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CHAPTER # 20 REVIEW Atef Abuelaish

Chapter 20 Forming and Atef Abuelaish

Chapter 20 Forming and Operating Atef Abuelaish

Forming and Operating Partnerships
Chapter 20 Forming and Operating Partnerships Atef Abuelaish

Learning Objectives Determine whether a flow-through entity is taxed as a partnership or S corporation, and distinguish the entity approach from the aggregate approach for taxing partnerships. Resolve tax issues applicable to partnership formations and other acquisitions of partnership interests, including gain recognition to partners and tax basis for partners and partnerships. Determine the appropriate accounting periods and methods for partnerships. Atef Abuelaish 20-7

Learning Objectives Calculate and characterize a partnership’s ordinary business income or loss and its separately stated items, and demonstrate how to report these items to partners. Explain the implications of a partner’s tax basis and the adjustments that affect it. Apply the basis, at-risk, and passive activity loss limits to losses from partnerships. Atef Abuelaish 20-8

Flow-Through Entities
Income earned by flow-through entities is not taxed at the entity level Owners of flow-through entities are taxed on the entity-level share of income allocated to them Income from flow-through entities is taxed only once when it “flows through” to owners of these entities Aggregate and Entity Concepts Entity approach Atef Abuelaish 20-9

Flow-Through Entities
Treats tax partnerships as entities separate from their partners Aggregate approach Treats tax partnerships as an aggregation of partners separate interests in the assets and liabilities of the partnership One of the most basic tenets of partnerships tax law - “Partnerships don’t pay taxes” - reflects the “aggregate approach” Partnerships, rather than partners, making most tax elections represents the entity concept Atef Abuelaish 20-10

Partnership Formations and Acquisitions of Partnership Interests
Acquiring partnership interests when partnerships are formed Partnership interest When a partnership is formed, partners may transfer cash, other tangible or intangible property, and services to it in exchange for an equity interest Partnership rights Right to receive a share in the partnership assets if the partnership were to liquidate, called a capital interest Right or obligation to receive a share of future profits or future losses, called a profits interest Partners who contribute services instead of property, frequently receive only profits interests Atef Abuelaish 20-11

Contributions of Property Depending on the transaction, realized gains and losses from the exchange of contributed property for partnership interests are either fully or partially deferred for tax purposes Similar to rationale for permitting tax deferral when corporations are formed Follows aggregate theory of partnership taxation Atef Abuelaish 20-12

Gain and loss recognition Generally, neither partnerships nor partners recognize gain or loss when they contribute property to partnerships Definition of property includes a wide variety of both tangible and intangible assets but not services General rule facilitates Contributions of property with built-in gains (FMV > tax basis) General rule discourages Contributions of property with built-in losses (FMV < tax basis) Atef Abuelaish 20-13

Partner’s initial tax basis (With-Out Debt) Required to compute partners taxable gains and losses when they sell their partnership interests Partner’s initial tax basis when partnership doesn't have any debt = sum of tax basis of property and cash contributed by partners Atef Abuelaish 20-14

Partner’s initial tax basis (With Debt) Computation of partner’s initial tax basis when partnership's have debt Each partner must include his/her share of the partnership’s debt in calculating the tax basis in her partnership interest Outside basis of partner contributing property must also reflect partner’s debt relief and any gain recognized from debt relief Atef Abuelaish 20-15

Partnership may have recourse debt Debts for which partners have economic risk of loss Usually allocated to the partners who will ultimately be responsible for paying it Partnership may have nonrecourse debt If secured by real property gives lenders the right to obtain the secured property in the event the partnership defaults on the debt Usually allocated according to partners’ profit-sharing ratios Atef Abuelaish 20-16

Allocating Partnership Debt
Example 1 When CCS was organized early in 2013, Nicole contributed $10,000 of cash and land with a fair market value of $150,000 and adjusted basis of $20,000 to CCS. The land was encumbered by a $40,000 nonrecourse mortgage executed three years before. Recalling that CCS already had $60,000 in bank debt before Nicole’s contribution, what tax bases to Nicole, Sarah, and Chanzz Inc. initially have in their CCS interests? Atef Abuelaish 20-17

