Chapter 10

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Chapter 10

  1. 1. Chapter 10 Partnership Taxation Income Tax Fundamentals 2011 Gerald E. Whittenburg Martha Altus-Buller 2011 Cengage Learning
  2. 2. Learning Objectives <ul><li>Define a partnership for tax purposes </li></ul><ul><li>Understand basic tax rules for forming and operating a partnership </li></ul><ul><li>Describe tax treatment of distributions </li></ul><ul><li>Determine partnership tax years </li></ul><ul><li>Identify tax treatment of transactions between partners and partnerships </li></ul><ul><li>Understand application of at-risk rules </li></ul><ul><li>Analyze pros/cons of limited liability companies </li></ul>2011 Cengage Learning
  3. 3. Nature of Partnership Taxation <ul><li>Partnerships must file an informational tax return called Form 1065 </li></ul><ul><ul><li>Partnership itself does not pay tax; rather, income/expenses ‘flow through’ to partners </li></ul></ul><ul><ul><li>Partnership income taxable to partner, even if he/she does not receive cash!! </li></ul></ul><ul><li>Partnerships must make various elections (depreciation and inventory methods, for example) </li></ul>2011 Cengage Learning
  4. 4. What is a Partnership? <ul><li>A partnership is a syndicate, group, pool, joint venture or other unincorporated organization through which any business, financial operation or venture is carried on </li></ul><ul><li>Partnerships are legal entities under civil law </li></ul><ul><li>In most states they have rights under Uniform Partnership Act </li></ul>2011 Cengage Learning
  5. 5. Partnership Agreement <ul><li>Can form general partnership by simple verbal agreement </li></ul><ul><ul><li>However, prudent to document agreement in writing </li></ul></ul><ul><ul><li>General partners usually take on risk of legal liability for certain partnership actions and debts </li></ul></ul><ul><ul><li>Limited liability partnerships (LLPs) or Limited Liability Companies (LLCs) limit some of that exposure </li></ul></ul><ul><li>LLPs and LLCs are required to register with state in which they are formed </li></ul>2011 Cengage Learning
  6. 6. Partnership Formation <ul><li>When forming a partnership, individuals contribute assets to partnership in exchange for a partnership interest </li></ul><ul><li>No gain/loss is usually recognized </li></ul><ul><li>Exceptions include </li></ul><ul><ul><li>When services are performed in exchange for partnership interest </li></ul></ul><ul><ul><li>When property is contributed with liabilities in excess of basis, then </li></ul></ul><ul><ul><li>Recognized Gain = Liabilities Allocable to Others – Adjusted Basis of Property Contributed </li></ul></ul>2011 Cengage Learning
  7. 7. Partnership Formation <ul><li>Partner’s basis in partnership interest </li></ul><ul><ul><li>Cash contributed </li></ul></ul><ul><ul><li>plus: Basis of property transferred to partnership </li></ul></ul><ul><ul><li>plus: Gain recognized (from prior screen) </li></ul></ul><ul><ul><li>less: Liabilities allocable to other partners </li></ul></ul><ul><ul><li>Equals: Partner’s initial basis in partnership </li></ul></ul>2011 Cengage Learning
  8. 8. Example #1 – Partnership Formation <ul><li>Example </li></ul><ul><li>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? </li></ul>2011 Cengage Learning
  9. 9. Solution <ul><li>Example </li></ul><ul><li>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? </li></ul><ul><li>Solution </li></ul><ul><li>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) </li></ul>2011 Cengage Learning Anna’s partnership basis = adjusted basis in equipment + income recognized - liability assumed by other partner
  10. 10. Example #2 – Partnership Formation <ul><li>Example </li></ul><ul><li>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? </li></ul>2011 Cengage Learning
  11. 11. Solution <ul><li>Example </li></ul><ul><li>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? </li></ul><ul><li>Solution </li></ul><ul><li>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 </li></ul><ul><li>Leisle’s basis in her partnership interest equals $0. </li></ul><ul><ul><li>$450,000 + $30,000 – .40($1,200,000) </li></ul></ul>2011 Cengage Learning Her adjusted basis in raw land + gain recognized - liability assumed by other partners
