Vol 02 chapter 10 2012


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Vol 02 chapter 10 2012

  1. 1. Chapter 10 Partnerships: Formation, Operation and Basis Corporations, Partnerships, Estates & Trusts© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1
  2. 2. The Big Picture (slide 1 of 3)• For 15 years, Maria has owned and operated a seaside bakery and cafe´ called The Beachsider. – Maria would like to expand and has talked to her landlord, Kyle about it.• The Beachsider is one of several older buildings on 3 acres of a 10-acre parcel that Kyle’s family has owned for years. – The remaining 7 acres are undeveloped.• Kyle and Maria talked to Josh, a real estate developer, and he proposed an expansion to The Beachsider and upgrades to the other buildings.
  3. 3. The Big Picture (slide 2 of 3)• The parties agreed to form a partnership to own and operate The Beachsider and to improve and lease the other buildings.• Under the plan, Kyle and Maria will each contribute ½ of the capital needed. – Kyle’s real estate is valued at about $2 million. – Maria’s bakery equipment and the cafe´ furnishings are valued at about $500,000. – The improvements will cost about $1.5 million, which Maria has agreed to contribute to the partnership.
  4. 4. The Big Picture (slide 3 of 3)• Josh will not contribute any capital to the partnership. – Instead, he will manage the construction and the operation of the partnership in exchange for 5% of the capital and 20% of the ongoing profits. – His capital interest is valued at $200,000.• What are the tax consequences if the trio forms Beachside Properties as a partnership to own and operate the shopping center? – What issues might arise later in the life of the entity?• Read the chapter and formulate your response.
  5. 5. Partnership Definition• An association of two or more persons to carry on a trade or business – Contribute money, property, labor – Expect to share in profit and losses• For tax purposes, includes: – Syndicate – Group – Pool – Joint venture, etc
  6. 6. Entities Taxed as Partnerships (slide 1 of 4)• General partnership – Consists of at least 2 partners – Partners are jointly and severally liable • Creditors can collect from both partnership and partners’ personal assets • General partner’s assets are at risk for malpractice of other partners even though not personally involved
  7. 7. Entities Taxed as Partnerships (slide 2 of 4)• Limited liability partnership (LLP) – An LLP partner is not personally liable for malpractice committed by other partners – Popular organizational form for large accounting firms
  8. 8. Entities Taxed as Partnerships (slide 3 of 4)• Limited partnership – Has at least one general partner • One or more limited partners – Only general partner(s) are personally liable to creditors • Limited partners’ loss is limited to equity investment
  9. 9. Entities Taxed as Partnerships (slide 4 of 4)• Limited liability company (LLC) – Combines the corporate benefit of limited liability with benefits of partnership taxation • Unlike corporations, income is subject to tax only once • Special allocations of income, losses, and cash flow are available – Owners are “members,” not partners, but if properly structured will receive partnership tax treatment
  10. 10. The Big Picture – Example 1 Types Of Partnerships (slide 1 of 2)• Return to the facts of The Big Picture on p. 10-2.• When Beachside Properties is formed, Kyle, Maria, and Josh must decide which type of partnership to utilize. – With a general partnership, Kyle, Maria, and Josh would each be jointly and severally liable for all entity debts. – With a limited partnership, one of the partners would be designated as a general partner and would be liable for all entity debts. – Because all 3 partners want to have limited liability, they decide not to use a general or limited partnership.
  11. 11. The Big Picture – Example 1 Types Of Partnerships (slide 2 of 2)• They do not consider a limited liability partnership because that entity form is typically reserved for service-providing entities.• With a limited liability company (or, if their state permits, a limited liability limited partnership), each partner’s losses will be limited to the partner’s contributed capital. – Therefore, Kyle, Maria, and Josh decide to form Beachside Properties as an LLC.
