1. Chapter 10: Partnership formation & Operation
406Lec10.PPTX
Chapter 10: Partnership formation & Operation
text p 10-2
All file form 1065.
- Informational only
- No income tax paid by entity
- Income & deductions are separately stated and flow to owners to claim.
General partnership
- All partners are personally liable for partnership debts.
- Usually all have the right to participate in management.
- Partners own an “interest”. (not shares)
Limited partnership
- Must have at least 1 general partner.
- All limited partners have limited liability for partnership debts.
- Limited partners can’t participate in management.
General
Partnership
Limited Partnership (LP)
Limited Liability Company (LLC)
Limited Liability Partnership (LLP)

2. Limited Partnership (LP)
Limited Liability Companies (LLC)
- All members (legally not partners) have limited liability for partnership debts
- Some can participate in management, some not.
- Members typically own “units Not shares of stock. That is a corporate term.
- Can “check the box” to be treated as corporation or partnership for tax.
Limited Liability Partnership (LLP)
- Similar to LLCs.
- Main difference is liability to member is more limited.
- Not liable for acts of other members or people under their supervision
General
Partnership
Limited Partnership (LP)
Limited Liability Company (LLC)
Limited Liability Partnership (LLP)

3. Overview of partnerships text p 10-5
Aggregate theory considers a partnership as an aggregation of sole proprietors who merely split up revenues, expenses, credits etc between themselves.
For example, partnership assets and liabilities are considered as shared pro-rata by each partner.
Entity theory considers a partnership as a separate entity for purposes of electing accounting period, methods. text p 10-5
“Interest” in a partnership can be divided into share of profits, losses and capital. Most partners own same share of all 3, but they can vary. text p 10-6

4. Examples: Aggregate theory of partnerships
A and B form AB partnership
A contributes cash of $10,000
B contributes building FMV=Basis=$20,000. Mortgage is $10,000.
Each partner has $5k cash, ½ Building of $10k, Mortgage of $5k.
Each partner basis in interest = basis in assets = $5k + $10k = $15k.
Say AB partnership buys $100,000 of equipment for $10,000 cash down payment and $90,000 debt.
Partnership has basis of $100,000 in equipment
Each partner considered paying $5,000 + $45,000 debt for $50,000 equipment.
Basis in partnership interest for each partner increased by $50, $5,000 cash out = $45,000 = increase in debt. 4

5. §721: Partnership formation text p 10-7
On formation, partner recognizes gain (not loss) if:
1 -Transfer reclassified as a sale or exchange IRS looks at distributions to partner shortly after contribution.
2 - Partnership is an investment company §721(b)
- 80% of assets are investment type.
- Gain triggered if result is to diversify portfolio.
3 – Calculations result in partner having a negative basis Partner can never have a negative basis in their partnership interest
4 - Capital interest is received for services text p 10-9
Treated as if partnership bought services with share of assets. Other partners get deduction or amortization. text p 10-10,13
Other partners could have recognized gain as transfer of part of their ownership for services. not in text
Exception: If only an interest in profits, then no income recognized.
Note: No 80% control requirement as in §351 for corporations.

6. (That is, the basis of assets to the partnership.)
§723: Partnership basis in assets received text p 10-8
Partnership’s basis and holding period in assets received carries over from the contributing partner.
Increase basis only for partner’s gain if an investment company
Character (ordinary or capital) is generally determined by partner’s ownership if sold within 5 years.
Some minor exceptions exist. text p 10-10
Depreciation recapture potential and holding period also carry over from partner to partnership.
Same rules for post-formation contributions.
This is referred to as the INSIDE BASIS. text p 10-5
(That is, the basis of assets to the partnership.)

7. §723: Partners basis in interest received
Partner’s initial basis in partnership equals: text p Partner’s basis of property contributed
plus Gain recognized by partner
less Share of partner’s liabilities** transferred to partnership assumed by other partners
plus Share of other partner’s liabilities ** transferred to partnership assumed by partner
This is referred to as the OUTSIDE BASIS. text p 10-5
(That is, the partner’s basis of his/her partnership investment.)
** In LIMITED PARTNERSHIPS, recourse debt is allocated to general partners only, whereas nonrecourse debt is allocated to both general and limited partners. text p This can get tricky with hypothetical liquidation rules.
In LLCs, all debt is allocated to all members.

8. Example: Partnership formation
P, S and T form the PST partnership with the following contributions:
P gives cash $30,000
S provides services valued at 30,000
T gives a building FMV $80,000
Basis in building = $60, Mortgage 50,000 30,000
Results: 8

9. Partnership income flow through text p 10-17
All items of income, deduction, gain, loss, tax preference (AMT) or credit must be reported as a separately stated item for each partner if such item could be limited or have differing effects on partners.
- See p for a partial list of items, p schedule K.
- Comprehensive list on next page (1065 K-1 codes)
If no differing effect of item, then net with other similar items to arrive at ordinary business income (loss).
Elect to allocate based on time owned if ownership changes during year or close the books on sale date and split into two short periods. text p 11-17
Sum of ordinary business income and all separately stated items equals net taxable income that flows through to partners.

