Partnerships
Contributions, Operations and Disposition
Partnership Definition
An association of two or more persons that carry on a trade or business
-Contribute money property or labor
-Expect to share in profits and losses
For tax purposes includes:
Syndicate Pool
Group Joint venture, etc.
that is carrying on a trade or business
Flow Through Entity
-Partnership is not a taxable entity. it is a flow-through entity.
-Income is taxed to owners, not the entity. Partners report their share of partnership income or loss on their own tax return.
-ordinary income is computed on form 1065
-Partnership ordinary income is also shown on Schedule K for 1065
-The Schedule K accumulates he information to be reported to partners
.
-Each partner receives a Schedule k-1
_Each partner respective percentage of interest representing his share of income, expense, gain and loss, as reported on the Schedule k-1 is reported on the 1040.
-Income, expense, credit, gain and loss on Schedule K-1 is reported on the 1040.
Allowable Partners in an Partnership
Estate
Trust
Corporation
Another partnership
Individual
Entities which cannot be Partnerships
Corporations
Insurance Companies
Tax Exempt organizations
Domestic LLC's with at least two members that files form 8832
Remember that a corporation can be a partner but he entity cannot be a partnership
Partnership Agreement
-The partnership agreement includes the original agreement that determines the partner's share of income, gains, losses, deductions and credits.
-Must be agreed to by all partners
-May be amended but no later than the date for filing the return for that year, excluding any extensions of time.
Substantial Economic Effect in the Partnership Agreement
-Allocations must meet substantial economic effect. Otherwise, the allocation will be made based on the partner's interest in the partnership.
-Substantial economic effect is two prone. you must first meet the economic effect test and secondly, the substantial test.
Economic Effect in the partnership agreement
-The allocations must meet 3 rules to satisfy the economic effect test. If the partnership agreement states and complies with the economic effect rules in the agreement, then the economic effect test is automatically met. The three rules are:
a. Capital accounts must be created and maintained in the manner set forth in the regulations
b. Liquidation distributions must be made in accordance with the partner's positive capital account balances.
c. Any partner with a deficit capital account following the liquidation of his interest is unconditionally obligated to restore the amount of such deficit to the partnership to be paid to creditors or distributed to other partners in accordance with their positive capital account balances.
The second part of Substantial economic effect is substantiality.
Substantiality
-It is a subjective test and each situation must be reviewed based on the fact and circumstances of the situation.
The rules are:
a. The allocation will substantially affect the dollar distributions from the partnership.
b. The partner to whom an allocation is made actually receives the economic benefit or burden corresponding to that
allocation.
Family Partnerships
-If capital is a material, income-producing factor, the family partner must actually own and control the partnership,
-If capital is not a material income-producing factor (service partnerships), the partners agree that contributions entitle them to a share of profits and capital or service must be substantial or vital.
Constructive Ownership
An individual is treated as owning the interest owned by his/her spouse, brothers and sisters, children, grandchildren and parents.
An interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered to be owned proportionately by or for its shareholders, partners, or beneficiaries.
Example of Constructive ownership
Facts: _______________ owns 40% of his business and his wife owns 30% of the business. His father owns the remaining 30%. What is the percentage___________ownership of the business.
Answer: 100%
Required Taxable Year
Partnerships must adopt the tax year under the earliest of the following tests met:
a. Majority partner's tax year (partners with the same tax year owning more than 50%.
b. Principal partner's tax year (all partners owning 5% or more).
c. Least aggregate deferral rule.
Majority Partner Example
Percentage ownership Tax year end
Facts Partner A 30% 12/31
Partner B 30% 12/31
Partner C 40% 6/30
Partner A & B have the same tax year ending of 12/31. Their total combined percentage is over 50%. It is 60%. Partner C has 40% and it is not over 50%.
Answer: The tax year ending 12/31 will be adopted by the partnership.
Principal Partner Example
Percentage ownership Tax Year End
Facts: Partner A 10% 4/30
Partner B 6% 4/30
The other 42 partners each own 2% of the partnership and 21
of these partners have a tax year ending 12/31 and the other
21 partners have a tax year ending 6/30.
What year must the partnership adopt under the principal partner rule?
Analysis: There are only 2 partners with more than 5% ownership with the same tax year ending date of 4//30.
