Partnership Part 2
Election by Partnership
1. Inventory method
2. Accounting method
3. Cash, accrual or hybrid
4. Depreciation method
5. Tax year
6. organization cost amortization
7. 179 deduction
8 Optional basis adjustment IRC 754
9. Election out of partnership rules
Loss Limits
A partner's distributive share of a partnership ordinary loss is allowable as a deduction to the extent of the partner's adjusted basis. To recognize a loss beyond the partner's adjusted basis in his interest in the partnership, the distribution must also:
A. Liquidate the partner's entire interest in the partnership.
B. Be made in the form of money, unrealized receivables or inventory items.
Loss Limitations
At-Risk Rules
The At-Risk rules apply to the partnership ordinary loss. The amount deductible on the form 1040 is the amount that the partner bears an economic risk of loss.
Passive Activity Rules
Passive activity rules also apply to the partner losses. A ordinary loss is generally passive to a partner unless the partner materially participates in the partnership activity.
Partnership Tax Administration
(TEFRA)
Applies when there are more than 10 partners. A tax matters partner (TMP) is designed to enter a settlement agreement which is binding to the other partners. A partner may disagree with the settlement by filing a notice with the IRS.
Distributions
There are three possible situation concerning inside and outside basis of partnership distributions:
1. Outside basis equals inside basis.
2. Outside basis is less than inside basis.
3. Outside basis is more than inside basis.
I. Situation number 1: Outside and Inside basis are Equal
The partnership (inside basis) of the distributed asset is equal to the partner's basis (outside basis).
Example
Facts:
Partner A has a basis of $20,000. The partnership distributes machinery with a partnership basis of $20,000. Outside and inside basis are equal and there is no further computation.
Before Distribution
Partner A Basis $20,000 Partnership
Assets:
Cash $100,000
Machinery $20,000
After Distribution
Partner A Partnership
Partner A basis $20,000 Assets:
Distribution ($20,000) Cash $100,000
0
The partnership basis of the machinery equals the partner's basis.
In all distributions there is an order to which the partner's basis is first applied. The following is the order:
1. Money distributed
2. Unrealized receivables
3 Inventory
3. 1221 assets
5. 1231 assets
II Situation 2 The Partner's basis (outside basis) is less than the partnership basis (outside basis) or to say it differently inside basis exceeds outside basis.
Example 1 of Outside basis less than Inside basis
Facts:
Partner A receives a liquidating distribution of $5,000 cash, a computer with a basis of $4,000 and a FMV of $1,500 and a desk with a basis of $1,500 and a FMV of $500.
Before Distribution
Partner A Partnership Basis
Basis $6,000 Basis FMV Decline
Cash Distribution (5,000) Cash $50,000 $50,000 0 Computer $ 4,000 $ 1,500 $2,500
Desk $ 1,500 $ 500 $1,000 $ 3,500
The partner has a basis of $6,000 and the cash of $5,000 is first applied leaving a balance of $1,000 of basis to be allocated to the remaining distributions, namely the computer and the desk.
Analysis:
The computer and the desk are in the same 1231 category and an allocation must be made. (Please note that if one of the assets was a 1221 asset you would allocate the remaining partner's basis up to the partnership basis of the 1221 asset. If there were any remaining basis it would be allocated to the next category of assets which would be 1231 assets.
Let's get back to our example. How do we compute the basis? The first thing we must do is to compute the basis decrease.
1. Basis Decrease
The basis decrease is: The partner's remaining basis to be allocated to the assets which in this case is $1,000 minus the total basis of the inside assets which is $5,500 ($4,000 plus $1,500).
$5,500
(1.000)
$4,500
1. Determine whether the basis decrease is more or less than the total unrealized depreciation
In our example, the basis decrease is $4,500 and the total decline (unrealized depreciation) is $3,500.
Answer: the basis decrease of $4,500 is more than the total decline of $3,500.
3. Determine the relative adjusted basis
In this situation because the basis decrease is more than the total unrealized depreciation, we allocate a ratio based on the relative adjusted basis.
