1 Chapter 9: Partnership Formation and Operation

2 PARTNERSHIP FORMATION & OPERATION (1 of 2)  Partnership definitions  Overview of partnership taxation  Contributions of property  Partnership elections  Ordinary income/loss vs. separately stated items  Partners’ distributive share of items

3 PARTNERSHIP FORMATION & OPERATION (2 of 2)  Special allocations  Partner’s basis in partnership interest  Special loss limitations  Transactions between partner & partnership  Guaranteed payments  Family partnerships  Self-employment income

4 Partnership Definitions  Tax definition of a partnership  General partnership  Limited partnership  Limited liability companies (LLCs)  Limited liability partnerships (LLPs)  Electing large partnership (ELP)

5 Tax Definition of a Partnership  Syndicate, group, pool, joint venture or other unincorporated organization that carries on a business

6 General Partnership  Two or more partners  All partners are general partners  May participate in management  May make commitments on behalf of partnership  Unlimited liability for partnership debts

7 Limited Partnership  One or more general partners and  One of more limited partners  Cannot participate in management  Cannot make commitments for partnership  Liability generally limited to amount invested in partnership

8 Limited Liability Companies (LLC)  May be taxed as a partnership or a corporation (using check-the-box Regs)  When taxed as a partnership, entity obtains flow-through and flexibility of partnership allocations while maintaining limited liability of a corp

9 Limited Liability Partnerships & Electing Large Partnerships  Limited liability partnerships (LLPs)  Used by many professional organizations  May be taxed as a partnership or a corporation (using check-the-box Regs)  Partners not liable for failures in work of other partners or people supervised by other partners  Electing large partnership (ELP)  Non-service partnerships of  100 ptrs

10 Overview of Partnership Taxation  Partnership profits and losses  Partner’s Basis  Partnership distributions

11 Partnership Profits and Losses (1 of 2)  Partnership files Form 1065  Information return with no tax due  Partners receive a Form K-1  Reports partner’s share of income or loss and separately reported items

12 Partnership Profits and Losses (2 of 2)  Partners include profit or loss and separate items on their individual return (Form 1040 for individuals)  Loss limitation  Partner’s losses limited to his/her basis in the partnership  At-risk rules and passive loss rules also apply

13 Partner’s Basis (1 of 2)  Items that increase basis  Partner’s share of partnership earnings, additional contributions, & additional assumption of partnership debt  Increase in basis for earnings prevents double taxation of earnings upon subsequent distribution

14 Partner’s Basis (2 of 2)  Items that decrease basis  Partner’s share of losses, distributions, & reduction in partnership debt

15 Partnership Distributions  Payment of money to partner usually tax-free because earnings previously taxed  If distributions exceed the partner’s basis, gain may be recognized

16 Contributions of Property  General rule  Exceptions to nonrecogntion rule  Effects of liabilities  Contributions of services  Basis  Organizational & syndication costs  See Topic Review C9-1 for summary

17 General Rule  General rule for property contributions in exchange for partnership interest  No gain or loss  §721 similar to §351

18 Exceptions to Nonrecognition Rule  Gain recognition at time of property contribution if  Partnership would be investment company if it were incorporated,  Contribution followed by a distribution resulting in a deemed sale, or  Liabilities assumed by partnership in excess of partner’s basis

19 Effects of Liabilities  Two effects of liabilities contributed by a partner to a partnership  Basis of each partner (including contributing partner) is increased by her share of liabilities, AND  Contributing partner treated as if partnership made cash distribution to the partner, decreasing partner’s basis  Gain would be recognized if deemed distribution exceeds partner’s basis

20 Contributions of Services (1 of 2)  Contribution of services in exchange for partnership interest  Income is FMV of services contributed

21 Contributions of Services (2 of 2)  Partnership deducts or capitalizes FMV of services, depending on the nature of the expense  Partnership recognizes gain or loss  FMV of services less basis in assets allocated to service partner