The other 42 partners own less than 5% and are not considered.
Answer: The partnership will adopt the tax year ending 4/30.
Least Aggregate Deferral Example
Facts_________ Partner A and B own a 50% interest in the partnership which started on July first. A's year is 1-1- thru 12-31. B's year is 10-1 thru 9-30. A and B each own 50% and cannot meet the majority interest rule because neither has more than 50%. Both are principal partners (5% or more) but do not have the same year end. They must use the least aggregate deferral test.
Test for taxable year end December 31:
Partners Year End Percentage interest Months Deferred Interest X Deferral
A 12/31 .50 0 0
B 9/30 .50 9 4.5
Total deferred 4.5
Test for taxable year end September 30:
A 12/31 .50 3 1.5
B 9/30 .50 0 0
Total deferred 1.5
Answer: Year ending 9/30 is the least deferral. The partnership will adopt the tax year ending 9/30.
Exceptions to the Required Year
Natural Business year:
Acceptable if at least 25% of annual gross receipts are received during the last 2 months of each of the preceding 3 years for any 12 month period.
Section 444
Acceptable if the new year results in no more than 3 month deferral. Must pay an amount approximating the amount of additional tax that would have resulted had the election not been made.
Example of Natural Business Year
Facts: A and B each own a 50% interest in the partnership which started on May 1st. The EA partnership is newly formed but had been in business as a sole proprietorship for more than 3 years. The partnership wants to adopt a tax year ending 6/30. The gross receipts for the three most recent years for the 12 month period ending 6/30 and the last two months of this period ending 6/30 are as follows:
Year Month Period Gross Receipts for 12 Mo. Period Gross Receipts for last 2 Months Percentage
1 5-1-thru 6/30 $ 290,000 $83,000 28.6%
2 5-1- thru 6/30 $ 320,000 $90,000 28.1%
3 5-1- thru 6/30 $340,000 $86,000 25.29%
In each of the 3 years, the last 2 months of each year represents 25% or more of gross receipts and satisfies the natural business test.
Answer: The partnership is entitled to adopt the tax year ending 6/30.
Formation of Partnership
An interest in a partnership can be acquired by:
1. Donation of property encumbered or unencumbered
2. Services
3. Cash purchase
4. Gift
5. Inheritance
6. Promissory Note
There is no gain or loss on contribution of money or property in exchange for a partnership interest.
Gain is deferred until a taxable disposition of
a. Property by the partnership
OR
b. Partnership interest by the partner
Contribution of services is ordinary income to the partner which is added to basis
Exceptions to non-taxability of Contributed Property
1. The partnership is an investment company of which 80% or more of the assets are marketable securities.
2. Contributed property is distributed to a different partner within 7 years of the contribution date. Gain is the lesser of the pre-contribution gain or the gain that would result if the property were sold at FMV.
3. When a partner contributes property to a partnership and immediately receives a distribution, the transaction is essentially a sale. gain realized is recognized to the extent that the contributed property is deemed purchased by the other partners.
4. A partner who contributed property receives a distribution of a different property other than money within 7 years of his/her contribution. the contributing partner recognizes gain on the lesser of:
a. FMV of distributed property over the partner's basis in his/her partnership interest
OR
b. The difference between the FMV and the adjusted basis of the contributed property at the contribution date.
5. To the extent liabilities assumed by the partnership exceed the partner's aggregate adjusted basis in all property contributed, the partner recognizes gain and basis in the partnership interest is zero.
Basis of Partnership Interest
For new partnerships, partner's basis usually equals:
a. adjusted basis of property contributed
plus
b. FMV of any services performed by partner in exchange of partnership interest and any money given.
A partner's basis in partnership interest is adjusted to reflect partnership activity which prevents double taxation of partnership income.
Adjustments to Basis
Initial Basis:
Add: Partner's share of partnership
Debt increase
Income items
Exempt Income items
Depletion adjustments
Subtract: Distributions
Withdrawals from partnership
Deductions
Losses
Basis Limitation
A partner's basis in the partnership interest can never be negative and can only decrease to zero.
Partnership Liabilities
Assumption of Liabilities:
Partnership liabilities affect partner's adjusted basis. Assumption of liabilities increases partner's share of liabilities.
a. Treated as a cash contribution to the partnership.
b. Increases partner's adjusted basis.