  12. 12. “Check-The-Box” Regs (slide 1 of 2)• Allows most unincorporated entities to select their federal tax status – If 2 or more owners, can choose to be treated as: • Partnership, or • Corporation – Permits some flexibility • Not all entities have a choice • e.g., New publicly traded partnerships must be taxed as corporations
  13. 13. “Check-The-Box” Regs (slide 2 of 2)• Some entities can be excluded from partnership treatment if organized for: – Investment (not active trade or business) – Joint production, extraction, or use of property – Underwriting, selling, or distributing a specific security• Owners simply report their share of operations on their own tax return
  14. 14. Partnership Taxation (slide 1 of 3)• Partnership is not a taxable entity – Flow through entity • Income taxed to owners, not entity • Partners report their share of partnership income or loss on their own tax return
  15. 15. Partnership Taxation (slide 2 of 3)• Generally, the calculation of partnership income is a 2-step approach – Step 1: Net ordinary income and expenses related to the trade or business of the partnership – Step 2: Segregate and report separately some partnership items – If an item of income, expense, gain or loss might affect any 2 partners’ tax liabilities differently, it is separately stated – e.g., Charitable contributions
  16. 16. Partnership Taxation (slide 3 of 3)• Electing large partnerships can net some items that would otherwise be separately stated – Must have at least 100 partners and elect simplified reporting procedures – Such partnerships separately report less than a dozen categories of items to their partners • e.g., Combine interest, nonqualifying dividends, and royalty income into one amount, and report the net amount to partners
  17. 17. Partnership Reporting• Partnership files Form 1065 – On page 1 of Form 1065, partnership reports ordinary income or loss from its trade or business activities – Schedule K accumulates information to be reported to partners • Provides ordinary income (loss) and separately stated items in total – Each partner (and the IRS) receives a Schedule K-1 • Reports each partner’s share of ordinary income (loss) and separately stated items
  18. 18. Conceptual Basis for Partnership Taxation (slide 1 of 2)• Involves 2 legal concepts: – Aggregate (or conduit) concept—Treats partnership as a channel with income, expense, gains, etc. flowing through to partners • Concept is reflected by the imposition of tax on the partners, not the partnership
  19. 19. Conceptual Basis for Partnership Taxation (slide 2 of 2)• Involves 2 legal concepts (cont’d): – Entity concept—Treats partners and partnerships as separate and is reflected by: • Partnership requirement to file its own information return • Treating partners as separate from the partnership in certain transactions between the two
  20. 20. Partner’s Ownership Interest• Each owner normally has a: – Capital interest • Measured by capital sharing ratio – Partner’s percentage ownership of capital – Profits (loss) interest • Partner’s % allocation of partnership ordinary income (loss) and separately stated items • Certain items may be “specially allocated” – Specified in the partnership agreement
  21. 21. Inside and Outside Bases• Inside basis – Refers to adjusted basis of each partnership asset – Each partner “owns” a share of the partnership’s inside basis for all its assets• Outside basis – Represents each partner’s basis in the partnership interest – All partners should maintain a record of their respective outside bases
  22. 22. Basis Issues (slide 1 of 3)• Partner’s outside basis is adjusted for income and losses that flow through from partnership • This ensures that partnership income is only taxed once
  23. 23. Basis Issues (slide 2 of 3)• Partner’s basis is important for determining: – Deductibility of partnership losses – Tax treatment of partnership distributions – Calculating gain or loss on the partner’s disposition of the partnership interest
  24. 24. Basis Issues (slide 3 of 3)• Partner’s capital account balance is usually not a good measure of a partner’s adjusted basis in a partnership interest for several reasons • e.g., Basis includes partner’s share of partnership liabilities; Capital account does not
  25. 25. Partnership Formation Transaction
  26. 26. Tax Consequences of Partnership Formation (slide 1 of 2)• Usually, no gain or loss is recognized by a partner or partnership on the contribution of money or property in exchange for a partnership interest• Gain (loss) is deferred until taxable disposition of: – Property by partnership, or – Partnership interest by partner
  27. 27. Tax Consequences of Partnership Formation (slide 2 of 2)• Partner’s basis in partnership interest = basis of contributed property – If partner contributes capital assets and §1231 assets, holding period of partnership interest includes holding period of assets contributed – For other assets including cash, holding period begins on date partnership interest is acquired – If multiple assets are contributed, partnership interest is apportioned and separate holding period applies to each portion
  28. 28. WST Partnership Formation Example (slide 1 of 2)• William contributes cash – Amount $20,000• Sarah contributes land – Basis $ 6,000 – FMV $20,000• Todd contributes equipment – Basis $22,000 – FMV $20,000