  12. 12. Changes in Partner’s Basis <ul><li>Changes occur to partner’s basis due to subsequent activities </li></ul><ul><li>Beginning Basis </li></ul><ul><li>+ Additional Contributions </li></ul><ul><li>+ Share of Net Ordinary Taxable Income </li></ul><ul><li>+ Share of Capital Gains/Other Income </li></ul><ul><li>- Distributions of Property or Cash </li></ul><ul><li>- Share of Net Loss from Operations * </li></ul><ul><li>- Share of Capital Losses/Other Deductions </li></ul><ul><li>+/- Increase/Decrease in Liabilities </li></ul><ul><li>Basis in Partnership Interest </li></ul><ul><li>*Note: Can’t take basis below 0 and must comply with at-risk limitations </li></ul>2011 Cengage Learning
  13. 13. Example – Basis Adjustments <ul><li>Example </li></ul><ul><li>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 2010 totaled $42,000. </li></ul><ul><li>What is Suresh’s basis in the partnership interest at year-end? </li></ul>2011 Cengage Learning
  14. 14. Solution <ul><li>Example </li></ul><ul><li>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 2010 totaled $42,000. </li></ul><ul><li>What is Suresh’s basis in the partnership interest at year-end? </li></ul><ul><li>Solution </li></ul><ul><li>$70,000 + .50($130,000) + .50($42,000) = $156,000 </li></ul><ul><li>Beginning balance + 50% liabilities + 50% net income </li></ul>2011 Cengage Learning
  15. 15. Partnership Income Reporting <ul><li>Partnerships do not pay tax </li></ul><ul><ul><li>All information flows through to be reported by the partners </li></ul></ul><ul><ul><li>Tax return is due by 15th of 4th month following close of partnership tax year </li></ul></ul><ul><li>Must report each element of income and expense separately on Form 1065 (Partnership Tax Return) </li></ul><ul><ul><li>Schedule K-1 shows allocable partnership income/expenses for each partner, based upon the individual ownership percentage </li></ul></ul><ul><ul><ul><li>Ordinary income/loss </li></ul></ul></ul><ul><ul><ul><li>Special income/deduction items such as charitable deductions, interest, capital gains/losses </li></ul></ul></ul>2011 Cengage Learning
  16. 16. Partnership Income Reporting <ul><li>Income and expenses flow through to individual’s tax return </li></ul><ul><li>On the individual partner’s tax return the deductible losses from partnership activities are limited to basis in partnership interest </li></ul><ul><ul><li>Cannot reduce basis below zero </li></ul></ul><ul><ul><li>Carry forward any unused losses to subsequent years (when there may be additional basis with which to absorb loss!) </li></ul></ul>2011 Cengage Learning
  17. 17. Current Distributions <ul><li>Partnerships may make distributions of money or other property to partners </li></ul><ul><ul><li>A current distribution is one that does not completely terminate a partner’s interest </li></ul></ul><ul><ul><li>No gain recognized by partner, unless partner’s basis in partnership has reached zero </li></ul></ul><ul><ul><ul><li>Then, only the portion of the current distribution that is in excess of partner’s basis is taxed </li></ul></ul></ul>2011 Cengage Learning
  18. 18. Guaranteed Payments <ul><li>Amount that a partner receives for services rendered or use of partner’s capital is called a guaranteed payment </li></ul><ul><ul><li>Guaranteed payments are made regardless of income/loss situation of partnership </li></ul></ul><ul><ul><li>Guaranteed payments are subtracted before partnership taxable income/loss is allocated to partners </li></ul></ul><ul><ul><li>Guaranteed payments are taxable ordinary income to partner and deductible by partnership </li></ul></ul>2011 Cengage Learning
  19. 19. Tax Years & Partnerships <ul><li>IRS establishes rigid rules pertaining to tax years as follows: </li></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>If this is not possible, it must adopt same tax year as majority of the principal partners </li></ul></ul><ul><ul><li>If neither of these work, partnership must use the least aggregate deferral method (see major tax service for more information) </li></ul></ul>2011 Cengage Learning