Relief of Liabilities:
Relief of liabilities decreases partner's share of liabilities.
a. Treated as a cash distribution to the partner.
b. Decreases partner's adjusted basis.
Two Types of Partnership Debt
A. Recourse debt of which at least one partner is personally liable. Allocation is
according to Constructive Liquidation Scenario.
B. Nonrecourse debt of which no partner is personally liable. Allocation to
partners is achieved by using a three tiered allocation method.
Constructive Liquidation Scenario
Assumptions
1. Partnership assets deemed to be worthless.
2. Assets deemed sold at 40 consideration; 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.
Constructive liquidation Example
Facts: Two partners form a partnership and each partner contributes $20,000 in cash. After the contribution, the basis and capital are as follows:
Partner A Partner B
Basis Capital Basis Capital
$20,000 $20,000 $20,000 $20,000
Continuation of facts: The partnership purchases a building in the amount of $100,000 after the formation of the partnership. The partnership pays $40,000 cash and assumes a recourse liability in the amount of $60,000.
The partnership agreement states that all items will be saved 50% to each partner with the exception of losses. Partner A will receive 80%of losses and partner B will receive 20% of losses.
The loss is allocated to the capital account to determine whether or not there is a negative capital account.
REMEMBER THAT THE BASIS CAN NEVER BE BELOW ZERO IN CONTRAST TO THE CAPITAL ACCOUNT WHICH CAN BE NEGATIVE OR BELOW ZERO.
Partner A Partner B
Capital Account Capital Account
Original: $20,000 $20,000
Hypothetical Loss (80,000) (20,000)
(60,000) -0-
Analysis:
Partner A has a negative balance of $60,000 in the capital account. The partnership agreement also states that Partner A and B will restore any negative balance in the capital accounts upon liquidation of the interest. What does this mean in terms of our example? This means that partner A would be required to pay back the $60,000 if the building was actually sold.
Remember that this is a hypothetical sale to evaluate what would happen if the building was actually sold.
Because Partner A would be required to pay back $60,000 upon actual sale of the building, he has an economic risk of loss in the amount of $60,000. Partner B has no economic risk of loss because his capital account would absorb the entire 20% loss of $20,000 and his capital account is at zero.
Therefore, Partner A has the economic risk of loss for the full amount of the loan which is $60,000 and the liability is added to basis.
Partner B does not receive any portion of the liability to add to basis as follows:
Partner A Partner B
Basis Basis
Original $20,000 $20,000
Assumption of recourse
liability $60,000 -0-
Adjusted Basis $80,000 $20,000
Holding Periods
If partner contributes capital assets and section 1231 assets, holding periods of partnership interests includes holding periods of assets contributed.
For other assets including cash, holding periods begins on the date, partnership's interest is acquired.
Multiple assets are contributed, partnership interest is apportioned and separate holder period applies to each portion.
Partnership property is divided into two classes:
a. capital gains 1221 and 1231 property
b. All other property including ordinary income property, unrealized receivables
Section 754
Sale or exchange of a partnership interest or distribution will create an imbalance between inside (partnership basis) and outside basis (basis of partner).
Sale or exchange of a partnership interest or distribution will create an imbalance between inside (partnership basis) and outside basis (basis of partner).
Purpose of IRC 754 election is to eliminate the inequality between inside and outside basis created by a sale or distribution.
The inside basis (partnership basis) is adjusted to correct for any difference.
Determine the amount of increase or decrease in the basis of partnership assets.
Sale of Partnership Interest
Increase partnership basis by the amount of gain
Decrease partnership basis by the amount of loss
Distribution
Increase by the amount that the distributee partner's basis in the property he/she receives in a liquidating
distribution is less than the partnership basis in the property
Decrease by the amount that the distributee partner's basis in property he/she receives in a liquidating
distribution is greater than the partnership basis in the property
For upward adjustments, allocation is on the basis of relative appreciation of classes and assets. No allocation is made to a depreciated class or asset.
For downward adjustments, allocation is on the basis of relative depreciation of classes and assets. No allocation is made to an appreciated class or asset.