Computer Desk
Basis $4,000 $1,500
Depreciation
(Decline) ($2,500) ($1,000)
Relative Adjusted Basis $1,500 $500
4. Determine the ratio
a. Computer $1,500 relative adjusted basis X 1,000 remaining basis = 750
$2,000 total relative adjusted basis
b. Desk $500 relative adjusted basis X 1,000 remaining basis = 250
$2,000
After Distribution
Partner A basis Partnership
Original basis $6,000 Cash $45,000
Distribution ($5,000)
Computer ( $750)
Desk ( $250
0
Example 2 of Outside basis less than Inside Basis
Facts:
Partner A has a basis of $50,000. In a liquidating distribution he/she receives properties C and D. Property C has a partnership basis of $30,000, FMV of $15,000 and decline of $15,000. Property D has a basis of $ 40,000, FMV of $30,000 and decline of 10,000 as follows:
Before Distribution
Partner A Partnership
Basis Basis FMV Decline
Cash $70,000 $70,000 0
$50,000 Property C $30,000 $15,000 $15,000
Property D $40,000 $30,000 $10,000
$25,000
1. Determine Basis Decrease
The first step is to determine the basis decrease which is the partner's basis of $50,000 minus the partnership basis of property C and D which is $70,000 ($30,000+ $40,000).
$70,000
($50,000)
$20,000 Basis decrease
2. Determine whether the basis decrease is more or less than the total unrealized depreciation
The basis decrease of $20,000 is Less than the total unrealized depreciation of assets to be distributed which is $25,000 ($15,000+ $10,000).
3. Determine the Ratio
This means that we now allocate the decrease (not the partner's basis) among those items in proportion to their respective amounts of unrealized depreciation (decline) as follows:
a. Property C $15,000 Unrealized Depreciation X $20,000 Basis Decrease = $12,000
25,000 Total Depreciation
b. Property D $10,000 Unrealized Depreciation X $20,000 Basis Decrease = $8,000
25,000 Total Depreciation
4. Reduce the partnership basis of each of the assets to be distributed by the amounts determined in step 3
Property C Property D
Partnership Basis $30,000 $40,000
($12,000) ($ 8,000)
$18,000 $32,000
After Distribution
Partner A Partnership
Original Basis $50,000 Cash 70,000
Property C ($18,000)
Property D ($32,000)
0
III. Situation Number 3 Partner's basis (outside basis) is greater than Partnership basis (Inside basis).
Example of Partner's basis greater than inside basis
In this situation, there will be a basis increase.
Facts:
Partner A has a basis of $5,500 and receives asset A with a basis of $500 and a FMV of $4,000, Asset B with a basis of $1,000 and a FMV of $1,000 in a liquidating distribution. Remember in a liquidating distribution, the basis must be reduced to zero.
Before Distribution
Partner A Partnership
Basis Basis FMV Appreciation
$5,500 Cash $8,000 $8,000 0
Asset A $ 500 $4,000 $3,500
Asset B $1,000 $1,000
1. The first step is to allocate the partner's basis up to the amount of the partnership basis
In this case Asset A will receive $500 and property B will receive $1,000.
2. Allocate the partner's basis up to the amount of unrealized appreciation.
The only asset with appreciation is Asset A of $3,500.
3. Allocate any remaining partner's basis using a ratio based on FMV
a. Asset A $4,000 FMV X 500 ( remaining basis to be allocated) = 400
$5,000 Total FMV
b. Asset $1,000 FMV X 500 (remaining basis to be allocated) = 100
$5,000
4. Add the basis in steps 1 through 3 to determine the total basis of each asset distributed
Asset A Asset B
Step 1 $ 500 $1,000
Step 2 $3,500 0
Step 3 $ 400 $ 100
$4,400 $1,100
Asset A now has a basis of $4,400 and asset B has a basis of $1,100 which brings the partner's basis down to zero.
Current Distribution
Same example as above
If this was a current distribution, each asset would receive the amount of the partnership basis and any remaining basis would continue to the next year as follows:
Partner A Basis
$5,500
Asset A ($ 500)
Asset B ($1,000)
$4,000 basis continuing to the following year if there are
no other adjustments to basis.
Disproportionate Distributions
Gain is recognized on a distribution of property that is disproportionate with respect to unrealized receivables (UR's) or substantially appreciated inventory (SAI)
The distributions will be recharacterized as of the UR's or SAI were distributed. In other words, as if a sale occurred.
