Partnership Classification
• What motivates choice to incorporate/nonincorporate?
– Applicable commercial law
– Tax treatment
– Investment and Business Preferences
• What are some non-tax considerations of entity
choice?
• Why are these non-tax considerations important?
Relevant classification of entities
for tax purposes
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Individual - How taxed?
Corporation - How taxed?
Partnership - How taxed?
Compare contrast corporation and
partnership taxation.
• Compare contrast individual taxation and
partnership taxation.
What is a partnership?
• IRC Sec. 761 defines partnership
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2 or more persons (i.e., partners) who
carry on a business
for profit
as co-owners
• Failure to meet these requirements may result in
ineligibility of partnership status
• IRS Pub 541: A partnership is an unincorporated
organization with 2+ members that carry on a
business etc. and divide profits/losses.
When do partnerships not exist/
Rules to Classify Partnerships
• Not a Partnership ( Reg. Sec. 1.761) if
– agreement to share expenses only
– lack of co-ownership (capital interest) -facts and
circumstances test
– lack of a business activity / active pursuit
• Rules used to classify
– Check the box regulations (Regs 301.7701) / AntiAbuse Rules / Rules that allow joint ventures to be
partnership or tenants in common.
Key Tax Related Issues
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Self Employment Tax
Treatment of Liabilities
At Risk Rules
Passive Activity Loss Rules
Tax Matters Partner: Unified Audit and Litigation
Procedures..TMP must be a general partner or
Member manager of LLC, not applicable to small
(<10 partners) or electing large partnerships
>100) electing out of Sub K treatment.
Joint Tenancy v. Partnership
• 3 Key reasons for proper classification
– Filing Requirements..Form 1065 needed for
partnerships
– Tax Elections made at the partnership level…individual
elections invalidated.
– As TIC, co-owner can more easily use like kind
exchange provisions. If a partnership, owners
themselves cannot engage in like-kind exchanges.
• Examples: Investment partnerships/
Expense sharing / Creditor-Debtor
Partnership Tax Years
• Sec 706(a) - a partner’s distributive share of partnership
items is included in gross income for any taxable year of
the partnership ending within or with the taxable year of
the partner.
– For a calendar year taxpayer, in what tax year of the individual is
the following partnership information included:
• Partnerships with a calendar year ending 12/31/04?
• Partnerships with a fiscal year 2/1/04 to 1/31/05?
• Partnerships with a fiscal year 12/1/04 to 11/30/05?
• Partnership tax years generally must have the same taxable
year as the common taxable year of the partners that in the
aggregate have interests greater than 50% (Majority
interest – generally on first day of tax year)
Partnership Tax Years (continued)
• If there is no partner/group of partners with the
same taxable year owning >50%, the partnership
must adopt the common taxable year of all of the
principal partners.
– Principal partner - person owning an interest of 5% or
greater in partnership capital or profits.
• If partnership is unable to determine its tax year
by reference to the majority interest or principal
partners - calendar year or year with least
aggregate deferral is used.
Partnership Tax Year
Continued
• Changes in tax years
– Majority interest / Principal Partner Changes
– If Y/E changes because of ownership changes, the
alteration is deemed an automatic change
– No 4 year spread – Use Form 1128 to make changes.
• When might you see a partnership have a year end
other than a calendar year? What is the most
common occurrence for this situation?
• A partnership can avoid the majority interest and
principal partner rules if a valid business purpose
for an alternate tax year exists.
Tax Years - Business Purpose
• Use Rev Proc 2002-38, 2002-22 to determine natural
business year
• Use 25% test - gross receipts from sales and services for
the last 2 months of the requested tax year must exceed
25%. This must be the case for 3 years prior to the
examination date. However at least 47 months must exist
for examination purposes even though only 36 months are
used.
• If a taxpayer fails the 25% test, they may apply for a
business purpose year end using a preponderance of the the
facts and circumstances - both tax and non-tax
considerations are factored into the request.
Sec. 444 Election
• Allows a year end to be kept (in case of existing
partnerships or elected for new partnerships that is
not the one authorized by IRS or using rules for
business purpose
• Requires and advance payment of the estimated
deferral benefit received from the tax year
difference.
• Deferral cannot exceed 3 months
• Firm is required to keep a non interest bearing
account with the IRS.
Accounting Methods
• Cash / Accrual / Hybrid…what are they?
• Treatment of Inventory?
• Changing accounting methods – automatic
versus required.
• Cannot use cash method if
– Tax Shelter
– Have corporate partner with avg. gross receipts
in excess of $5million.