Allocating Partnership Debt
Example 1 Solution Atef Abuelaish 20-18

Gain on Contributed Property
Example 2 Assume Sarah and Chanzz Inc., but not Nicole, personally guarantee all $100,000 of CCS’s debt ($60,000 bank loan + $40,000 mortgage on land). How much gain, if any, would Nicole recognize on her contribution to CCS and what would be the basis in her CCS interest? Atef Abuelaish 20-19

Gain on Contributed Property

Contribution of Services Capital interest represents a current economic entitlement amenable to measurement Service partners receiving capital interests report ordinary income Service partner’s tax basis in the capital interest = amount of ordinary income she/he recognizes Profits interests No liquidation value when received Service partner will not recognize income and non-service partners will not receive deductions Atef Abuelaish 20-21

Services for Capital Interest
Example 3 On December 31, 2010, all members of CCS agreed Sarah would receive an additional capital interest in CCS with a liquidation value of $20,000 and an increase in her profit-and-loss-sharing ratio from percent to 40 percent (leaving the other members with a 30 percent share of profits and losses),to compensate her for the time she would spend on an additional project. At this point, CCS’s debt was $100,000. What are the tax consequences to Sarah and CCS of giving her an additional capital interest? Atef Abuelaish 20-22

Services for Capital Interest

Services for Profits Interest
Example 4 Assuming Sarah received only a profits interest for her services instead of the capital interest she received in the previous example, what are the tax consequences to Sarah, Nicole, Chanzz Inc., and CCS? Atef Abuelaish 20-24

Services for Profits Interest

Partnership Accounting Periods, Methods, and Tax Elections
Includes Election of overall accounting method Election to expense a portion of organization and start-up costs Election to expense tangible personal property Partnership makes most tax elections Accounting Methods Partnerships are generally eligible to use the cash method unless they have average gross receipts greater than $5 million and have corporate partners Atef Abuelaish 20-26

Reporting the Results of Partnership operations
Ordinary Business Income (Loss) and Separately Stated Items Separately stated items change partners’ tax liabilities when they are separately stated Partnership ordinary business income (loss) is all partnership income (loss) exclusive of any separately stated items of income (loss) Separately stated items share one common characteristic Are treated differently from a partner’s share of ordinary business income (loss) for tax purposes Atef Abuelaish 20-27

Atef Abuelaish 20-28

Guaranteed Payments Fixed amounts paid to partners regardless of profit or loss earned by partnership Treated as ordinary income by partners receiving them Generally deducted in computing a partnership’s ordinary income or loss for the year Separately stated to the partners receiving them Self-Employment Tax Shares of ordinary business income (loss) may or may not be treated by LLC members as self-employment income (loss), depending on the extent of their involvement with the LLC Atef Abuelaish 20-29

Shares of ordinary business income (loss) are always Treated as self-employment income (loss) by general partners Not treated as self-employment income (loss) by limited partners LLC members that should be classified as general partners when applying the self-employment tax rules are the members who have Personal liability for the debts of the LLC by reason of being an LLC member, Authority to contract on behalf of the LLC, or Participated in more than 500 hours in the LLC’s trade or business Atef Abuelaish 20-30

Partnership Compliance Issues Although partnerships don’t pay taxes, they are required to file Form 1065, U.S. Return of Partnership Income, with the IRS by March 15 for a calendar year partnership Page 1 of Form 1065 shows details of calculation of the partnership’s ordinary business income (loss) for the year Page 3, Schedule K, lists the partnership’s ordinary business income (loss) and separately stated items Schedule K-1s are included with Form 1065 when it is filed, and Schedule K-1s are also separately provided to all partners Atef Abuelaish 20-31

Loss Limitations Operating losses, can generate current tax benefits when partners can deduct them against other sources of taxable income Ordinary losses from partnerships are deductible against any type of taxable income Losses are deductible on the partner’s tax return only when they clear three separate hurdles Tax basis At-risk amount Passive activity loss hurdles Atef Abuelaish 20-32

Loss Limitations 1) Tax Basis Limitation
In a sense, partner’s basis represents the amount a partner has invested in a partnership or may have to invest to satisfy her debt obligations Partners may not utilize partnership losses in excess of their outside basis in their partnership interests Losses allocated in excess of their basis must be suspended and carried forward indefinitely until partners have sufficient basis to utilize the losses Partners may create additional tax basis by making capital contributions Atef Abuelaish 20-33