  29. 29. WST Partnership Formation Example (slide 2 of 2) Gain or loss Basis in Partnership’sPartner Recognized Interest Property BasisWilliam $-0- $20,000 $20,000Sarah $-0- $ 6,000 $ 6,000Todd $-0- $22,000 $22,000Neither the partnership nor any of the partners recognizes gain or loss on the transaction
  30. 30. Exceptions to Tax-Free Treatment on Partnership Formation (slide 1 of 4)• Transfers of appreciated stock to investment partnership – Gain will be recognized by contributing partner – Prevents multiple investors from diversifying their portfolios tax-free
  31. 31. Exceptions to Tax-Free Treatment on Partnership Formation (slide 2 of 4)• If transaction is essentially a taxable exchange of properties, gain will be recognized – e.g., Individual A contributes land and Individual B contributes equipment to a new partnership; shortly thereafter, the partnership distributes the land to B and the equipment to A; Partnership liquidates – IRS will disregard transfer to partnership and treat as taxable exchange between A & B
  32. 32. Exceptions to Tax-Free Treatment on Partnership Formation (slide 3 of 4)• Disguised Sale – e.g., Partner contributes property to a partnership; Shortly thereafter, partner receives a distribution from the partnership • Payment may be viewed as a purchase of the property by the partnership
  33. 33. Exceptions to Tax-Free Treatment on Partnership Formation (slide 4 of 4)• Receipt of partnership interest in exchange for services rendered to partnership – Services are not treated as “property” – Partner recognizes ordinary compensation income = FMV of partnership interest received• Partnership may deduct the amount included in the service partner’s income if the services are of a deductible nature – If the services are not deductible by the partnership, they must be capitalized to an asset account
  34. 34. The Big Picture – Example 15 Contributions To The Partnership (slide 1 of 2)• Return to the facts of The Big Picture on p. 10-2.• Kyle and Maria make the following capital contributions to the newly formed LLC. – Kyle contributes real estate, basis $600,000, FMV $2 million. – Maria contributes bakery equipment, basis $0, FMV $500,000.• No tax consequences on formation of Beachside Properties, LLC for the LLC, Kyle, or Maria. – Kyle does not recognize his $1.4 million realized gain. – Maria does not recognize her $500,000 realized gain.• Kyle takes a substituted basis of $600,000 for his interest.• Maria takes a substituted basis of $1.5 million ($1.5 million for contributed cash + $0 for contributed property).
  35. 35. The Big Picture – Example 15 Contributions To The Partnership (slide 2 of 2)• Beachside Properties has the following adjusted basis in the contributed property. – A carryover basis of $600,000 for the real estate contributed by Kyle. – A carryover basis of $0 for the property contributed by Maria.• To the extent that the buildings and other land improvements are depreciable, the LLC ‘‘steps into Kyle’s shoes’’ in calculating depreciation deductions.• Because Josh receives his 5% capital interest in the LLC in exchange for services, the $200,000 is taxable to him. – Beachside Properties either capitalizes or expenses the cost of the services, depending on their nature.• Josh’s 20% profits interest will be taxed to him as profits are allocated to him.
  36. 36. Tax Issues Relative to Contributed Property (slide 1 of 3)• Contributions of depreciable property and intangible assets – Partnership “steps into shoes” of contributing partner • Continues the same cost recovery and amortization calculations • Cannot expense contributed depreciable property under §179
  37. 37. Tax Issues Relative to Contributed Property (slide 2 of 3)• Gain or loss is ordinary when partnership disposes of: – Contributed unrealized receivables – Contributed property that was inventory in contributor’s hands, if disposed of within 5 years of contribution • Inventory includes all tangible property except capital assets and real or depreciable business assets
  38. 38. Tax Issues Relative to Contributed Property (slide 3 of 3)• If contributed property is disposed of at a loss and the property had a ‘‘built-in’’ capital loss on the contribution date – Loss is treated as a capital loss if disposed of within 5 years of the contribution – Capital loss is limited to amount of ‘‘built-in’’ loss on date of contribution
  39. 39. Elections Made by Partnership (slide 1 of 2)• Inventory method• Accounting method – Cash, accrual or hybrid• Depreciation method• Tax year• Organizational cost amortization• Start-up expense amortization
  40. 40. Elections Made by Partnership (slide 2 of 2)• Optional basis adjustment (§754)• §179 deduction• Nonrecognition treatment for involuntary conversions• Election out of partnership rules
  41. 41. Organizational Costs (slide 1 of 2)• For organization costs incurred after October 22, 2004, the partnership may elect to deduct up to $5,000 of the costs in year business begins – Deductible amount must be reduced by organization costs that exceed $50,000 – Remaining amounts are amortizable over 180 months beginning with month the partnership begins business• For organization costs incurred before that date, the taxpayer could elect to amortize the amount over 60 months
