionate Nonliquidating Distribution
Examples (slide 1 of 6)
Bill’s basis in partnership interest: $30,000
Proportionate nonliquidating distributions
(independent fact situations):
Assets Distributed
A
B
Cash
$15,000 $15,000
Land—basis
N/A
$ 6,000
(Fair mkt value)
N/A
$10,000
Accts rec—basis
N/A
N/A
(Fair mkt value)
N/A
N/A
C .
$ 5,000
N/A
N/A
-0$16,000
Proportionate Nonliquidating Distribution
Examples (slide 2 of 6)
A
B
C
.
Basis in interest
$30,000
$30,000
$30,000
Cash distributed
Basis after cash
Acct. rec. distrib.
Basis after A.R.
Land Distrib.
Basis after all dist.
( 15,000)
15,000
N/A
15,000
N/A
$15,000
(15,000)
15,000
N/A
15,000
( 6,000)
$ 9,000
(5,000)
25,000
(-0-)
25,000
N/A
$25,000
Proportionate Nonliquidating Distribution
Examples (slide 3 of 6)
Basis in p’ship int.
Basis in cash
Basis in land
Basis in A/R
Total basis
A
$15,000
15,000
N/A
N/A
$30,000
Sale of non-cash assets
at FMV: Selling price N/A
Basis
N/A
Gain
N/A
B
$9,000
15,000
6,000
N/A
$30,000
C .
$25,000
5,000
N/A
-0$30,000
$10,000
(6,000)
$4,000
$16,000
(-0-)
$16,000
Proportionate Nonliquidating Distribution
Examples (slide 4 of 6)
Bill’s basis in partnership interest:
$30,000
Proportionate nonliquidating distributions
(independent fact situations):
Assets Distributed
Cash
Relief of liabilities
Land-basis
(Fair mkt value)
D
$40,000
N/A
N/A
N/A
E
N/A
40,000
N/A
N/A
F .
$20,000
N/A
$30,000
$50,000
Proportionate Nonliquidating Distribution
Examples (slide 5 of 6)
Basis in interest
Cash distributed
Relief of liabilities
Gain recognized
Basis after cash (and
deemed cash) dist.
Land distrib.
Basis after all distrib.
D
$30,000
(40,000)
N/A
10,000
E
$30,000
N/A
(40,000)
10,000
F .
$30,000
(20,000)
N/A
N/A .
-0N/A
-0-
-0N/A
-0-
10,000
(10,000)
-0-
Proportionate Nonliquidating Distribution
Examples (slide 6 of 6)
Basis in p'ship int.
Basis in cash
Liabilities relieved
Basis in land
Gain recognized
Original basis
Sale of non-cash assets
at FMV: Selling price
Basis
Gain
D
-040,000
N/A
N/A
(10,000)
30,000
N/A
N/A
N/A
E
-0N/A
40,000
N/A
(10,000)
30,000
N/A
N/A
N/A
F .
-020,000
N/A
10,000
N/A .
30,000
$50,000
(10,000)
$40,000
Effect of Liquidating Distribution
• In general:
– 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
Exceptions to Liquidating Distribution
Rules (slide 1 of 2)
• Gain is recognized if:
– Cash distributed exceeds partner’s basis
– Precontribution gain exceptions
– Disproportionate distribution
Exceptions to Liquidating Distribution
Rules (slide 2 of 2)
• 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
Proportionate Liquidating Distribution Examples
(slide 1 of 4)
Bill’s basis in partnership interest: $30,000
Proportionate liquidating distributions (partnership also
liquidates) (independent fact situations):
G
H
I
.
Cash
$50,000
$10,000
$10,000
Unrealized rec.
N/A
-0-0(Fair mkt value)
N/A
$16,000
$16,000
Filing cabinet (1231) N/A
N/A
300
(Fair mkt value)
N/A
N/A
300
Proportionate Liquidating Distribution Examples
(slide 2 of 4)
Basis in interest
Cash distribution
Gain recognized
Basis after cash
A/R distrib.
