These lectures cover taxation of partnership, inside and outside basis, distribution from partnership and separately stated items.
Taxation of Partnership
Partnership Income Allocation to Partners
Partners' Basis in a Partnership
Distribution From Partnership to Partners
What Is a Partnership?
Partnerships are governed by Subchapter K of the Internal Revenue Code. A partnership is defined as an association formed by two or more persons to carry on a trade or business, with each contributing money, property, labor, or skill, and with all expecting to share in profits and losses. The entity must be unincorporated and cannot be otherwise classified as a corporation, trust, or estate.
Types of Partnerships: taxation of partnership
You’ll encounter several types of partnerships. They are all governed by Subchapter K, but slight differences in structure suit them for different situations. Partnership entities are defined and formed under state law. They are typically distinguished based on the classification of the partners as or and the types of business permitted to be conducted by the entity.
General and limited partners are classified based on whether they can participate in entity management and the extent to which they are personally liable for partnership debts.
• General partners can participate in managing the entity. If the debt is recourse to the partnership (i.e., secured by all partnership assets rather than specific partner- ship properties), a general partner legally can be called upon for repayment.
• Limited partners are typically not permitted to participate in entity management. They are only liable for partnership debts to the extent of any unpaid contributions they have contractually agreed to make to the partnership. taxation of partnership
Some of the more common types of entities treated as partnerships include the following. taxation of partnership
• A consists of two or more partners who are general partners and who may participate in management of the entity; there are no limited partners. General partnerships often are used for operating activities (e.g., product manufacturing or sales) and corporate joint ventures.
• A is a partnership with at least one general partner and one or more limited partners.2 These partnerships often have numerous limited partners and are used to raise capital for real estate development, oil and gas exploration, research and development, and various financial product investment vehicles. To reduce exposure to the entity’s liabilities, the general partners are often entities that, themselves, have limited liability, such as a C corporation.
With respect to the LLC’s debts, members are treated as limited partners. However, LLC members generally participate in management of the LLC, although many LLCs have member classes where participation is not permitted. Therefore, an LLC combines the corporate benefit of limited liability for the own- ers with the benefits of partnership taxation, including the single level of tax and some other benefits discussed later. A properly structured multi-owner3 LLC is generally treated as a partnership for all Federal tax purposes. Almost all states permit capital-intensive companies, nonprofessional service-oriented businesses, and some professional service-providing companies to operate as LLCs.
A istreatedsimilarlytoageneralpartnershipinmost states. The primary difference between an LLP and a general partnership is that an LLP partner is not personally liable for any malpractice committed by other partners. The LLP is currently the organizational form of choice for the large accounting firms.
A document outlines the rights and obligations of the partners; the allocation of income, deductions, and cash flows; initial and future capital contribution requirements; conditions for terminating the partnership; and other matters. The governing agreement of an LLC has a similar structure and is known as an .
Key Concepts in Taxation of Partnership Income. taxation of partnership
A partnership is not a taxable entity. Rather, the taxable income or loss of the partner- ship flows through to the partners at the end of the partnership’s tax year.8 The partner- ship itself pays no Federal income tax (although certain U.S. states assess franchise taxes or other fees or taxes). Instead, the partners report their allocable share of the partnership’s income or loss on their tax returns and pay any tax due.
This result applies whether or not the partnership distributes any cash to the partners during the year. A partner’s withdrawals generally are not taxable (unless they exceed the partner’s basis in the partnership interest).
Conceptual Framework for Partnership Taxation. taxation of partnership
The unique tax treatment of partners and partnerships can be traced to two legal con- cepts: the and the . These theories influ- ence practically every partnership tax rule.
Aggregate (or Conduit) Concept The aggregate concept treats the partnership as a channel through which income, credits, deductions, and other items flow to the partners. The partnership is regarded as a collection of taxpayers joined in an agency relationship. For example, the income tax is imposed on the partners rather than the partnership.
Entity Concept The entity concept treats partners and partnerships as separate units and gives the partnership its own tax “personality.” For example, the partnership must file an information return that summarizes its activities for the tax year. As another example, in certain transactions between a partner and the entity, the partnership is treated as separate and distinct from the partner.