Loss Limitations 2) At-Risk Limitation
More restrictive when compared to tax basis limitation Adopted to limit the ability of partners to use nonrecourse debt as a means of creating tax basis Limits partners’ losses to their at-risk amount Only nonrecourse debt considered to be at-risk is nonrecourse real estate mortgages from commercial lenders called “qualified nonrecourse financing” Partners are considered to be at-risk for Amount equal to cash and the tax basis of property contributed to the partnership and Recourse debt and qualified nonrecourse financing allocated to them Atef Abuelaish 20-34

Loss Limitations 3) Passive Activity Loss Limitation
Enacted as a backstop to the at-risk rules and are applied after the tax basis and at-risk limitation Applies primarily to individuals and also to estates, trusts, closely held C corporations, and personal service corporations Limits the ability of partners in rental real estate partnerships and other partnerships they don’t actively manage from using their ordinary losses from these activities to reduce other sources of taxable income Passive activity Activity which involves the conduct of a trade or business, and in which the taxpayer does not “materially participate” Atef Abuelaish 20-35

Dispositions of partnerships interest and
Chapter 21 Dispositions of partnerships interest and Atef Abuelaish

Dispositions of partnerships interest and partnership distributions
Chapter 21 Dispositions of partnerships interest and partnership distributions Atef Abuelaish

Learning Objectives Determine the tax consequences to the buyer and seller of the disposition of a partnership interest, including the amount and character of gain or loss recognized. List the reasons for distributions, and compare operating and liquidating distributions. Determine the tax consequences of proportionate operating distributions. Atef Abuelaish

Learning Objectives 4. Determine the tax consequences of proportionate liquidating distributions. 5. Explain the significance of disproportionate distributions. 6. Explain the rationale for special basis adjustments, determine when they are necessary, and calculate the special basis adjustment for dispositions and distributions. Atef Abuelaish

Break for Minutes Atef Abuelaish

Basics of Sales of Partnership Interests
Raises unique issues because of the flow-through nature of the entity If tax rules follow an entity approach, the interest is considered a separate asset and sale of partnership interest would be very similar to the sale of corporate stock If tax rules use the aggregate approach, the disposition represents a sale of the partner’s share of each of the partnership’s assets Atef Abuelaish

Seller Issues Primary tax concern is calculating the amount and character of gain or loss on the sale Selling partner determines gain or loss as the difference between the amount realized and his/her outside basis in partnership Hot Assets 1) Unrealized receivables include the right to receive payment for “goods delivered, or to be delivered” or “services rendered, or to be rendered” Atef Abuelaish

For cash-method taxpayers, unrealized receivables include amounts earned but not yet received For accrual-method taxpayers accounts receivable are not considered unrealized receivables because accrual-method taxpayers have already realized and recognized these items as ordinary income 2) Inventory items include classic inventory, defined as property held for sale to customers in the ordinary course of business. Inventory items also include any assets that are not capital assets or §1231 assets. Atef Abuelaish

Process for determining gain or loss Step 1: Total gain or loss = Amount realized – Outside basis Step 2: Calculate the partner’s share of gain or loss from hot assets as if the partnership sold these assets at their fair market value. This represents the ordinary portion of the gain or loss Capital gain or loss = Step 1 – Step 2 Atef Abuelaish

Buyer and Partnership Issues For sale transaction, the new investor’s outside basis will be equal to his cost of the partnership interest To the extent that the new investor shares in the partnership liabilities, his/her share of partnership liabilities increases his outside basis Varying Interest Rule Partners’ interests increase when they contribute property or cash to a partnership or purchase a partnership interest Atef Abuelaish

Partners’ interests decrease when they receive partnership distributions or sell all or a portion of their partnership interests Two methods for allocating income or loss to partners when their interests change during the year Allows the partnership to prorate income or loss to partners with varying interests Sanctions an interim closing of the partnership’s books Atef Abuelaish