Loss recognized
Basis after A/R
Filing cabinet
Ending basis
G
$30,000
(50,000)
20,000
-0N/A
N/A
-0N/A
$ -0-
H
$30,000
(10,000)
N/A
20,000
-0(20,000)
-0N/A
$ -0-
I
.
$30,000
(10,000)
N/A
20,000
-0N/A
20,000
(20,000)
$ -0-
Proportionate Liquidating Distribution Examples
(slide 3 of 4)
Basis in p’ship int.
Basis in cash
Basis in A/R
Basis in filing cabinet
Capital (Gain)/loss
Original basis
G
H
I
.
$ -050,000
N/A
N/A
(20,000)
$30,000
$ -010,000
-0N/A
20,000
$30,000
$ -010,000
-020,000
N/A .
$30,000
Proportionate Liquidating Distribution Examples
(slide 4 of 4)
Sale of non-cash assets at FMV:
Example H:
A/R
Selling price
$16,000
Basis
-0Gain/(loss)
$16,000
Example I:
Selling price
Basis
Gain/(loss)
$16,000
-0$16,000
(Ordinary)
Fil.Cab.
N/A
N/A
N/A
(Ordinary)
Total .
$16,000
-0- .
$16,000
$
$16,300
20,000
($3,700)
300
20,000
($19,700)
(May be ord)
Sale of Partnership Interest
(slide 1 of 4)
• 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 are treated as part of consideration paid for
the partnership interest
Sale of Partnership Interest
(slide 2 of 4)
• Partnership tax year closes for selling partner
on sale date
– Partner’s share of income through sale date is
calculated
• Can prorate annual income or use interim closing of the
books
– Taxed to selling partner and increases basis in
partnership interest
Sale of Partnership Interest
(slide 3 of 4)
• Effect of hot assets
– Hot assets include:
• Unrealized receivables (same as for disproportionate
distributions)
• Inventory
– Includes all partnership property except money, capital assets,
and §1231 assets
Sale of Partnership Interest
(slide 4 of 4)
• Effect of hot assets (cont’d)
– 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
Limited Liability Companies
• A LLC with 2 or more owners is taxed as a
partnership
– LLC members are not personally liable for debts of
the entity
• Effectively treated as a limited partnership with no
general partners
– LLCs are relatively new so there is no established
body of case law available
• Makes planning difficult
Limited Liability Partnerships
• Partners are not personally liable for the
malpractice and torts of their partners
• Taxable as a partnership
• Conversion of a general partnership into a LLP
is not taxable if all of the general partners
become LLP partners and hold the same
proportionate interest
Refocus On The Big Picture (slide 1 of 3)
•After considering the various types of partnerships,
Kyle, Maria, and Josh decide to form Beachside
Properties as an LLC (see Example 1).
•On formation of the entity, there was no tax to the LLC
or to any of its members (see Example 13).
•Beachside Properties computes its income as shown in
Examples 16 and 17 and allocates the income as
illustrated in Examples 23 and 24.
Refocus On The Big Picture (slide 2 of 3)
• The LLC’s income affects the members’ bases and
capital accounts as shown in Examples 30 and 31.
•Payments to the members for services or for the use of
their capital are treated as guaranteed payments.
–The amounts are deducted by the LLC and reported as
income by the LLC member (see Examples 36 and 37).
•An important consideration for the LLC members is
whether their distributive shares and guaranteed
payments will be treated as self-employment income
(see Example 38).
Refocus On The Big Picture (slide 3 of 3)
What If?
•What happens in the future when the LLC members
decide to expand or renovate Beachside’s facilities?
– At that time, the existing members can contribute
additional funds, the LLC can obtain new members, or the
entity can solicit third-party financing.
– An LLC is not subject to the 80% control requirement
applicable to corporations.
• Therefore, new investors can contribute cash or other property in
exchange for interests in the LLC—and the transaction will qualify
for tax-deferred treatment under § 721.
If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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