  42. 42. Organizational Costs (slide 2 of 2)• Organizational costs include costs: – Incident to creation of the partnership, chargeable to a capital account, and of a character that, if incident to the creation of a partnership with an ascertainable life, would be amortized over that life • Includes accounting fees and legal fees connected with the partnership’s formation• Costs incurred for the following items are not organization costs: – Acquiring and transferring assets to the partnership – Admitting and removing partners, other than at formation – Negotiating operating contracts – Syndication costs
  43. 43. Start-up Costs (slide 1 of 2)• Start-up costs—include operating costs incurred after entity is formed but before it begins business including: – Marketing surveys prior to conducting business – Pre-operating advertising expenses – Costs of establishing an accounting system – Costs incurred to train employees before business begins, and – Salaries paid to executives and employees before the start of business
  44. 44. Start-up Costs (slide 2 of 2)• Partnership may elect to deduct up to $5,000 of start- up costs in the year it begins business – Deductible amount must be reduced by start-up costs in excess of $50,000 – Costs that are not deductible under this provision are amortizable over 180 months beginning with the month in which the partnership begins business• For start-up costs incurred before October 23, 2004, the taxpayer could elect to amortize those costs over 60 months
  45. 45. Method of Accounting (slide 1 of 2)• New partnership may adopt cash, accrual or hybrid method – Cash method cannot be adopted if partnership: • Has one or more C corporation partners • Is a tax shelter
  46. 46. Method of Accounting (slide 2 of 2)• New partnership may adopt cash, accrual or hybrid method (cont’d) – C Corp partner does not preclude use of cash method if: • Partnership has average annual gross receipts of $5 million or less for preceding 3 year period • C corp partner(s) is a qualified personal service corp, or • Partnership is engaged in farming business
  47. 47. Required Taxable Year• Partnership must adopt tax year under earliest of following tests met: – Majority partner’s tax year (partners with same tax year owning >50%) – Principal partners’ tax year (all partners owning 5% or more) – Least aggregate deferral rule
  48. 48. Least Aggregate Deferral Example (slide 1 of 2)• George owns 50% and has June 30 year end• Henry owns 50% and has October 31 year end• Neither partner owns a “majority” (>50%)• Both are “principal partners” (5% or more), but do not have same year end – Must use least aggregate deferral test to determine required taxable year
  49. 49. Least Aggregate Deferral Example (slide 2 of 2)1. Test June 30 as possible year end: Partner. Year End % Mo. Deferral Weight George June 50% 0 0.0 Henry October 50% 4 2.0 Total weighted deferral 2.02. Test October 31 as possible year end: George June 50% 8 4.0 Henry October 50% 0 0.0 Total weighted deferral 4.0June has the least aggregate deferral so it is the tax year for partnership.
  50. 50. Alternative Tax Years• Other alternatives may be available if: – Establish to IRS’s satisfaction that a business purpose exists for another tax year • e.g., Natural business year at end of peak season – Choose tax year with no more than 3 month deferral • Partnership must maintain with the IRS a prepaid, non- interest-bearing deposit of estimated deferred taxes – • Elect a 52- to 53-week taxable year
  51. 51. Measuring Income of Partnership• Calculation of partnership income is a 2-step approach – Step 1: Net ordinary income and expenses related to the trade or business of the partnership – Step 2: Segregate and report separately some partnership items
  52. 52. Separately Stated Items (slide 1 of 2)• If an item of income, expense, gain or loss might affect any 2 partners’ tax liabilities differently, it is separately stated
  53. 53. Separately Stated Items (slide 2 of 2)• Separately stated items fall under the “aggregate” concept – Each partner owns a specific share of each item of partnership income, gain, loss or deduction • Character is determined at partnership level • Taxation is determined at partner level
  54. 54. Examples of Separately Stated Items (slide 1 of 2)• Short and long-term capital gains and losses• §1231 gains and losses• Domestic production activities deduction• Charitable contributions• Interest income and other portfolio income• Expenses related to portfolio income
  55. 55. Examples of Separately Stated Items (slide 2 of 2)• Personalty expensed under §179• Special allocations of income or expense• AMT preference and adjustment items• Passive activity items• Self-employment income• Foreign taxes paid
  56. 56. The Big Picture – Example 23 Income Measurement (slide 1 of 4)• Return to the facts of The Big Picture on p. 10-2.• In its 2nd year of operations, Beachside Properties, LLC, reports income and expenses as follows: Sales revenue $600,000 Cost of sales 200,000 Salaries to employees 100,000 Cost recovery deductions 60,000 Utilities, supplies, and repairs 40,000 Taxes and licenses (including payroll taxes) 20,000 Contribution to art museum 6,000 Short-term capital gain 12,000 Net income from rental real estate 300,000 Qualified dividends received 4,000 Exempt income (bond interest) 2,100 AMT adjustment (cost recovery) 5,000 Payment of medical expenses on behalf of partner Kyle 4,000• The LLC experienced a $20,000 net loss from operations last year, its first year of business.