Operating Distributions
Are usually paid to distribute the business profits to the partners but can also reduce a partner’s ownership Operating Distributions of Cash Only Partners generally do not recognize gain or loss on the distribution of property or money One exception is when the distribution is greater than the partner’s outside basis. Partners will recognize gain in this case Atef Abuelaish

Partner simply reduces his/her (outside) basis in the partnership interest by the amount of the distribution Partnership’s basis in its remaining assets remains unchanged Partner never recognizes a loss from an operating distribution Atef Abuelaish

Operating Distributions That Include Property Other Than Money Partners must reallocate their outside basis to the distributed assets (including money) and their continuing partnership interests Carryover basis - Partner takes a basis in the distributed property equal to the partnership basis in the property Atef Abuelaish

Order in which to allocate outside basis to the bases of distributed assets First, the partner allocates the outside basis to any money received and then to other property as a carryover basis Remainder is the partner’s outside basis after the distribution Atef Abuelaish

When the partnership distributes property other than money with a basis that exceeds the remaining outside basis, the partner assigns the remaining outside basis to the distributed assets, and the partner’s outside basis is reduced to zero Atef Abuelaish

Liquidating Distributions
Tax issues are basically: to determine whether the terminating partner recognizes gain or loss and to reallocate his or her entire outside basis to the distributed assets Rationale behind the rules for liquidating distributions is simply to replace the partner’s outside basis with the underlying partnership assets distributed to the terminating partner Atef Abuelaish

In theory, there would be no gain or loss on the distribution, and the asset bases would be the same in the partner’s hands as they were inside the partnership however this rarely occurs So the rules are designed to determine when gain or loss must be recognized and to allocate the partner’s outside basis to the distributed assets Atef Abuelaish

Gain or Loss Recognition in Liquidating Distributions Generally partners and partnerships do not recognize gain or loss Exception Gain - Partner recognizes gain when partnership distributes money (includes debt relief) and the amount exceeds the partner’s outside basis in the partnership interest Atef Abuelaish

Loss - Partner recognizes loss when two conditions are met Distribution consists of only cash and hot assets, and Partner’s outside basis exceeds the sum of the bases of the distributed assets Basis in Distributed Property Primary objective is to allocate the partner’s entire outside basis in the partnership to the assets the partner receives in the liquidating distribution Atef Abuelaish

Allocation essentially depends on two things the partnership’s bases in distributed assets relative to the partner’s outside basis and the type of property distributed—whether it is money, hot assets, or other property Atef Abuelaish

Atef Abuelaish

Partner’s Outside Basis Is Greater Than Inside Basis of Distributed Assets Scenario 1: Distributions of money, inventory, and /or unrealized receivables Suppose Greg has an outside basis of $334,000, including his share of liabilities of $66,000. In a liquidating distribution, he receives $159,000 cash and inventory with a fair market value and basis of $49,000. Will Greg recognize a gain or loss? (Example 21-16). Atef Abuelaish

Answer: Yes, to prevent the conversion of a capital loss to an ordinary loss, Greg recognizes a $60,000 capital loss. If the inventory distributed to Greg is also considered inventory in his hands, the eventual sale of the inventory will generate ordinary income. If the inventory is a capital asset to Greg, a sale of the asset within five years of the distribution will generate ordinary income. After five years, the gain or loss would be capital. Atef Abuelaish

Partner’s Outside Basis is Greater than Inside Basis of Distributed Assets Scenario 2: Other property included in distributions Partner allocates entire outside basis to distributed assets. Partner may increase the bases of any “other” property (not hot assets) but does not recognize gain or loss. Atef Abuelaish

Procedure: Step 1: Assign outside basis to distributed assets in amount equal to the assets’ inside basis. Step 2: Allocate the required increase to assets with unrealized appreciation. Step 3: Allocate any remaining required increase to the distributed assets in proportion to their relative FMVs using Basis Allocation = Required basis × (FMV asset / Sum of FMV distributed other property) Atef Abuelaish

Atef Abuelaish

Partner’s Outside Basis Is Less Than Inside Basis of Distributed Assets Scenario 3: Distributions of money only Same tax consequences as in operating distributions of only money Atef Abuelaish

Partner’s Outside Basis Is Less Than Inside Basis of Distributed Assets Scenario 4: Distributions of money, inventory, and /or unrealized receivables Partner reduces the basis in the distributed assets other than money but does not recognize gain or loss Atef Abuelaish