Organizational Costs
The partnership may elect to deduct up to $5,000 of the costs in the year business begins. The amount must be reduced by organization costs that exceed $50,000. Remaining amounts are amortizable over 180 months beginning with the month the partnership begin's business. Organizational costs include costs:
a. Incident to creation of the partnership with an ascertainable life, would be amortized over that life.
b. Includes accounting fees and legal fees connected with the partnership formation.
A partnership on the cash basis of accounting is not allowed a deduction for organizational expense until the expenses are actually paid. A taxpayer is deemed to have made the election and no separate statement attached to the return is necessary.
Syndication Costs
Syndication costs are not amortizable. They are costs of issuing and marketing partnership interests. Examples are prospectus, preparation costs and commissions on sale of limited partnership interests. They might alter the amount of gain or loss when the partnership terminates.
Capital Accounts
Basis and the partner's capital account are computed slightly differently. The man difference is the calculation of liabilities. A partner's initial capital account balance is the fair market value (net of liabilities) he/she contributed to the partnership.
Comparison of Basis and Capital Account Example
Facts: Partner A contributes a building with an adjusted basis of $100,000 and mortgage of $25,000 for a 50% partnership interest in the partnership. Assume the basis and fair market value are equal. The basis and capital account are computed as follows:
Partner A
Basis Capital Account
Building $100,000 $75,000 (FMV 100,000-$25,000 Lib.)
Relief of Liability (25,000)
Assumption of Lib. 12,500
$87,500 $75,000
Taxable Income
The first page of the form 1065 reports the income of the partnership and expense to determine partnership ordinary income or loss. Taxable income consists of ordinary income/loss and separately stated items. If any item of income, expense, gain or loss might affect any partner's tax liabilities differently, it is separately stated.
Separately Stated Items
Each partner owns a specific share of each item of partnership income, gain, loss or deduction. Character is determined at the partnership level. Taxation is determined at the partner level. The separately stated items are as follows:
1. Net short term capital gain and net long term capital gain or loss from the sale of capital assets
2. Section 1231 gains and losses
3. Section179 deductions
4. Depletion on oil and gas wells
5. Foreign income taxes paid or accrued
6. Charitable contributions
7. Dividends that are eligible for a corporate dividends-received deduction
8. Tax-exempt income and related expenses
9. Investment income and related expenses
10 Rental activities portfolio income, and related expenses
11 Recovery items ( prior taxes, bad debts)
Taxable Income Example
Facts:
The FDE Company has the following income and expenses:
Sales revenue $100,000
Salaries $ 40,000
Rent $ 10,000
Utilities $ 3,000
Charitable Contrib. $ 2,000
1231 Gains $ 3,600
Interest Income $ 5,000
Compute the ordinary gain/loss and specify which of the above constitutes a separately stated item.
Partnership Ordinary Gain/Loss
Revenue:
Sales Revenue $100,000
Minus Expenses
Salaries (40,000)
Rent (10,000)
Utilities (3,000)
(53,000)
Ordinary Gain $47,000
Separately Stated items
1. Interest Income $5,000
2. Charitable Contributions $2,000
3. 1231 Gains $3,600
Each partner is entitled to his/her respective percentage of ordinary income/loss and separately stated items.
Precondition Gain or Loss
Precondition gain or loss must be allocated to partners taking into account the difference between basis and FMV of property on date of contribution. For nondepreciable property this means any built in gain or loss must be allocated to the contributing partner when deposited by the partnership in a taxable transaction.
Precondition Gain/Loss Example
Facts:
Partner A contributed property with a basis of $50,000 and $100,000 FMV at date of contribution for a 20% interest in an EA partnership. 10 years later the property was sold for $250,000 to a third party for a gain of $200,000 ($250,000-$50,000)
Date of Contribution Partner A
Basis FMV Built in Gain (BIG)
$50,000 $100,000 $50,000
Date of Sale
Allocation of Gain Allocation to Partner A
Gain $200,000
BIG $50,000 $50,000 BIG
Remaining $150,000
20% to Partner A
(20% X 150,000) $30,000 $30,000
$80,000
For remaining $120,000
Partners
Partner A recognizes $50,0000 BIG and 20% of the remainder of $!50,000 (20% of 150,000) which is $30,000.
The total gain to Partner A is $80,000.