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3 4 Things
Nine Practical
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You Should
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About Partnership 7Taxation
Hak Dickenson
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When it comes to partnership taxation, clients don’t want theory.
Here are some practical concepts you can use on their behalf.
ing with a partnership can be. Indeed, with the
exception of specialists who work in the partnership taxation area day-in and day-out, many
practitioners are not that familiar with the inner
workings of partnership taxation.
Despite its complexity, partnership is still one
of the favorite forms of organization in use.
Therefore, tax practitioners who do not work
A TAX PRACTITIONER OFTEN HELPS
clients select a form of organization in which
they will conduct their business. With the increasing popularity of the check-the-box rules,
clients typically know that a partnership as
business organization can have certain advantages over C or S corporations. Clients, however, may or may not know how complex work-
Hak Dickenson, a tax practitioner for 28 years, is a member of the ABA Section of Taxation and the Texas Bar’s
Tax Section.
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The Practical Tax Lawyer
daily with partnership taxation but are likely to
engage in business discussions about the use of
partnership should be familiar with some of the
fundamental aspects of Subchapter K. Although the particular best items to discuss may
be subject to debate, it would be a good start for
a tax practitioner to know the “nine practical
things” as set forth in this article.
ONE—LLC, GENERAL PARTNERSHIP, LP
OR LLP? • Once a tax practitioner and the
client have decided that a partnership should be
the form of the business organization, instead of
a C or S corporation, a further discussion is necessary to choose among a limited liability company (“LLC”), traditional partnership, limited
partnership (“LP”), or limited liability partnership (“LLP”). Typically, a tax practitioner
should work with a lawyer who is familiar with
the particular jurisdiction’s state law on LLC,
partnership, LP, LLP, and other substantive aspects of the business organizations.
LLC
In very general terms, here is how one can
typically compare the different forms of organizations that are treated as partnerships for
Federal income tax purposes. An LLC has the liability shield of a C corporation, and also has
the advantage of pass-through attributes of the
partnership for tax purposes. As a hybrid form
of entity, an LLC may generally be managed either by its members or by managers, somewhat
like an LP or even a C corporation. In larger
joint ventures, LLCs are commonly operated
through management committees at the upper
level of the partnership.
General Partnership
A partner in a general partnership is generally responsible for acts of other partners in the
Fall 2001
performance of business affairs of the partnership, including some negligent acts of another
partner in the partnership. In other words, all
partners in a general partnership share equal responsibility for the rights and liabilities of the
partnership.
LP
An LP would typically have a general partner
and a number of limited partners. A general
partner in an LP manages and operates the limited partnership, and the limited partners are
generally passive investors and their liability is
limited to the extent of their investment in the
partnership.
LLP
An LLP is like a general partnership, except
that the partners have limited liability against
either the tort liabilities of the partnership or all
of the partnership liabilities, depending upon
the particular partnership statute. Partners in an
LLP generally stand on equal footing to each
other, unlike the relationship between the general and limited partners in an LP. However, in
an LLP all partners’ liabilities are limited to their
investment in the partnership.
In the eyes of the service, LLCs, general partnerships, LPs, or LLPs are all regarded as partnerships for Federal income tax purposes.
TWO—DEALING WITH PARTNERSHIP
TERMS AND DEFINITIONS • One of the
more confusing aspects of partnership for a
client is to listen to tax practitioners discuss capital accounts, tax basis, book basis, inside basis,
outside basis, and fair market value (“FMV”).
Although some practitioners may disagree, to
avoid any unnecessary confusion in terminolo-
Partnership Taxation
gy, it is better to think of “capital account” in
terms of the IRS tax regulations, rather than to
associate it with any general financial or accounting concepts. The term “capital account”
can be thought of in a special context of a partner’s economic stake in the partnership. In practical terms, it is also a very important part of the
partnership allocation rules. More detail on capital accounts will come later; for now, however,
it is helpful to remember that at the end of the
day, the partnership’s ending capital account
balances of the partners reflect what each partner would be entitled to if the partnership were
to terminate.
Book Value
The term “book value” in the partnership
context is commonly understood to mean a
value of property determined at the time of
contribution of the property. Thus, the book
value is the FMV of the property at the time of
contribution, and often determines the percentage of relative equity ownership of the
partners in the partnership. In contrast to
“book value,” the term “FMV” will be used to
determine the value of a property as of a particular day. Thus, when a “book value” is adjusted upward in accordance with FMV, a
“book up” can occur. The “book up” will be
discussed later in this article as well.
