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 Cash contributed plus: Basis of property transferred to partnership plus: Gain recognized (from prior screen) less: Liabilities allocable to other partners Equals: Partner’s initial basis in partnership 2012 Cengage Learning

Example #1 – Partnership Formation 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 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 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 If this is not possible, it must adopt same tax year as majority of the principal partners If neither of these work, partnership must use the least aggregate deferral method (see major tax service for more information) 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