Chapter 10
Partnership Taxation
Income Tax Fundamentals 2012
Gerald E. Whittenburg
Martha Altus-Buller
2012 Cengage Learning
Learning 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 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)
2012 Cengage Learning
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
2012 Cengage Learning
Partnership 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
2012 Cengage Learning
Partnership 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
2012 Cengage Learning
Partnership Formation
Partner’s basis in partnership interest
plus:
plus:
less:
Equals:
Cash contributed
Basis of property transferred to
partnership
Gain recognized (from prior screen)
Liabilities allocable to other partners
Partner’s initial basis in partnership
2012 Cengage Learning
Example #1 –
Partnership 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?
2012 Cengage Learning
Solution
Example
Anna 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
2012 Cengage Learning
Example #2 –
Partnership 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?
2012 Cengage Learning
Solution
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?
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
2012 Cengage Learning
Changes 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
2012 Cengage Learning
Example –
Basis 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 2011 totaled $42,000.
What is Suresh’s basis in the partnership interest
at year-end?
2012 Cengage Learning
Solution
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
2012 Cengage Learning
Partnership 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
2012 Cengage Learning
Partnership 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!)
2012 Cengage Learning
1099-K Reporting Merchant
Card and Third-Party Payments
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 transactions
The
partnership, LLC or corporation will report
this income on Line 1 of their tax return
2012 Cengage Learning
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
2012 Cengage Learning
Guaranteed 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
2012 Cengage Learning
Tax Years & Partnerships
IRS
establishes rigid rules pertaining to tax
years as follows:
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)
o
2012 Cengage Learning
Transactions Between
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”
2012 Cengage Learning
At-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
2012 Cengage Learning
At-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
2012 Cengage Learning
At-Risk Rules &
Real 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
2012 Cengage Learning
Example
Real 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?
2012 Cengage Learning
Solution
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.
2012 Cengage Learning
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)
2012 Cengage Learning
Limited 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.
2012 Cengage Learning
That’s All
2012 Cengage Learning