  57. 57. The Big Picture – Example 23 Income Measurement (slide 2 of 4)• Refer to Form 1065 in Appendix B. Beachside’s ordinary income is determined and reported on the partnership return as follows:Nonseparately Stated Items (Ordinary Income)—Form 1065, Pages 1and 4 Sales revenue $600,000 Cost of sales (200,000) Salaries to employees (100,000) Cost recovery deductions (60,000) Utilities, supplies, and repairs (40,000) Taxes and licenses (including payroll taxes) (20,000) Ordinary income (Form 1065, page 1, line 22, and Form 1065, page 4 [Schedule K], line 1) $180,000
  58. 58. The Big Picture – Example 23 Income Measurement (slide 3 of 4)• Beachside is not a allowed a deduction for last year’s $20,000 NOL – This item was passed through to the LLC members in the previous year.• The LLC is not allowed a deduction for payment of Kyle’s medical expenses. – This payment is probably handled as a distribution to Kyle, who may report it as a medical expense on his Schedule A in determining his itemized deductions.• The AMT adjustment is not a separate component of the LLC’s income – It must be reported by Beachside’s members so that they can properly calculate any AMT liability.
  59. 59. The Big Picture – Example 23 Income Measurement (slide 4 of 4)• Beachside’s separately stated income and deduction items are: Separately Stated Income and Deductions (Schedule K) Net income from rental real estate (Line 2) $300,000 Qualified dividends received (Line 6) 4,000 Short-term capital gain (Line 9a) 12,000 Contribution to art museum (Line 13a) 6,000• The LLC reports the following additional information that the partners must report or utilize in preparing their tax returns: Additional Information (Schedule K) AMT adjustment—cost recovery (Line 17a) $5,000 Tax-exempt income—bond interest (Line 18a) 2,100
  60. 60. The Big Picture – Example 24 Book-tax Reconciliation• Continue with the facts in Example 23 and consider the book-tax reconciliation.• Beachside Properties, LLC, must prepare the Analysis of Income (Loss) and Schedule M–1 on Form 1065, page 5. – In preparing these schedules, the LLC combines the ordinary income of $180,000 and the 4 separately stated amounts in Example 23 to arrive at ‘‘net income’’ of $490,000.• This amount is shown on line 1 of the Analysis of Income (Loss) and is the amount to which book income is reconciled on Schedule M–1, line 9.
  61. 61. The Big Picture – Example 25 Maria’s Reported Amounts• Assume the same facts as in Example 23, but now consider the effect of the LLC’s operations on one of its members.• Maria, a 40% owner, will receive a Schedule K–1 from Beachside Properties, on which she is allocated a 40% share of ordinary income and separately stated items.• Thus, on her Form 1040, Maria includes: Ordinary income $72,000 Charitable contribution $2,400 Short-term capital gain $4,800 Passive rent income $120,000 Qualified dividend income $1,600• Maria will disclose her $840 share of tax-exempt interest on the first page of Form 1040.• In determining her AMT liability (if any), Maria will take into account a $2,000 positive adjustment.