10. Form 1065 K-1 codes This is required to be provided to each partner.

11. Special allocations of income, gain/loss, deductions
Regulations provide that non-prorata special allocations of income and loss are allowed but must have a substantial economic effect. text p 10-25
- Can’t shift income or deductions just to save taxes.
- Allocations that ↑ or ↓ capital account must be equalized with cash or partner claims phantom income to zero out at end.
§704(c) Requires allocations of gain/loss, income/deduction are to be made to partner who contributes property which has basis not equal to value at date of contribution text p 10-12, 26
- Stops shifting of pre-contribution gain or loss to other partners.
- No time limit for allocation. If asset sold 10 years later, allocation required.

12. Example: §704(c) pre-contribution allocation
In previous example P, S and T form the PST partnership:
P gives cash $30,000
S provides services valued at 30,000
T gives a building FMV $80,000
Basis in building = $60, Mortgage 50,000 30,000
Assume building is sold for $89,000 (ignore depreciation effects).
Gain to partners?
NOTE: During ownership, non-contributing partners calculate their share of depreciation based on FMV. Contributing partner gets what is leftover by using original basis. (P & S use MACRS % x $80k, T gets MACRS% x 60k – P & S deductions) 12

13. Special allocations of income, gain/loss, deductions
§ 707(c): Guaranteed payments to a partner not based on partnership income are income to the recipient partner and are deductible by the partnership. text p 10-18, 28
These are different than mere draws of partnership income.
Self Employment (SE) tax assessed on: text p 10-37
guaranteed payments for services
all partnership income less deductions of general partners and managing LLC members.
(Except investment related and §1231 gain/loss)

14. Example: Guaranteed Payments
Drs. O and P form OP Dental Partnership as 50/50 partners.
Dr. O will be paid $10,000 extra for management duties.
Both doctors receive 30% of individual patient billing.
In 2017, OP had $600,000 profit before doctor payments.
O billed $200,000 and P billed $600,000.
Partners share of income is: 14

15. Losses will be nondeductible or distributions taxable
§723: Partners ongoing basis adjustments
Partner’s initial basis is adjusted for each partner’s share of ongoing items in the following order: text p 10-30
+ Additional capital contributions
+ Increase in partnership debt (see slide 7 regarding recourse/nonrecourse rules)
+ Business net income
+ Separately stated income /gain items (includes nontaxable)
- Distributions to partner
- Decrease in partnership debt
- Business loss
- Separately stated deduction/loss items (nondeductible too)
Basis can never be negative
Losses will be nondeductible or distributions taxable

16. Example: Partners basis in interest, flow through
Smith owns 10% of XYZ LLC. Basis is $50,000. For 2017 XYZ had:
Sales $300,000
Interest income (all taxable) 1,000
Cost of goods sold -200,000
MACRS depreciation (not §179) -10,000
§179 elected expense -40,000
Meals & entertainment total (50% not deductible) -4,000
Rent expense -15,000
Wages to employees + payroll taxes -25,000
Cash distributions to partners (not guaranteed) 50,000
A/P 1/1/17 = $10,000. A/P 12/31/17 = $2,000.
What are the effects of these items on Smith’s tax return and basis?
Ordinary business income =
Smith K-1 (10%): Business income , Interest income , §179 is , Nondeductible items , Distributions
Smith ending basis 16

17. Miscellaneous
§704(d) Loss deduction is limited to basis in partnership interest. Carryforward indefinitely until basis is increased.
- Stops negative basis text p 10-35
Losses also limited by At Risk and Passive Activity Loss rules. text p 10-35
- Covered in BUSADM 405 Tax 1 class.
Related party loss rules apply between a greater than 50% partner and partnership. text p 10-39
- Disallowed loss can be used to offset subsequent gain on sale by related party.
- Related party rules can reclassify capital gain to ordinary.
Organization & start-up $ year amortization rules same as corporations. text p 10-13

18. Miscellaneous
Under general rules requiring accounting methods that fairly reflect income, IRS can reallocate income to partners who perform services.
- Applies often to family businesses text p 10-30
Partnership year end is generally the same of it’s partners.
- There are rules if partners have varying year ends text p 10-15
Several elections made by partnership apply to all partners. Also some limits apply to partners as a group. text p 10-12
- Overall accounting method text p 10-14
- One §179 expense amount for assets purchased
Follows entity theory (slide 2) that partnership sometimes is considered to have a separate identity from it’s owners.

19. Miscellaneous Report on form 1065 text p 10-21
- NEW for 2016: Due 2 ½ months after year end. 6 month extension possible.
- Page 1 nets non-separate items to arrive at ordinary business income.
- Page 4 contains schedule K which lists all separately stated items.
- Page 5 contains Analysis of Net Income = net taxable income.
This is net of everything (net business income + separately stated)
- Page 5 also has schedules L, M-1 and M-2 similar to corporations.
- Schedules K-1 are attached to form1065 which detail each partner’s % share of schedule K items. This all goes to IRS. text p 10-29
Sum of each line of all the K-1s = corresponding line on schedule K.
- Copy of Schedule K-1 is also provided to each partner to use in reporting partnership items on their tax returns.
Follows aggregate theory (slide 2) that partnership is just a grouping of individual owners.