Procedure: Step 1: Assign outside basis to distributed assets in amount equal to the assets’ inside basis Step 2: Allocate the required decrease to assets with unrealized depreciation Step 3: Allocate any remaining required decrease to the distributed assets in proportion to their adjusted bases using Basis Allocation = Required Decrease × (AB asset / Sum of AB distributed assets) Atef Abuelaish

Partner’s Outside Basis Is Less Than Inside Basis of Distributed Assets Scenario 5: Other property included in distributions Terminating partner does not recognize gain or loss but rather decreases the basis in the property distributed Procedure is similar to the procedure under Scenario 4 except the required decrease reduces bases in other property rather than hot assets Atef Abuelaish

Character and Holding Period of Distributed Assets Generally, character stays the same to the partner as it was in the partnership Inventory retains “taint” of ordinary income for five years after distribution Partner’s holding period includes the partnership’s holding period Atef Abuelaish

Disproportionate Distributions
Both operating and liquidating distributions can be disproportionate distributions; When distribution changes a partner’s relative ownership of partnership hot assets To prevent partners from converting ordinary income into capital gains through distributions Partner must treat a portion of the distribution as a sale or exchange, which results in recognition of gain (or loss) Atef Abuelaish

Special Basis Adjustments
Helps to eliminate discrepancies between the inside and outside bases and correct artificial income or loss at the partnership level Basis discrepancies arise in two situations: Following sales of partnership interests, and Following distributions when the basis of distributed property is increased or decreased and when the distributee partner recognizes a gain or loss on the distribution Atef Abuelaish

Partnership makes §754 election. Once made, special basis adjustments are required for: Subsequent sales of partnership interests Partnership distributions Even without §754 election, special basis adjustments are required in some cases For sales of partnership interests if the partnership has a “substantial built-in loss” at the time of the sale For distributions if there is a substantial basis reduction Atef Abuelaish

Atef Abuelaish

Special Basis Adjustments for Dispositions Special basis adjustment partnership makes when a partner sells his/her partnership interest designed to give the new partner a share in the partnership assets equal to his/her outside basis Inside bases of the continuing partners remain unchanged so their income and losses will continue to be accurately allocated Atef Abuelaish

Adjustment is equal to the difference between the new investor’s outside basis and his/her share of inside basis New investor’s outside basis is generally equal to the cost of his/her partnership interest plus his/her share of partnership liabilities When a new partners' special basis adjustment is allocated to depreciable or amortizable assets, the new investor will benefit from additional depreciation or amortization Atef Abuelaish

Example 21-26 Atef Abuelaish

Atef Abuelaish

Special Basis Adjustments for Distributions Potential problem exists when the partnership distributes property to the partners and the basis of the distributed property is changed as a result of the distribution Affects the common basis of partnership property and not merely one partner’s basis Positive basis adjustment will increase the basis in the partnership assets Atef Abuelaish

When a partner receiving distributed property recognizes a gain on the distribution; When a partner receiving distributed property takes a basis in the property less than the partnership’s basis in the property Negative basis adjustment will decrease the basis in partnership assets When a partner receiving distributed property in a liquidating distribution recognizes a loss on the distribution, and Atef Abuelaish

When a partner receiving distributed property takes a basis in the property greater than the partnership’s basis in the property Allocation of special basis adjustment among the partnership’s assets for distributions is intended to offset any inequitable gain or loss the partners would have realized absent the adjustment Atef Abuelaish

Happiness is having all homework up to date
Homework assignment Using Connect – 6 Questions for 60 Points for Chapter 21. Tax Return; Course Project: Corporation Tax Return Problem # 2 “Blue Catering Service Inc.'s (BCS) 2016 Form 1120” on Pages C-16 till C-18. Complete the “Connect Orientation” at Connect web site for 5 points, before 03/26/2017. Prepare case # 1 on pages C-13 to C-16 and form 1120 for next meeting on 04/03. Prepare chapters 15, 16, 17, 18, and 19 for Mid-Term Exam on 3/27 for 90 Points. Happiness is having all homework up to date Atef Abuelaish

Thank you and See You Next Week at the Same Time, Take Care
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