P'ships 1, p. 1
570 Lecture Notes
Ch 21: Partnerships - Part 1
I.
Overview
A. Definition of Partnership – An association of 2 or more “persons” to carry on a trade
or business with the intention of splitting profits. Includes joint ventures, associations,
etc.
1.
General partnerships
 Each partner jointly and severally liable for all partnership debt.
B.
2.
Limited partnerships
 At least 1 general partner and at least 1 limited partner
 Limited partner’s loss limited to equity investment
3.
Limited liability partnerships (LLPs)
 Owners are considered general partners
 But, partner is not liable for malpractice of other partners
4.
Limited liability companies (LLCs)
 Owners are considered “members” and not partners
 Owners have the limited liability of a corporation
 Generally taxed as a partnership
5.
“Check-The-Box” Rules (Form 8832)
 Allows most (not all) unincorporated entities to choose tax status (corporation
or partnership)
Taxation and Reporting
1.
Flow-through entity
2.
Timing of income recognition
P’ship Yr. |-----------------------------------------------|
Ptr Yr.
3.
|-----------------------------------------------|
Partnership years (Priority Ranking)
a. Majority Partnership Interest (>50%)
b. All Principal Partners with same year-end
c. Least Aggregate Deferral Calculation
d. Natural Business Year or §444 Election
P'ships 1, p. 2
C.
Some Terminology
1.
Capital interest – % owned in assets at liquidation
Profits interest - % allocation of current operating results (P&L)
2.
II.
Inside basis – P’ship basis in assets
Outside basis – Ptr’s basis in ownership interest
Formation of Partnerships
A. General Consequences
 No Gain (Loss) to partners
 No Gain (Loss) to partnership
 Ptr’s Outside Basis =
Substituted basis from property contributed;
 P’ship Inside Basis =
Carryover from partner
B.
Nontaxable exchange of property for partnership interest.
1.
Exceptions
 Transfer of appreciated stock to investment partnership.
Gain (FMV – Basis) is recognized by partner at contribution.
 Services provided by partner.
Capital Interest received – taxable to partner
Profits Interest (only) received – no income to partner, as it’s an interest in
future profits
 Essentially an exchange (transfer followed by distribution).
 Contributed appreciated property distributed to partners within 7 years of
contribution date.
Built-In Gain (BIG) recognized by contributing partner at distribution.
- Gain results in increase in partner’s outside basis
 Excess boot problems (recourse debt > basis)
P'ships 1, p. 3
D.
Partnership basis in assets received
1.
All tax attributes (holding period, depreciation recapture potential) carryover
* Note – P’ship does NOT increase inside basis if partner recognizes gain at
contribution.
2.
Tainted property (§724)
Caused by sale of property contributed by a partner AND
Character of Gain(Loss) by partnership would be different from the partner’s
 Inventory to partner  §1231 or capital to partnership (5 year taint)
ALL Gain from sales (including post-contribution gain) is ordinary.
 Unrealized receivables of partner (no time limit)
Ordinary income @ collection by partnership
 Capital loss property to partner  ordinary to partnership (5 year taint)
ONLY the Built-In Loss is tainted as capital.
Post-contribution loss can be ordinary.
E.
Partner's basis in investment
1.
Initial basis from contribution of property
Holding Period for Partnership Interest
Basis of property transferred
 If capital or §1231 asset
- Boot received (including debt)
transferred, HP transfers
+ Partnership debt assumed
 If ordinary asset, new HP starts
+ Gain recognized
 If both, allocate
Example 1: A & B contribute $100,000 cash and $100,000 (FMV) of property (basis
of $35,000), respectively, as equal partners.
Partner Gain(Loss) Recog.
A
Outside Basis
P’ship Inside Basis
B
2.
Effects of liabilities at contribution.
Example 2: Same as above, except B's property has a $50,000 recourse debt.
Partner Gain(Loss) Recog.
A
B
Outside Basis
P’ship Inside Basis
P'ships 1, p. 4
Example 3: Same as above, except B's property has a $90,000 recourse debt.
Partner Gain(Loss) Recog.
A
Outside Basis
P’ship Inside Basis
B
3.
Precontribution (aka “Built-In”) Gains & Losses.
Any built-in gain(loss) on property contributed by partner must be
allocated to that partner upon sale by partnership.
Example: Same facts as Example 1. AB Partnership sells B’s asset for $120,000.
a.
b.
Contributions of Depreciable Property
- Track the BIG & subsequent depreciation, including recapture.
Example: C&D form equal partnership. C contributes $100,000 cash; D
contributes equipment ($100,000 FMV; $50,000 basis). CD Partnership takes
$25,000 MACRS in year 1, and then sells the equipment in year 2 for $50,000.
4.
Other tidbits on formation
a.
Organization costs include legal fees for drafting the partnership
agreement, filing fees, cost of required notices, etc. Start-Up costs include
business acquisition or creation costs & preactivity costs.
- Tax treatment allows $10,000 immediate deduction, phased-out if
>$60,000; 15-year amortization for excess.
b.
5.
Syndication fees (cost of issuing & marketing partnership interests)
include prospectuses & commissions on sales of limited partnership
interests. These are NOT amortizable.
Adjustments to basis (subsequent to formation)
a.
P&L (includes Tax-Exempt Income, Nondeductible items, Separately
Stated items)
P'ships 1, p. 5
b.