Combined Concepts The “aggregate” concept governs most of the “general rules” for partnerships; the “entity” concept governs many of the exceptions to those general rules. Some rules are governed by both aggregate and entity concepts.
Inside and Outside Basis, taxation of partnership
The partnership basis rules are the key reason single taxation of partnership income is possible. In general, this aggregate concept works to ensure that the partnership’s equals the sum of the for all partners. Inside basis refers to the partnership’s adjusted tax basis for each asset it owns. Outside basis represents each
partner’s basis in the partnership interest. When income or gain flows through to a partner from the partnership, the partner’s
outside basis in the partnership interest is increased. When a deduction or loss flows through to a partner, the outside basis is reduced. These adjustments ensure that these items are taxed only once.
In many cases—especially upon formation of the partnership—the sum of the part- nership’s inside bases in its assets equals the sum of the partners’ outside bases in their partnership interests. In this chapter, you can assume that inside and outside bases are equal unless noted otherwise.
Separately Stated Items. taxation of partnership
In keeping with the aggregate theory, many items of partnership income, expense, gain, or loss retain their identity as they flow through to the partners. This separate flow-through of certain items is required because such might affect any two partners’ tax liabilities in different ways. For example, charitable contributions are separately stated because partners need to compute their own deductions for charitable contributions. taxation of partnership
Typically, a partnership combines income and expenses related to the partnership’s trade or business activities into a single income or loss amount that is passed through to the partners. As shown in Example 19, most other partnership items, such as investment income, gains, and losses, are separately stated.
Partners’ Ownership and Allocation of Partnership Items
Another “aggregate” concept is that each partner typically owns both a and a in the partnership. A capital interest is measured by a part- ner’s , which is the partner’s percentage ownership of the capital of the partnership. Generally, this is the share of capital the partner would receive if the entity was liquidated.
A profits (loss) interest is simply the partner’s share of the partnership’s current operating results. are usually specified in the partnership agreement and are used to determine each partner’s allocation of the partnership’s ordinary taxable income (loss) and separately stated items.
A key advantage of partnerships is that these ratios and allocations can differ for a given partner, provided the rules discussed later in the chapter are followed. These rules generally work to ensure that everything evens out over time—at the latest, by the time the partnership liquidates.
The partnership agreement may provide for a of various items to specified partners. It may also allocate items in a different proportion from the general profit and loss sharing ratios. As discussed later in the chapter, for a special allocation to be recognized for tax purposes, it must produce nontax economic consequences to the partners receiving the allocation.
Contributions to the Partnership. separately stated items
Congress intended the partnership formation transaction to be tax-neutral so that the partners could readily form a partnership without, in most cases, facing prohibitive tax consequences. separately stated items
Gain or Loss Recognition
As a general rule, neither the partner nor the partnership recognizes any realized gain or loss that arises when a partner contributes property to a partnership. This applies when the property is contributed in exchange for a partnership interest upon formation of the entity or if the contribution occurs at some later date. The realized gain or loss is deferred, rather than forgiven. taxation of partnership
There are two reasons for this treatment. First, forming a partnership allows investors to combine their assets toward greater economic goals than could be achieved separately. Only the form of ownership, rather than the amount owned by each investor, has changed. Second, because the partnership interest received is typically a nonliquid asset, the partner may not have sufficient cash with which to pay the tax. separately stated items
Guaranteed Payments Paid by the Partnership. Taxation of partnership
A is a payment to a partner for services performed by the partner or for the use of the partner’s capital. These payments resemble the salary or interest payments of other businesses. The partnership either deducts or capitalizes the payment, depending on its nature. As discussed later, regardless of the partnership’s treatment, the partner reports the payment as ordinary income. taxation of partnership
Guaranteed payments are usually expressed as a fixed-dollar amount or as a percentage of capital the partner has invested in the partnership. By definition, a guaranteed payment cannot be calculated based on partnership income (e.g., as a percentage of annual income).