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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 inherited 30 years ago. –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.

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.

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.

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

Entities Taxed as Partnerships (slide 1 of 4) General partnership –Consists of at least 2 general 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

Entities Taxed as Partnerships (slide 2 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

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

Entities Taxed as Partnerships (slide 4 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 Limited liability limited partnership (LLLP) –An extension of the limited partnership form –All partners, whether general or limited, are accorded limited liability

The Big Picture – Example 1 Types Of Partnerships (slide 1 of 2) Return to the facts of The Big Picture on p. 21-1. 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.

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.

“Check-The-Box” Regs 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

Election Out of Subchapter K Some entities can elect to be excluded from partnership treatment if organized for certain activities –Owners simply report their share of operations on their own tax return –Such elections are not common

Key Concepts in 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

Key Concepts in Partnership Taxation (slide 2 of 3) 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

Key Concepts in Partnership Taxation (slide 3 of 3) 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

Partnership Taxation (slide 1 of 2) 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

Partnership Taxation (slide 2 of 2) 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

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

Inside and Outside Bases Inside basis –Refers to the partnership’s adjusted basis for each asset it owns –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

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

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

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

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

Partnership Formation Transaction

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

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

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

WST Partnership Formation Example (slide 2 of 2) Gain or lossBasis inPartnership’s Partner RecognizedInterestProperty 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

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

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

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 Distribution may be viewed as a purchase of the property by the partnership

Exceptions to Tax-Free Treatment on Partnership Formation (slide 4 of 4) Receipt of fully vested partnership interest in exchange for services rendered to partnership –Receipt of the partnership interest is generally taxable to the partner 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

Tax Issues Relative to Contributed Property (slide 1 of 4) 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

Tax Issues Relative to Contributed Property (slide 2 of 4) 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

Tax Issues Relative to Contributed Property (slide 3 of 4) 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

Tax Issues Relative to Contributed Property (slide 4 of 4) Special allocations must be made relative to contributed property that is appreciated or depreciated –The partnership’s income and losses must be allocated under § 704(c) to ensure that the inherent gain or loss is not shifted away from the contributing partner –Discussed later in the chapter

The Big Picture – Example 13 Contributions To The Partnership (slide 1 of 2) Return to the facts of The Big Picture on p. 21-1. Kyle’s and Maria’s capital contributions to the newly formed LLC are as follows –Kyle contributes real estate, FMV $2 million, consisting of land with basis = $600,000 and fully depreciated building, basis = $0. –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).

The Big Picture – Example 13 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. If the buildings and other land improvements had any remaining depreciable basis, the LLC would ‘‘steps into the member’s shoes’’ in calculating depreciation deductions. When Josh vests in his 5% capital interest in the LLC in exchange for services, the $200,000 is taxable to him. –Beachside Properties will probably capitalize this amount because it relates to construction Josh’s 20% interest in future profits will be taxed to him as profits are earned by the partnership.

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

Elections Made by Partnership (slide 2 of 2) Optional basis adjustment (§754) §179 deduction Nonrecognition treatment for involuntary conversions Election out of partnership rules

Organizational Costs (slide 1 of 2) Partnership may elect to deduct up to $5,000 of organization 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

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

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

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

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

Method of Accounting (slide 2 of 2) C Corp partner does not preclude use of cash method if: –Partnership meets the $5 million or less gross receipts test –C corp partner(s) is a qualified personal service corp, or –Partnership is engaged in farming business

Required Taxable Year Partnership must adopt tax year under first of the following tests that applies:

Least Aggregate Deferral – Example 16 (slide 1 of 2) Crimson, Inc., and Indigo, Inc., are equal partners in the CI Partnership. –Crimson uses the calendar year, and Indigo uses a fiscal year ending August 31. Neither Crimson nor Indigo is a majority partner as neither owns more than 50%. Although Crimson and Indigo are both principal partners, they do not have the same tax year. Therefore, the general rules indicate that the partnership’s required tax year must be determined by the “least aggregate deferral rule.” The following computations support August 31 as CI’s tax year.