  62. 62. Partnership Allocations (slide 1 of 3)• Partnership agreement can provide that a partner share capital, profits, and losses in different ratios – e.g., Partnership agreement may provide that a partner has a 30% capital sharing ratio, yet be allocated 40% of the profits and 20% of the losses – Such special allocations are permissible if certain rules are followed • e.g., Economic effect test
  63. 63. Partnership Allocations (slide 2 of 3)• The economic effect test requires that: – An allocation must be reflected in a partner’s capital account – When partner’s interest is liquidated, partner must receive assets with FMV = the positive balance in the capital account – A partner with a negative capital account must restore that account upon liquidation
  64. 64. Partnership Allocations (slide 3 of 3)• Precontribution 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 disposed of by partnership in taxable transaction • For depreciable property, allocations related to the built-in loss can be made only to the contributing partner – For allocations to other partners, the partnership’s basis in the loss property is treated as being the fair market value of the property at the contribution date
  65. 65. The Big Picture – Example 30 Precontribution Gain or Loss (slide 1 of 2)• Return to the facts of The Big Picture on p. 10-2.• When Beachside Properties, LLC, was formed – Kyle contributed property FMV $2 million, basis $600,000. – Maria contributed equip. & furnishings with FMV $500,000, basis $0.• For § 704(b) book accounting purposes, Beachside records the land and other properties at their FMV. – For tax purposes, the LLC takes carryover bases in the properties.• The LLC must keep track of the differences between the basis in each property and the value at the contribution date. – If any property is sold, gain must be allocated to contributing partner to extent of previously unrecognized built-in gain.
  66. 66. The Big Picture – Example 30 Precontribution Gain or Loss (slide 2 of 2)• For example, if Beachside sells the land contributed by Kyle for $2.3 million, the gain would be calculated and allocated as follows: § 704(b) Book Tax Amount realized $2,300,000 $2,300,000 Less: Adjusted basis 2,000,000 600,000 Gain realized $ 300,000 $1,700,000 Built-in gain to Kyle –0– 1,400,000 Remaining gain (allocated proportionately) $ 300,000 $ 300,000• For tax purposes, – Kyle would recognize $1,520,000 of the gain [($300,000 X 40%) + $1,400,000] – Maria would recognize $120,000($300,000 X 40%), and – Josh would recognize $60,000($300,000 X 20%).
  67. 67. Basis of Partnership Interest (slide 1 of 3)• For new partnerships, partner’s basis usually equals: – Adjusted basis of property contributed, plus – FMV of any services performed by partner in exchange for partnership interest
  68. 68. Basis of Partnership Interest (slide 2 of 3)• For existing partnerships, basis depends on how interest was acquired – If purchased from another partner, basis = amount paid for the interest – If acquired by gift, basis = donor’s basis plus, in certain cases, a portion of the gift tax paid on the transfer – If acquired through inheritance, basis = FMV on date of death (or alternate valuation date)
  69. 69. Basis of Partnership Interest (slide 3 of 3)• A partner’s basis in partnership interest is adjusted to reflect partnership activity – This prevents double taxation of partnership income
  70. 70. Basis Example (slide 1 of 2)• Pam is a 30% partner in the PDQ partnership• Pam’s beginning basis is $20,000• PDQ reports current income of $50,000• Pam sells her interest for $35,000 at the end of the year
  71. 71. Basis Example (slide 2 of 2) With Basis Without Basis Adjustment AdjustmentSelling Price(A) $ 35,000 $35,000Less: Basis in interestBeginning basis 20,000 20,000Share of current income 15,000 - 0- .Ending basis (B) 35,000 20,000Taxable gain (A)-(B) $ -0- $15,000–If no basis adjustment, Pams $15,000 share of partnership income is taxed twice: as ordinary income and as gain on sale of interest
  72. 72. Adjustments to Basis• Initial Basis – + Partner’s subsequent contributions to partnership – + Partner’s share of partnership: • Debt increase • Income items • Exempt income items • Depletion adjustment – – Distributions and withdrawals from partnership – – Partner’s share of partnership: • Debt decreases • Nondeductible expenses • Deductions and losses
