©The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Chapter 14 Partnership Taxation “People who complain about taxes can be divided into two classes: men and women.” --- Anonymous

14-2 LO #1- Partnership Formation Typically, a partner recognizes no gain or loss on the formation of a partnership Outside basis – the basis of the partnership interest in the hands of the partner Inside basis – the partner’s share of the basis of the individual assets in the partnership Inside basis usually equals outside basis

14-3 LO #1- Partnership Formation Basis-in, Basis-out – The beginning basis to the partnership is usually the basis of the contributed assets. Steps into the shoes – the basis of assets in the hands of the partnership is the same as the basis in the hands of the contributing partner.

14-4 LO #1- Partnership Formation Holding periods – general rule is that the holding period of the partnership interest includes the partner’s holding period when Section 1231 or capital assets are contributed Contribution of ordinary assets – the holding period begins on the date of the contribution.

14-5 LO #1- Partnership Formation Contribution of services – a partner providing services in exchange for a partnership interest recognizes ordinary income to the extent of the FMV of the partnership interest Assumed liabilities by the partnership – any release of liability by a contributing partner is treated as a money distribution to the partner (reduces basis)

14-6 LO #1- Partnership Formation Concept Check Generally, a partner does not recognize a gain on the formation of a partnership. True 2.Typically, the basis of the assets contributed to a partnership is the same in the hands of the partnership as it was in the hands of the contributing partner. True 3.If two taxpayers form a partnership and each has a 50% interest in it, each partners outside basis must be equal. False

14-7 LO #1- Partnership Formation Concept Check A partner does not have to recognize a gain on the receipt of a partnership interest in exchange for services. False 5.A partner who assumes an increased portion of the partnership debt, is treated as making a cash contribution and his or her basis in the partnership increases. True

14-8 LO #2 - Partnership Ordinary Income or Loss Ordinary income or loss –Sales, revenue from services –Ordinary & necessary expenses –No items are included in ordinary income or losses that can be treated differently at the partner level. These are “separately stated items.” Guaranteed payments – payments made to partners that are calculated without regard to partnership income

14-9 LO #2 - Partnership Ordinary Income or Loss Depreciation –Follow the same rules as a sole proprietorship –Section 179 expense must be separately stated Partner health premium –Partners cannot exclude from income the health insurance premiums paid by the partnership –Premiums are treated as guaranteed payments

14-10 LO #2 - Ordinary Income/Loss Concept Check A partnership can deduct which of the following in determining partnership ordinary income or loss: a. all ordinary and necessary expenses. b. guaranteed payments. c. depreciation. d. all of the above. Answer: D 2. What tax form is the partnership required to file each year? a. Form b. Form c. Form d. Form 1120-S. Answer: C 3. A payment made to a partner that is must calculated without regard to partnership income is a: a. partner salary. b. partner withdraw. c. loan to a partner. d. guaranteed payment. Answer: D

14-11 LO #3 – Separately Stated Items General rule - All income and expense items of a partnership that may be treated differently at the partner level must be “separately stated.” –Table 14-1 in text Most common separately stated items –Rental income –Interest and dividend income –Capital gains and losses –Section 179 expense

14-12 LO #3 – Separately Stated Items Schedule K-1 – reports the share of ordinary income and separately stated items for each partner. Line numbers of the K-1 correspond to the Schedule K of Form 1065

14-13 LO #3 – Separately Stated Items Self-employment Income – since a partner is not an employee of the partnership, income from the partnership is considered self- employment income Calculation: –1. Ordinary income from Schedule K-1, line 1 –2. Plus any guaranteed payments from Schedule K-1, line 4 –3. Less any §1231 gain included in ordinary income –4. Less any §179 expense from Schedule K-1, line 12

14-14 LO #3 – Separately Stated Items Concept Check Why are items such as rental income/loss, capital gains/losses, and charitable contributions that flow-through a partnership treated as separately stated? All income and expense items of a partnership that may be treated differently at the partner level must be “separately stated.” Rental income/loss, capital gains/losses, and charitable contributions all can be treated differently at the partner level. For example, an individual partner can take up to $3,000 of capital losses against ordinary income where a corporate partner in the same partnership can not. 2.Why is income from a partnership treated as self-employment income? A partner is not an employee of the partnership. Thus, income received by the partner from the partnership has no social security or Medicare withheld by the partnership.

