©2009 Pearson Education, Inc. Publishing as Prentice Hall

PARTNERSHIP FORMATION & OPERATION (1 of 2) Partnership definitions Overview of partnership taxation Partnership formation Partnership elections Partnership reporting of income Partner reporting of income ©2009 Pearson Education, Inc. Publishing as Prentice Hall

PARTNERSHIP FORMATION & OPERATION (2 of 2) Basis for partnership interest Special loss limitations Partnership-partner transactions Family partnerships Tax planning considerations Compliance and procedural considerations ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Partnership Definitions Tax definition of a partnership General partnership Limited partnership Limited liability limited partnership Limited liability companies (LLCs) Limited liability partnerships (LLPs) Electing large partnership (ELP) ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Tax Definition of a Partnership Syndicate, group, pool, joint venture, or other unincorporated organization that carries on a business ©2009 Pearson Education, Inc. Publishing as Prentice Hall

©2009 Pearson Education, Inc. Publishing as Prentice Hall General Partnership Two or more partners All partners are general partners May participate in management May make commitments on behalf of partnership Unlimited liability for partnership debts ©2009 Pearson Education, Inc. Publishing as Prentice Hall

©2009 Pearson Education, Inc. Publishing as Prentice Hall Limited Partnership One or more general partners and One of more limited partners Cannot participate in management Cannot make commitments for partnership Liability generally limited to amount invested in partnership ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Limited Liability Limited Partnership Formed under state’s limited partnership laws General partners have limited liability ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Limited Liability Companies (LLC) May be taxed as a partnership or a corp (using check-the-box Regs) When taxed as a partnership, entity obtains pass-through and flexibility of partnership allocations while maintaining limited liability of a corp 53% of all partnerships in 2005 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Limited Liability Partnerships (LLP) Used by many professional organizations May be taxed as a partnership or a corporation using check-the-box Regs Partners not liable for failures in work of other partners or people supervised by other partners ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Electing Large Partnerships (ELP) May elect to have simplified set of reporting rules apply if Non-service partnership, and  100 partners ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Overview of Partnership Taxation Partnership profits and losses Partner’s basis Partnership distributions ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Partnership Profits and Losses (1 of 2) Partnership files Form 1065 Information return with no tax due Partners receive a Form K-1 Reports partner’s share of income or loss and separately reported items ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Partnership Profits and Losses (2 of 2) Partners include profit or loss and separate items on their entity’s return Form 1040 for individuals Loss limitation Partner’s losses limited to entity’s basis in the partnership At-risk rules and passive loss rules also apply ©2009 Pearson Education, Inc. Publishing as Prentice Hall

©2009 Pearson Education, Inc. Publishing as Prentice Hall Partner’s Basis (1 of 2) Items that increase basis Partner’s share of partnership earnings, additional contributions, & additional assumption of partnership debt Increase in basis for earnings prevents double taxation of earnings upon subsequent distribution ©2009 Pearson Education, Inc. Publishing as Prentice Hall

©2009 Pearson Education, Inc. Publishing as Prentice Hall Partner’s Basis (2 of 2) Items that decrease basis Partner’s share of losses Distributions Reduction in partnership debt ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Partnership Distributions Generally nontaxable Return of previously taxed earnings Earnings increased partner’s basis Distributions reduce partner’s basis Distributions in excess of basis are generally recognized as taxable gain ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Partnership Formation Contribution of property Contributions of services Organizational & syndication costs See Topic Review C9-1 for summary ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Contribution of Property General nonrecognition rule Exceptions to nonrecognition rule Effect of liabilities Basis ©2009 Pearson Education, Inc. Publishing as Prentice Hall

General Nonrecognition Rule Property contributions general rule No gain or loss §721 similar to §351 Partner has substituted basis in partnership interest Partnership gets carryover basis Holding period tacks on for partner and partnership ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Exceptions to Nonrecognition Rule Gain recognition at time of property contribution if Partnership would be investment company if it were incorporated, Contribution followed by a distribution resulting in a deemed sale, or Liabilities assumed by partnership in excess of partner’s basis ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Effect of Liabilities Contributed by Partner to Partnership Basis of each partner (including contributing partner) increased by her share of liabilities, AND Contributing partner treated as if partnership made cash distribution to partner, decreasing partner’s basis Gain would be recognized if deemed distribution exceeds partner’s basis ©2009 Pearson Education, Inc. Publishing as Prentice Hall