  20. 20. Transactions Between Partners & Partnerships <ul><li>Generally, transactions between partners and the partnership are not regarded as related party transactions </li></ul><ul><li>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) </li></ul><ul><ul><li>And a gain results : it is taxed as ordinary income </li></ul></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>*Note: Indirect ownership means “through spouse, siblings, lineal descendants and ancestors” </li></ul></ul>2011 Cengage Learning
  21. 21. At-Risk Limitations <ul><li>Partners cannot deduct losses from activities in excess of their investment </li></ul><ul><ul><li>Losses limited to amounts at risk (AAR) in those activities </li></ul></ul><ul><li>Definitions </li></ul><ul><ul><li>A “nonrecourse liability” is a debt for which the borrower is not personally liable and doesn’t count towards AAR </li></ul></ul><ul><ul><li>“ 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 </li></ul></ul><ul><li>Taxpayers are at-risk for an amount equal to </li></ul><ul><ul><li> Cash and property contributed to partnership </li></ul></ul><ul><ul><li> + Liabilities on encumbered properties (recourse debt) </li></ul></ul><ul><ul><li>+ Liabilities for which taxpayer is personally liable (recourse debt) </li></ul></ul><ul><ul><li>+ Retained profits in activity </li></ul></ul>2011 Cengage Learning
  22. 22. At-Risk Limitations <ul><li>Taxpayer allowed a loss deduction allocable to business activity to the extent of: </li></ul><ul><ul><li>Income received or accrued from activity without regard to amount at risk </li></ul></ul><ul><ul><li>or </li></ul></ul><ul><ul><li>Taxpayer’s amount at risk at the end of the tax year </li></ul></ul>2011 Cengage Learning
  23. 23. At-Risk Rules & Real Estate <ul><li>Real estate acquired before 1987 is not subject to at-risk rules </li></ul><ul><li>For real estate acquired after 1986, the amount of “qualified nonrecourse financing” is considered to be the amount at risk </li></ul><ul><ul><li>This is defined as debt secured by real estate and borrowed from person who regularly engages in the lending of money </li></ul></ul><ul><ul><li>Does not apply to financing from seller or promoter </li></ul></ul>2011 Cengage Learning
  24. 24. Example Real Estate & At-Risk <ul><li>Example </li></ul><ul><li>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? </li></ul>2011 Cengage Learning
  25. 25. Solution <ul><li>Example </li></ul><ul><li>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? </li></ul><ul><li>Solution </li></ul><ul><li>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. </li></ul>2011 Cengage Learning
  26. 26. Limited Liability Companies <ul><li>Limited Liability Companies (LLCs) have attributes of both partnerships and corporations </li></ul><ul><li>Advantages of LLCs are numerous </li></ul><ul><ul><li>Taxable income/loss passes through to owners </li></ul></ul><ul><ul><li>No general partner requirement </li></ul></ul><ul><ul><li>Owners can participate in management </li></ul></ul><ul><ul><li>Owners have limited liability </li></ul></ul><ul><ul><li>LLC ownership interest is not a security </li></ul></ul><ul><ul><li>Tax attributes pass through to owners </li></ul></ul><ul><ul><li>Offer greater tax flexibility than S corporations (single member LLCs are very common) </li></ul></ul>2011 Cengage Learning
  27. 27. Limited Liability Companies <ul><li>Disadvantages of LLCs </li></ul><ul><ul><li>Because of newness, limited amount of case law dealing with limited liability companies </li></ul></ul><ul><ul><li>States are not uniform in treatment of LLCs, so potential for confusion if LLC is operating in more than one state </li></ul></ul><ul><ul><li>Note: LLCs are quickly becoming a major form </li></ul></ul><ul><ul><li>of business organization in the U.S . </li></ul></ul>2011 Cengage Learning
  28. 28. That’s All 2011 Cengage Learning

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