14-15 LO #4 – Basis of the Partnership Interest Outside basis calculation (calculated for each partner) –Basis of property contributed –Plus: FMV of services rendered (or cost, if partnership interest was purchased) –Plus: Basis of cash or property contributions after formation –Plus: Share of partnership ordinary income –Plus: Share of separately stated income or gain items –Plus: Share in partnership liabilities –Less: Basis of cash or property distributed (but not below zero) –Less: Share of partnership ordinary loss (but not below zero) –Less: Share of separately stated loss/expense items –Less: Release of partnership liabilities

14-16 LO #4 – Basis of the Partnership Interest - Concept Check A partner must use basis to determine the gain or loss on a sale of the partnership interest and whether losses are deductible. True 2.A partner’s basis is not increased by his or her share of tax exempt income items. False 3.In the calculation of basis, the order of the basis adjustments is not important. False 4.A partner’s basis is never increased by his or her share of recourse liabilities. False

14-17 LO #5 – Partnership Distributions General rule - a partner recognizes no gain or loss on a non-liquidating distribution Gain is recognized only: –Only money or marketable securities are distributed in excess of the partner’s basis –Current distribution triggers a pre- contribution gain

14-18 LO #5 – Partnership Distributions Pre-contribution gain - occurs when a partner contributes appreciated property to a partnership and, within seven years, the partnership distributes the same property to another partner. Basis of distributed property – typically the partner steps into the shoes of the partnership.

14-19 LO #5 – Partnership Distributions Concept Check Which of the following is true concerning recognition of gain on a distribution from a partnership? a. gain is recognized if the partner receives property with a basis greater than his or hers partnership interest basis. b. gain is recognized if the partner receives cash in excess of his or her basis. c. the partner never recognizes a gain on a partnership distribution. d. the partner always recognizes a gain on a partnership distribution. Answer: B 2. Nelson has a partnership basis of $12,000. He receives from the partnership a distribution of furniture with a basis to the partnership of $16,000 and a FMV of $10,000. Nelson’s basis in the furniture after the distribution from the partnership: a. $10,000. b. $12,000. c. $16,000. d. none of the above. Answer: B

14-20 LO #5 – Partnership Distributions Concept Check Assume the same facts as #2. However, Nelson also receives a cash distribution of $4,000 with the furniture. The basis in the furniture after the distributions is: a. $ 8,000. b. $10,000. c. $12,000. d. $16,000. Answer: A

14-21 LO #6 – Disposal or Liquidation of a Partnership Interest Liquidation –Rules similar to current distributions –A distribution of money in excess of basis causes a capital gain –A loss can be recognized when the amount received in liquidation is less than the partner’s outside basis and only money, receivables and/or inventory are received

14-22 LO #6 – Disposal or Liquidation of a Partnership Interest Sale of a partnership interest –Treated as a sale of a capital asset –If the partnership has substantially appreciated inventory or accounts receivable, some of the capital gain could be ordinary Individual partners report sale on Form 1040, Schedule D.

14-23 LO #6 – Disposal or Liquidation of a Partnership Interest-Concept Check Shelly has a basis in her partnership interest of $30,000. She receives the following assets in complete liquidation of the partnership interest: Cash$ 9,000 Inventory (basis)$ 6,000 Equipment (basis)$ 8,000 Land (basis)$12,000 a. What is Shelly’s recognized gain? b. What is Shelly’s basis in each of the assets distributed? Answer: a. Shelly’s recognized gain would be $0. She did not receive cash in excess of her basis. b. Shelly’s basis in the assets would be as follows: Cash$9,000 Inventory$6,000 Equipment ($15,000 × $8,000/$20,000)$6,000 Land ($15,000 × $12,000/$20,000)$9,000

14-24 LO #6 – Disposal or Liquidation of a Partnership Interest-Concept Check Callie purchased a 60% partnership interest for $55,000 in March She had income of $18,000 from the partnership in 2005 and $26,000 in She made no additional contributions to or withdrawals from the partnership. On December 30, 2006, Callie sold her partnership interest for $107,000. a. What is her basis before the sale? b. What is her gain or loss? c. Is the gain or loss (if any) capital or ordinary? Answer: a. $99,000 ($55,000 beginning basis + $18,000 + $26,000) b. $8,000 ($107,000 sales price - $99,000 basis) c. Since the partnership interest is a capital asset and there was no mention of inventory or receivables in the partnership, then the gain would be a long term capital gain.