Recourse debt
- Allocate ONLY to general partners
 Pre 1/89
- Use LOSS Ratio from P&L agreement
 Post 1/89
Constructive Liquidation Scenario:
1) Partnership assets deemed to be worthless
2) Assets deemed sold at $0; losses determined
3) Losses allocated to partners under partnership agreement
4) Partners with negative capital accounts deemed to contribute cash
5) Deemed contributed cash would repay partnership debt
6) Partnership deemed to liquidate
 RESULT: Partner’s share of recourse debt = Cash contribution
used to repay debt (Step 5).
c.
Nonrecourse debt
- Allocate to ALL partners (including limited partners)
 Pre 1/89
- Use GAIN Ratio from P&L agreement
 Post 1/89
Three-step allocation:
1) “Minimum gain” allocated (basically the gain which would arise
on foreclosure of property)
2) Precontribution gain = built-in debt gain allocated to contributing
partner
3) Remaining debt allocated by profit-sharing ratio.
P'ships 1, p. 6
EXAMPLES OF DEBT ALLOCATION:
Recourse Debt Example:
A, B, & C are partners in the ABC Partnership. The P&L agreement allocates profits equally and
losses 20/40/40. A condensed balance sheet shows the following:
Assets
$500,000
Recourse Debt
$200,000
A, Capital
150,000
B, Capital
100,000
O, Capital
50,000
Total
$500,000
The constructive liquidation scenario would sell the assets for $0 and allocate the $500,000 loss:
Beg.
Loss
End.
A, Capital
150,000
(100,000)
50,000
B, Capital
100,000
(200,000)
(100,000)
O, Capital
50,000
(200,000)
(150,000)
(200,000)
B and C would be required to restore their negative capital balances to pay the debt of $200,000.
Therefore, only B & C are deemed to bear the economic risk & share the recourse debt in the
ratio of those negative capital accounts. B is allocated ($100,000 / $250,000) of the total
$200,000 recourse debt, or$80,000. That same logic applies to C, so C is allocated ($150,000 /
$250,000) of the $200,000 recourse debt, or $120,000.
End result: A has an outside basis of $150,000, B has an outside basis of $180,000 ($100,000 +
$80,000) & C has an outside basis of $170,000 ($50,000 + $120,000).
Nonrecourse Debt Example:
A contributes an asset to the AB Partnership in exchange for a 50% interest in capital and P&L.
The asset has an adjusted basis of $40,000, FMV of $70,000, and is encumbered by a
nonrecourse debt of $50,000.
The NR debt allocated to A under the 3-step scenario follows:
Minimum Gain (Debt > FMV)
Precontribution Gain (Lower of (Debt or FMV) > Basis)
Remaining Debt (P&L agreement on Profit allocation = 50%)
Debt allocated to T
$ -010,000
20,000
$30,000
So, A’s outside basis is:
Basis transferred in
- Boot received
+ Share of debt
Outside basis
$40,000
- 50,000
+ 30,000
$ 20,000
P'ships 1, p. 7
III. Operations
A. Separately reported items
1.
Capital Gains (Losses)
2.
§1231 G(L)
3.
Charitable contributions
4.
Dividend income
5.
Foreign taxes
6.
a few others
7.
Ordinary income
B.
Example:
Ordinary Income
(Form 1065 Front)
Sales
$345,000
Dividends Received
Separately stated
(Schedule K)
$345,000
20,000
20,000
Municipal Bond Interest
8,000
8,000
Net STCG
3,000
3,000
Net LTCL
(12,000)
(12,000)
Employee salaries
Guaranteed payments
Other operating expenses
Charitable contributions
Ordinary Income
C.
(135,000)
(135,000)
(20,000)
(20,000)
(110,000)
(110,000)
20,000
(2,000)
2,000
$80,000
Guaranteed Payments (Defn) Amounts paid to partners without regard to profits
(salary or % interest on capital balance).
- DEDUCT to arrive at Ordinary Income & allocate to specific partner(s)
Example: A & B are equal partners in AB Partnership above. B receives the $20,000
guaranteed payment. What is B’s share of the ordinary income?
Example, con’t: Suppose the AB Partnership information above relates to its 10/1/y2 –
9/30/y3 fiscal year, and B’s guaranteed payments were $5,000 from 10/1/y2 – 12/31/y2
and $15,000 from 1/1/y3 – 9/30/y3. How does B (calendar-year) report?
P'ships 1, p. 8
D.
FICA/SECA tax issues
1. Partners are not employees
- No income tax withholding
- No FICA tax, all SECA
- No fringe benefits
- Retirement plans are Keogh plans
2.
What is subject to Self-Employment tax?
General partners = Guaranteed payments + Ordinary Income share
Limited partners = Guaranteed payments (only if salary form, not interest)
IV. Other Issues
A. Special Allocations
1.
Substantial economic effect
2.
"Substantial" requires that the tax effect cannot be disproportionately large
relative to the economic effect, e.g., cannot allocate tax exempt items to one
partner and taxable items to another just to avoid taxes.
3.
B.
Requires 3 things in partnership agreement:
a.
Must maintain capital accounts to reflect the allocation
b.
Distributions at liquidation must be made based on capital accounts.
c.
Deficits at liquidation must be repaid.
At Risk and Passive Activity Loss Limitations.
Example: Assume G and L are the general and limited partners, respectively.
G, Capital = $10
Recourse debt = $20
L, Capital = $100
Current year loss = $(300) P&L ratio is 20/80.
1st – At-Risk Limits
2nd – Passive Activity Loss