22 Basis  Partner’s basis in partnership equal to money contributed plus partner’s basis in contributed property plus gain recognized on contribution  Partnership’s basis in property is partner’s old basis before contribution  Holding period also carries over

23 Organizational and Syndication Costs  Organization costs are capital expenditures  May immediately expense $5K and amortize the rest over 180 months  $5K immediate expense reduced $ for $ for cumulative organization costs >$50K

24 Partnership Elections  Tax year  Must be same as majority partner or partners with a 50% or more interest  See Topic Review C9-2  Overall accounting method  Inventory valuation method  Depreciation method

25 Ordinary Income/Loss vs. Separately Stated Items (1 of 2)  Separately stated items include:  Net S-T capital gains and losses  Net L-T capital gains and losses  §1231 gains and losses  Charitable contributions  Dividends eligible for DRD  Foreign or possession taxes

26 Ordinary Income/Loss vs. Separately Stated Items (2 of 2)  Separately stated items (continued)  Tax-exempt interest  Portfolio activities  Passive activities  U.S. production activities deduction  Any items subject to special allocation  Partnership ordinary income/loss  All items not separately stated

27 Partners’ Distributive Share of Items  Normally determined by terms of partnership agreement  Portion of partnership taxable and nontaxable income partner agreed to report for tax purposes  Amount not necessarily same as actual amounts distributed to partner in a particular year

28 Special Allocations  Pre-contribution gains or losses must be allocated to contributing partner  Allocations not related to contributed property must have substantial economic effect  Allocations affect partners’ capital accounts, and  Partners must make up deficit in capital account upon liquidation of partnership

29 Partner’s Basis in Partnership Interest (1 of 2)  Beginning basis  Amount paid for interest OR  Basis of property/ services contributed  Additions to basis  Additional contributions, earnings or assumption of liabilities  Reductions result from withdrawals, losses or decrease in share of liabilities

30 Partner’s Basis in Partnership Interest (2 of 2)  Effect of liabilities on partner basis Partner’s basis before liabs +Increases in share of ptrshp liabs -Decreases in share of ptrshp liabs +Ptrshp liabs assumed by this partner -This partner’s liabs assumed by ptrshp =Partner’s basis in the ptrshp interest  See Topic Review C9-3

31 Special Loss Limitations (1 of 2)  Loss recognition limitations  Partner’s basis in partnership interest  Portion of partner’s basis not “at risk”  At risk definition: amount partner would lose should the partnership suddenly become worthless.

32 Special Loss Limitations (2 of 2)  Loss recognition limitations (continued)  Designation of partnership interest as a “passive activity”  “Passive” losses can only be used to offset “passive” income.  Disallowed losses are suspended, and can be used to offset future passive income, or when the passive activity is sold

33 Transactions Between Partner & Partnership  Loss sales  No loss deducted on sale of property between a partnership and a > 50% owner (direct or indirect)  Gain sales  Gains on sale of property involving a >50% owner produce ordinary income unless property will be a capital asset in hands of new owner

34 Guaranteed Payments  Always ordinary income to recipient  Partner treats payment as if made to an outsider  Deduct or capitalize  If deductible, GP reduces partnership ordinary income, which is allocated based on partnership agreement

35 Family Partnerships (1 of 2)  Safe-harbor rule under §704(e) for family partnerships  Interest must be a capital interest,  Partner has right to receive assets if partnership liquidates immediately  Capital must be a material income producing factor, AND  Family member must be true owner

36 Family Partnerships (2 of 2)  Donor-donee allocations of income  Donor must be allocated reasonable compensation for services rendered to partnership  Remaining partnership income must be allocated based on relative capital interest

37 Self-Employment Income  Individuals who are partners must pay SE tax on the following income from a partnership:  Guaranteed payments  Partnership ordinary income or loss  All separately stated items, except  Capital and §1231 gains/losses, interest, dividends, and rental income

38 Comments or questions about PowerPoint Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business