1 Chapter 9: Partnership Formation and Operation

2 PARTNERSHIP FORMATION & OPERATION (1 of 2) n Partnership definitions n Overview of partnership taxation n Contributions of Property n Partnership elections n Ordinary income/loss vs. separately stated items n Partners’ distributive share of items

3 PARTNERSHIP FORMATION & OPERATION (2 of 2) n Special allocations n Partner’s basis in partnership interest n Special loss limitations n Guaranteed payments n Transactions between partner & partnership n Family partnerships

4 Partnership Definitions (1 of 5) n Tax definition of a partnership –Syndicate, group, pool, joint venture or other unincorporated organization that carries on a business

5 Partnership Definitions (2 of 5) n General partnership –Two or more partners –All partners are general partners »May participate in mgmt »May make commitments on behalf of partnership »Unlimited liability for partnership debts

6 Partnership Definitions (3 of 5) n 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

7 Partnership Definitions (4 of 5) n Limited liability companies (LLCs) –May be taxed as a partnership or a corp (using check-the-box regs) –Allows entity to obtain flow-through and flexibility of partnership allocations while maintaining limited liability of a corp.

8 Partnership Definitions (5 of 5) n Limited liability partnerships(LLPs) –Used by many professional organizations –May be taxed as a partnership or a corp (using check-the-box regs) –Partners not liable for failures in work of other partners or people supervised by other partners n Electing large partnership (ELP) –Non-service partnerships w/  100 ptrs

9 Overview of Partnership Taxation n Partnership profits and losses n Partner’s Basis n Partnership distributions

10 Partnership Profits and Losses (1 of 2) n Partnership files Form 1065 –Information return with no tax due n Partners receive a Form K-1 –Reports partner’s share of income or loss and separately reported items

11 Partnership Profits and Losses (2 of 2) n Partners include profit or loss and separate items on their individual return (Form 1040 for individuals) n Loss limitation –Partner’s losses limited to his/her basis in the partnership –At-risk rules and passive loss rules also apply

12 Partner’s Basis n Partner’s basis increased by share of partnership earnings, additional contributions, & additional assumption of partnership debt n Partner’s basis decreased by losses, distributions, & reduction in partnership debt

13 Partnership Distributions n Payment of money to partner usually tax-free because earnings previously taxed n If distributions exceed the partner’s basis, gain may be recognized

14 Contributions of Property n General rule n Exceptions to nonrecogntion rule n Contributions of services n Basis n See Topic Review C9-1 for summary

15 General Rule n General rule for property contributions in exchange for partnership interest –No gain or loss –§721 similar to §351

16 Exceptions to Nonrecognition Rule n Gains recognition at time of property contribution –Partnership would be investment company if it were incorporated –Contribution followed by a distribution resulting in a deemed sale –Liabilities assumed by partnership in excess of partner’s basis

17 Contributions of Services (1 of 2) n Contribution of services in exchange for partnership interest –Income is FMV of services contributed

18 Contributions of Services (2 of 2) n Partnership deducts or capitalizes FMV of services, depending on the nature of the expense –Partnership recognizes gain or loss »FMV of services – basis in assets allocated to service partner

19 Basis n Partner’s basis in partnership equal to money contributed plus partner’s basis in contributed property plus gain recognized on contribution n Partnership’s basis in property is partner’s old basis before contribution –Holding period also carries over

20 Partnership Elections n Tax year –Must be same as majority partner or partners with a 50% or more interest –See Topic Review C9-2 n Overall accounting method n Inventory valuation method n Depreciation method

21 Ordinary Income/Loss vs. Separately Stated Items (1 of 2) n Separately stated items –Net S-T capital gains and losses –Net L-T capital gains and losses –§1231 gains and losses –Charitable contributions –Dividends eligible for DRD

22 Ordinary Income/Loss vs. Separately Stated Items (2 of 2) n Separately stated items (continued) –Foreign or possession taxes –Tax-exempt interest –Any items subject to special allocation n Partnership ordinary income/loss –All items not separately stated

23 Partners’ Distributive Share of Items n 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

24 Special Allocations (1 of 2) n Pre-contribution gains or losses must be allocated to contributing partner for contributions

25 Special Allocations (2 of 2) n Allocations not related to contributed property must have substantial economic effect –Allocations affect partners’ capital accounts, and –Partners must make up deficit in capital account upon liquidation of partnership

26 Partner’s Basis in Partnership Interest (1 of 2) n Beginning basis –Amount paid for interest OR –Basis of property/ services contributed n Additions to basis –Additional contributions, earnings or assumption of liabilities n Reductions result from withdrawals, losses or transfer of liabilities

27 Partner’s Basis in Partnership Interest (2 of 2) n Affect 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

28 Special Loss Limitations (1 of 2) n Loss recognition limitations –Partner’s basis in partnership interest –Portion of partner’s basis not “at risk” »Amount partner would lose should the partnership suddenly become worthless.

29 Special Loss Limitations (2 of 2) n 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

30 Transactions Between Partner & Partnership n Loss sales –No loss deducted on sale of property between a partnership and a  50% owner (direct or indirect) n 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

31 Guaranteed Payments n Always ordinary income to recipient n Deductible by the partnership from ordinary income n Losses due to guaranteed payments allocated among partners

32 Family Partnerships (1 of 2) n Interest must be a capital interest –Partner has right to receive assets if partnership liquidates immediately n Capital must be a material income producing factor n Family member must be true owner

33 Family Partnerships (2 of 2) n 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

34 Self-Employment Income n 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

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