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. 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. 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. 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. 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. 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. 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. 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. 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. 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. “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. “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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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
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. 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. 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. WST Partnership Formation
Example (slide 2 of 2)
Gain or loss Basis in Partnership’s
Partner Recognized Interest Property
Basis
William $-0- $20,000 $20,000
Sarah $-0- $ 6,000 $ 6,000
Todd $-0- $22,000 $22,000
Neither the partnership nor any of the partners recognizes
gain or loss on the transaction
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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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 2.0
2. Test October 31 as possible year end:
George June 50% 8 4.0
Henry October 50% 0 0.0
Total weighted deferral 4.0
June has the least aggregate deferral so it is the tax year for partnership.
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. 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. 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. 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. 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. 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. 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. 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 1
and 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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. Basis Example
(slide 2 of 2)
With Basis Without Basis
Adjustment Adjustment
Selling Price(A) $ 35,000 $35,000
Less: Basis in interest
Beginning basis 20,000 20,000
Share of current income 15,000 - 0- .
Ending basis (B) 35,000 20,000
Taxable gain (A)-(B) $ -0- $15,000
–If no basis adjustment, Pam's $15,000 share of partnership
income is taxed twice: as ordinary income and as gain on
sale of interest
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. Basis Limitation
• A partner’s basis in the partnership interest can
never be negative
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. 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. 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. 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. 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. 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. 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. 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. 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. 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. Loss Limitations
(slide 2 of 2)
Section Description
704(d) Basis in partnership interest
465 At-risk limitation
469 Passive loss limitation
• Limitations are applied successively to
amounts which are deductible at all prior
levels
85. Loss Limitation Example
(slide 1 of 2)
Meg's basis in interest $50,000
At-risk amount $35,000
Passive income, other sources $25,000
Share of partnership losses (passive) $60,000
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. 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. 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. 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. 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. 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. 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. 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. 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. 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. Refocus On The Big Picture (slide 1 of 3)
•After considering the various types of partnerships,
Kyle, Maria, and Josh decide to form Beachside
Properties as an LLC (see Example 1).
•On formation of the entity, there was no tax to the LLC
or to any of its members (see Example 15).
•Beachside Properties computes its income as shown in
Example 23 and allocates the income as illustrated in
Examples 24 and 25.
97. Refocus On The Big Picture (slide 2 of 3)
• The LLC’s income affects the members’ bases
and capital accounts as shown in Examples 30
and 36.
•An important consideration for the LLC
members is whether their distributive shares and
guaranteed payments will be treated as self-
employment income (see Example 48).
98. Refocus On The Big Picture (slide 3 of 3)
What If?
•What happens in the future when the LLC members
decide 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.