  73. 73. Basis Limitation• A partner’s basis in the partnership interest can never be negative
  74. 74. Partnership Liabilities• Affect partner’s adjusted basis – Increase in partner’s share of liabilities • Treated as a cash contribution to the partnership • Increases partner’s adjusted basis – Decrease in partner’s share of liabilities • Treated as a cash distribution to the partner • Decreases partner’s adjusted basis
  75. 75. Allocation of Partnership Liabilities• Two types of partnership debt – Recourse debt—At least one partner is personally liable • Allocate to partners using a “Constructive Liquidation Scenario” – Nonrecourse debt—No partner is personally liable • Allocate to partners using a three-tiered allocation
  76. 76. Constructive Liquidation Scenario• 1. Partnership assets deemed to be worthless• 2. Assets deemed sold at $0; 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• - Partner’s share of recourse debt = Cash contribution• used to repay debt (Step 5)
  77. 77. Nonrecourse Debt Allocation• Three step allocation: – 1. “Minimum Gain” allocated under regulations • Minimum gain is basically gain which would arise on foreclosure of property – 2. Liability = precontribution gain allocated to contributing partner – 3. Remaining debt commonly allocated by profit sharing ratios (other allocation methods could be used)
  78. 78. The Big Picture – Example 36 Basis In Partnership Interest (slide 1 of 4)• Return to the facts of The Big Picture on p. 10-2.• How is Maria’s basis affected by the income and deductions of Beachside Properties, LLC?• Assume the following: – At the beginning of the tax year (Beachside’s second year of operations), Maria’s basis in her LLC interest was $1.6 million. • Includes her $200,000 share of the LLC’s $500,000 of nonrecourse debt. – At the end of the year, Beachside had $600,000 of debt, which was again treated as nonrecourse to all the LLC members.
  79. 79. The Big Picture – Example 36 Basis In Partnership Interest (slide 2 of 4)• During the year, Maria contributes to the LLC: – Cash $100,000, and – Additional property, basis $0, FMV $50,000.• On December 31, the LLC distributes $20,000 cash to her.• Maria’s share of Beachside’s income, gain, and deductions is as described in Example 25.
  80. 80. The Big Picture – Example 36 Basis In Partnership Interest (slide 3 of 4)• Maria’s basis at year-end calculated using the ordering rules shown in Figure 10.3. is as follows: Beginning basis $1,600,000 Contributions, including increase in share of liabilities: Share of net increase in LLC liabilities [40% X ($600,000 - $500,000)] 40,000 Cash contribution to LLC capital 100,000 Maria’s basis in noncash capital contribution –0– Share of LLC income items: Ordinary LLC income 72,000 LLC’s net passive income from rental real estate 120,000 Tax-exempt income 840 Short-term capital gain 4,800 Qualified dividend income 1,600 Distributions and withdrawals: Capital withdrawal (20,000) Share of LLC deduction items: Charitable contribution (2,400) Ending basis $1,916,840
  81. 81. The Big Picture – Example 36 Basis In Partnership Interest (slide 4 of 4)• As will be explained in Chapter 11, Maria could withdraw cash from the LLC up to the amount of her basis without paying tax on the distribution.• Maria’s basis does not appear on the LLC’s tax return or on her Schedule K–1. – All partners are responsible for maintaining their own basis calculations.
  82. 82. The Big Picture – Example 37 Partner’s Capital Account• Maria’s Schedule K–1 will show her capital account rollforward from the prior year to the current year.• Assume that her capital account is calculated on a tax basis and that the beginning capital account balance was $1.4 million.• The reconciliation shown on Schedule K–1 will be as follows: Beginning capital account $1,400,000 Capital contributed during the year 100,000 Current-year increase (decrease) 196,840 Withdrawals and distributions (20,000) Ending capital account $1,676,840• Although this will not always be the case, Maria’s ending capital account balance differs from her ending basis by the amount of her $240,000 share of the LLC’s nonrecourse debt.