©2009 Pearson Education, Inc. Publishing as Prentice Hall Basis Money contributed + Partner’s basis in contributed prop + Gain recognized on contribution Partner’s (outside) basis in partnership Partnership’s basis in property Partner’s old basis before contribution Depr Recap potential transfers to ptrshp ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Contributions of Services (1 of 2) Contribution of services in exchange for partnership interest Income is FMV of services contributed ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Contributions of Services (2 of 2) Partnership deducts or capitalizes FMV of services, depending on the nature of the expense Partnership recognizes gain or loss FMV of services less basis in assets allocated to service partner ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Organizational and Syndication Costs Organization costs are capital expenditures May immediately expense $5K and amortize the rest over 180 months $5K immediate expense reduced $ for $ for cumulative organization costs > $50K ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Partnership Elections Tax year Must be same as majority partner or partners with a 50% or more interest See Topic Review C9-2 Overall accounting method Inventory valuation method Depreciation method ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Partnership Reporting of Income (1 of 2) Separately stated items include: Net S-T capital gains and losses Net L-T capital gains and losses §1231 gains and losses Charitable contributions Dividends eligible for DRD Foreign or possession taxes ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Partnership Reporting of Income (2 of 2) Separately stated items (continued) Tax-exempt interest Portfolio activities Passive activities U.S. production activities deduction Any items subject to special allocation Partnership ordinary income/loss All items not separately stated ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Partner Reporting of Income Partner’s Distributive Share Normally determined by terms of partnership agreement Portion of partnership taxable and nontaxable income partner agreed to report for tax purposes Amount not necessarily same as actual amounts distributed to partner in a particular year ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Partner Reporting of Income Special Allocations Pre-contribution gains or losses must be allocated to contributing partner Allocations unrelated to contrib prop must have substantial economic effect Allocations affect partners’ capital accounts, and Partners must make up deficit in capital account upon liquidation of partnership ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Basis for Partnership Interest (1 of 2) Beginning basis Amount paid for interest OR Basis of property/services contributed Additions to basis Additional contributions, earnings, or assumption of liabilities Reductions result from withdrawals, losses, or decrease in share of liabilities ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Basis for Partnership Interest (2 of 2) Effect of liabilities on partner basis Partner’s basis before liabs + Increases in share of ptrshp liabs - Decreases in share of ptrshp liabs + Ptrshp liabs assumed by this partner - This partner’s liabs assumed by ptrshp = Partner’s basis in the ptrshp interest See Topic Review C9-3 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Special Loss Limitations (1 of 2) Loss recognition limitations Partner’s basis in partnership interest Portion of partner’s basis not “at risk” At risk definition: amount partner would lose should the partnership suddenly become worthless ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Special Loss Limitations (2 of 2) Loss recognition limitations (continued) Designation of partnership interest as a “passive activity” “Passive” losses can only be used to offset “passive” income Disallowed losses are suspended, and can be used to offset future passive income, or when the passive activity is sold ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Partnership-Partner Transactions (Related Party Issues) Loss sales No loss deducted on sale of property between a partnership and a > 50% owner (direct or indirect) Gain sales Gains on sale of property involving a > 50% owner produce ordinary income unless property will be a capital asset in hands of new owner ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Partnership-Partner Transactions (Guaranteed Payments) Always ordinary income to recipient Partner treats payment as if made to an outsider Deduct or capitalize If deductible, GP reduces partnership ordinary income, which is allocated based on partnership agreement ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Family Partnerships (1 of 2) Safe-harbor rule under §704(e) for family partnerships Interest must be a capital interest, Partner has right to receive assets if partnership liquidates immediately Capital must be a material income producing factor, AND Family member must be true owner ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Family Partnerships (2 of 2) Donor-donee allocations of income Donor must be allocated reasonable compensation for services rendered to partnership Remaining partnership income must be allocated based on relative capital interest ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Tax Planning Considerations Timing of loss recognition Accelerate personal income to absorb partnership losses Delay personal income recognition to use anticipated future partnership losses ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Compliance and Procedural Considerations (1 of 2) Forms Form 1065 for partnership Form K-1 for each partner Schedule M-3 required instead of M-1 for large partnerships Sec. 444 election Use Form 8716 ©2009 Pearson Education, Inc. Publishing as Prentice Hall

Compliance and Procedural Considerations (2 of 2) Self-employment income Individuals who are partners must pay SE tax on the following income from a partnership: Guaranteed payments Partnership ordinary income or loss All separately stated items, except Capital and §1231 gains/losses, interest, dividends, and rental income ©2009 Pearson Education, Inc. Publishing as Prentice Hall

©2009 Pearson Education, Inc. Publishing as Prentice Hall