Guaranteed Payment
Guaranteed payments are payments to a partner for use of Capital or for services provided to partnership.
they may not be determined by reference to partnership income. Usually expressed as a fixed dollar amount of or as a percentage of capital. They may be deducted or capitalized by partnership depending on the nature of the payment. The guaranteed payment is deductible by the partnership if it meets ordinary and necessary business expense test. It may create a partnership loss. It is includable in income of the partner receiving the payment as ordinary income at the time the partnership deducts the payments. The guaranteed payment is shown on Schedule K and Schedule K-1 of form 1065.
Example
Partner A has a guaranteed payment for services of $25,000. The only income the partnership made was from the sale of a capital asset. Even though the income was capital to the partnership, Partner A will recognize this as ordinary income, and pay self employment tax. It can increase the loss as follows:
Partnership loss $20,000
Guaranteed payment $25,000
Increased loss 45,000
Allocation to Partner A:
Guaranteed payment $25,000
Loss 50% X 45,000 (22,500)
Payments to Partners
707(a) 707(b) Distribution
1. Acting in a capacity as Acting in a capacity as a partner Capacity as a partner
other than a partner in some instances and non-
partner in other instances
____________________________________________________________________________________
2. Services are not Services are central to the N/A
central to the partnership's main function
partnership's main
function.
___________________________________________________________________________________
3. Not based on Not based on partnership Based on partnership
income income income
___________________________________________________________________________________
4, Partnership Partnership deduction is No partnership
deduction is not capitalized deduction
not capitalized
__________________________________________________________________________________
5. Receives 1099 Schedule K-1 Schedule k-1
__________________________________________________________________________________
6. Ordinary in Ordinary in character Capital gain or ordinary income
character (Depends on what asset is
distributed) __________________________________________________________________________________
Sale of a Partnership Interest
The sale of a partnership interest usually results in a capital gain or loss
Gain or loss is the difference between the amount realized and the adjusted basis of the partnership interest.
The amount realized includes the relief of any liabilities that have been assumed by the buyer.
Example
Facts:
Partner A sold his interest in the partnership for $29,000. Basis is $24,000 including $10,000 liabilities.
Computation:
Selling Price is $29,0000
+ relief of liabilities $10,000
$39,000
Gain: Selling price $39,000
minus basis ($24,000)
$15,000 Gain
Gain or loss is ordinary when partnership disposes of:
A. contributed or acquired unrealized receivables
B. inventory
C. money
Unrealized Receivables include:
1. A mining property for which exploration expenses were deducted.
2. Stock in a domestic International Sales Corporation (DISC)
3. Certain farmland for which expenses for soil and water conservation on land clearing were obtained.
4. Franchises, trademarks, or other trade names
5. Oil, gas or geothermal property for which intangible drilling and development cost were deducted.
6. Stock of certain controlled foreign corporations.
7. Market discount bonds and short term obligations
8. Property subject to recapture or depreciation under IRC 1245 and 1250
Example of Partnership Interest
Facts:
Partner A with 25% interest sells his interest with basis of $100,000 to B for $200,000. Gain on sale is $100,000
Assets of Partnership are:
Basis FMV
Cash $ 80,000 $ 80,000
Land $160,000 $300,000
Inventory $280,000 $400,000
Substantially appreciated inventory is 120% of basis and in this case, 120% would be $336,000.
The inventory appreciated to $400,000. This means that the inventory appreciated more than 120% and is
an unrealized receivable.
Partner A will have ordinary income on the gain of $100,000 as follows: 25% of the appreciation of $120,000
($280,000-$400,000) = $30,0000.
Summary
$100,000 gain
$ 30,000 ordinary income
$70,000 Capital gain
Of the $100,000 gain, $30,000 is ordinary and $70.000 is capital gain
Termination of Partnership
Termination occurs when the operations of the partnership cease.
When 50% or more of the total partnership interest are sold or exchanged within any 12 month period
Consequence of termination: the tax year of a partnership closes with respect to a partner whose entire
interest in the partnership terminates by death, liquidation or other means.
Payments to a Retired Partner
Payments to a retired partner in liquidation of an interest that are treated as distributive share of
partnership income are not taxable
and
payments in the form of guaranteed payments are taxable and subject to self-employment tax.
THE END