Tax Basis
The term “tax basis” is a term that is already
familiar to tax practitioners. It is used here in the
sense of section 1012 of the Internal Revenue
Code (“Code”): the acquisition cost of a property, with adjustment for depreciation or amortization taken in connection with the property.
The term “inside basis” means tax basis of the
property held by the partnership, and the term
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“outside basis” means a partner’s basis in her
partnership interest in the partnership. The inside basis determines the tax depreciation or
other amortization of the partnership assets that
will be allocated to each partner, and the outside
basis will be the basis for determining any gain
or loss of a partner when she has disposed of
her partnership interest.
Example: AB partnership is formed, with A
contributing $100 cash and B contributing a
building valued at $100. The tax basis of the
building at the time of contribution is $60. After
the contribution, the partnership has tax basis
(inside basis) of $100 for cash and of $60 for the
building. A’s outside basis (in the partnership
interest) is $100, and B’s outside basis (in the
partnership interest) is $60. A and B each have a
capital account of $100 and the book value of
each property contributed is $100.
To see how the partnership would work at
the end of the line, suppose shortly after the formation of the AB partnership, the partnership
decides it was a mistake to form the partnership
and, therefore, decides to liquidate the partnership. Since each partner’s capital account is
$100, each partner is entitled to $100 upon such
liquidation. Such a result of the amount of liquidating distribution in this case makes common
sense since each partner had contributed a
property valued at $100, and that is the value of
property each partner received upon liquidation—and indeed, that is the value of distribution each partner should be entitled to.
THREE—“SUBSTANTIAL ECONOMIC EFFECT” RULE • On the whole, the partnership
is intended to be a flexible vehicle to do business. That flexibility, however, is limited by
the regulations. Any partnership allocation,
whether a tax item involving income, gain,
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The Practical Tax Lawyer
loss, or deduction, must generally be reasonable, have economic justifications, and meet
the technical requirements of the regulations—particularly, the “substantial economic
effect” rule. If an allocation does not meet the
substantial economic effect rule, then the
Service can redetermine the taxpayer’s allocation in accordance with the partner’s interest
in the partnership as determined by taking
into account all facts and circumstances.
The regulations provide a safe harbor for
meeting the substantial economic effect rule.
Under the safe harbor, there is a two-part test for
determining substantial economic effect: one is a
mechanical test relating to the “economic effect”
part of the rule; and the other is a subjective test
relating to the “substantial” part of the rule.
Economic Effect Test of the Safe Harbor
There are three ways to satisfy the safe harbor’s “economic effect” test:
• The primary rule;
• The alternative rule with qualified income
offset rule; and
• The economic equivalence test.
The Primary Rule
The primary rule strictly follows the capital
account rules, and under the capital account
rules an allocation has an economic effect if: (a)
the partner’s capital accounts are determined
and maintained in accordance with regulations
for the duration of the partnership; (b) liquidation proceeds are required to be distributed in
accordance with positive balance of the capital
accounts; and (c) a partner is required to restore
her deficit capital balance. Treas. Reg. §1.7041(b)(2).
Fall 2001
Alternative Rule with
Qualified Income Offset Rule
Under the alternative rule to satisfy the
“economic effect” test, the first two requirements under the primary rule (as set forth in
(a) and (b) just above) must be satisfied. In addition, the alternative rule requires that the
deficit restoration requirement (under (c)
above) must be satisfied by the “qualified income offset” rule. It should be noted that this
qualified income offset rule really says nothing
about how a negative account of partners
should be restored. Rather, the rule comes into
play “if, and only if” a partner “unexpectedly”
receives an adjustment, allocation, or distribution that can create a deficit account, and such
partner would be allocated sufficient income
or gain to eliminate such deficit account.
Economic Equivalence Test
If an allocation fails both the primary rule
and the alternative qualified income offset
rule, the allocation will be nonetheless respected and deemed to meet the economic effect test
if it meets the “economic equivalence” test.
The question of whether economic equivalence test is satisfied under the particular circumstance is answered by examining the economic responsibility of the partners if the partnership were to liquidate, regardless of the
economic performance of the partnership.
Treas. Reg. §1.704-1(b)(2)(ii). In that regard, one
must look to the state law to determine which
partner(s) bears responsibility for the ultimate
liability of the partnership.
“Substantial” Test of the Safe Harbor
The “substantial” part of substantial economic effect safe harbor deals with the issue of
whether there exists a “reasonable possibility”