  83. 83. Loss Limitations (slide 1 of 2)• Partnership losses flow through to partners for use on their tax returns – Amount and nature of losses that may be used by partners may be limited – Three different loss limitations apply • Only losses that make it through all three limits are deductible by a partner
  84. 84. Loss Limitations (slide 2 of 2)Section Description704(d) Basis in partnership interest465 At-risk limitation469 Passive loss limitation• Limitations are applied successively to amounts which are deductible at all prior levels
  85. 85. Loss Limitation Example (slide 1 of 2)Megs basis in interest $50,000At-risk amount $35,000Passive income, other sources $25,000Share of partnership losses (passive) $60,000
  86. 86. Loss Limitation Example (slide 2 of 2)Provisions Deductible loss Suspended loss 704(d) $ 50,000 $ 10,000 465 35,000 15,000 469 25,000* 10,000*Amount deducted on tax return: $25,000 -passes all three loss limitations
  87. 87. Guaranteed Payments• Payment to partner for use of capital or for services provided to partnership – May not be determined by reference to partnership income – Usually expressed as a fixed dollar amount or as a % of capital
  88. 88. Treatment of Guaranteed Payments (slide 1 of 2)• May be deducted or capitalized by partnership depending on the nature of the payment – Deductible by partnership if meets “ordinary and necessary business expense” test – May create partnership loss
  89. 89. Treatment of Guaranteed Payments (slide 2 of 2)• Includable in income of partner at time partnership deducts – Treated as if received on last day of partnership tax year – Character is ordinary income to recipient partner
  90. 90. Other Transactions Between Partner and Partnership (slide 1 of 2)• May be treated as if partner were an outsider, for example: – Loan transactions – Rental payments – Sales of property
  91. 91. Other Transactions Between Partner and Partnership (slide 2 of 2)• Timing of deduction for payment by an accrual basis partnership to a cash basis partner depends on whether payment is: – Guaranteed payment • Included in partner’s income on last day of partnership year when accrued (even if not paid until the next year) – Payment to partner treated as an outsider • Deduction cannot be claimed until partner includes the amount in income
  92. 92. Sales of Property• No loss is recognized on the sale of property between a partnership and a partner who owns > 50% of partnership capital or profits – If property is subsequently sold at a gain, the disallowed loss reduces gain recognized
  93. 93. Partners as Employees• A partner usually does not qualify as an employee for tax purpose resulting in the following tax consequences: – A partner receiving guaranteed payments from the partnership is not subject to tax withholding – The partnership cannot deduct payments for a partner’s fringe benefits – A general partner’s distributive share of ordinary partnership income and guaranteed payments for services are generally subject to the Federal self-employment tax
  94. 94. The Big Picture – Example 48 Self-employment Tax Of Partners (slide 1 of 2)• Return to the facts of The Big Picture on p. 10-2.• Josh is the managing member of Beachside Properties, LLC. – He has the sole authority to contract for the LLC and works 1,000 hours per year in the business.• Maria works 1,000 hours per year in the cafe.• Kyle has generally not been involved in the LLC’s operations.• Kyle and Josh each receive a guaranteed payment of $5,000 per month from the LLC. – Josh’s payment is for services. – Kyle’s is for use of his $2 million of land. – Maria receives a guaranteed payment of $10,000 per month. • $5,000 is for services, and • $5,000 is for the use of her $2 million of capital.
  95. 95. The Big Picture – Example 48 Self-employment Tax Of Partners (slide 2 of 2)• If Beachside follows the Proposed Regulations, the members’ distributive shares and guaranteed payments will be treated as follows:* Under the Proposed Regulations, Maria’s distributive share is not SE income for two reasons: (1) she is a general partner by virtue of working more than 500 hours per year; and (2) Kyle, a ‘‘limited partner,’’ has an interest with identical rights to Maria’s.
  96. 96. Refocus On The Big Picture (slide 1 of 3)•After considering the various types of partnerships,Kyle, Maria, and Josh decide to form BeachsideProperties as an LLC (see Example 1).•On formation of the entity, there was no tax to the LLCor to any of its members (see Example 15).•Beachside Properties computes its income as shown inExample 23 and allocates the income as illustrated inExamples 24 and 25.
  97. 97. Refocus On The Big Picture (slide 2 of 3)• The LLC’s income affects the members’ basesand capital accounts as shown in Examples 30and 36.•An important consideration for the LLCmembers is whether their distributive shares andguaranteed payments will be treated as self-employment income (see Example 48).
  98. 98. Refocus On The Big Picture (slide 3 of 3)What If?•What happens in the future when the LLC membersdecide to expand or renovate Beachside’s facilities? – At that time, the existing members can contribute additional funds, the LLC can obtain new members, or the entity can solicit third-party financing. – An LLC is not subject to the 80% control requirement applicable to corporations. • Therefore, new investors can contribute cash or other property in exchange for interests in the LLC—and the transaction will qualify for tax-deferred treatment under § 721.
  99. 99. If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 99