Least Aggregate Deferral Example 16 (slide 2 of 2)

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

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

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

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

Examples of Separately Stated Items (slide 1 of 2) Net 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

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

The Big Picture – Example 17 Income Measurement & Reporting (slide 1 of 4)

The Big Picture – Example 17 Income Measurement & Reporting (slide 2 of 4) The LLC experienced a $250,000 net loss from operations last year, its first year of business. Beachside will determine its ordinary income or loss for the year, along with its separately stated items. The guaranteed payments are reported as income by the members and are either deducted or capitalized by the LLC. In addition, Beachside will report additional information the partners might need to prepare their individual income tax returns.

The Big Picture – Example 17 Income Measurement & Reporting (slide 3 of 4) Beachside is not a allowed a deduction for last year’s $250,000 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 Big Picture – Example 17 Income Measurement & Reporting (slide 4 of 4) Similarly, the LLC cannot deduct the distribution to Josh. –Distributions are discussed later in this chapter. 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.

The Big Picture – Example 18 Guaranteed Payments Paid by the Partnership (slide 1 of 2) Return to the facts of The Big Picture as updated in Example 17. Assume that Josh was elected as managing member of Beachside Properties, LLC. –He has the sole authority to contract for the LLC. –He works 1,000 hours per year in the business. Maria works 1,000 hours per year in the cafe. After transferring his land to Beachside, Kyle has generally not been involved in the LLC’s operations. In addition, recall that the LLC uses capital contributed by Maria and Kyle of $2 million each.

The Big Picture – Example 18 Guaranteed Payments Paid by the Partnership (slide 2 of 2) Return to the facts of The Big Picture as updated in Example 17. Josh and Maria both receive guaranteed payments of $5,000 per month for services to the LLC. In addition, Maria and Kyle both receive guaranteed payments of $5,000 per month for the LLC’s use of their capital. The guaranteed payments total $240,000 for the year (12 months X $5,000 X 4 payments). Beachside may deduct these payments.

The Big Picture – Example 19 Income Measurement & Reporting (slide 1 of 2) Continue with the facts of Examples 17 and 18. Beachside’s ordinary income is presented on Form 1065, page 1, as follows.

The Big Picture – Example 19 Income Measurement & Reporting (slide 2 of 2) Beachside’s Ordinary Income and Separately Stated Items are reported on Schedule K as follows.

The Big Picture – Example 20 Income Measurement & Reporting

The Big Picture – Example 21 Income Measurement & Reporting Continue with the facts in Examples 17 to 20. 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, guaranteed payments of $240,000, and the four separately stated income and deduction amounts to arrive at “net income” of $730,000. –This amount is shown on line 1 of the Analysis of Income (Loss) and is the amount to which book income of $492,100 is reconciled on Schedule M–1, line 9.

The Big Picture – Example 21 Income Measurement & Reporting Continue with the facts in Examples 17 to 20.

The Big Picture – Example 22 Balance Sheet and Capital Accounts

Partnership Allocations (slide 1 of 4) 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

Partnership Allocations (slide 2 of 4) 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 This can best be envisioned as a contribution of cash to the partnership equal to the negative balance

The Big Picture – Example 23 Special Allocations (slide 1 of 2) Continue with Examples 17 to 19, and the Beachside Properties Form 1065 excerpts. Maria arrives at the bakery at 4 A.M. (or earlier) six days a week to make sure her cinnamon rolls and croissants are ready when the bakery opens at 6. Consequently, the other LLC members have agreed with Maria that she should be allocated the first $30,000 of profits from bakery operations each year, starting in year 2. Although the § 704(b) book income may differ from the $180,000 taxable income, to simplify this illustration, assume they are the same amount. Maria is entitled to the first $30,000 shown on that page. The remaining $150,000 of ordinary income and all other items of partnership income, gain, loss, or deduction are allocated based on the members’ profit-sharing percentages.

The Big Picture – Example 23 Special Allocations (slide 2 of 2) Continue with Examples 17 to 19, and the Beachside Properties Form 1065 excerpts. Assume for this example only that the bakery operations are the only item impacting the § 704(b) book capital accounts this year, and that the initial § 704(b) book capital amounts are as follows:

Partnership Allocations (slide 3 of 4) Substantiality –Partnership allocations must also have “substantial” effect In general, an allocation does not meet the “substantial” test unless it has economic consequences in addition to tax consequences that might benefit a subset of the partners

The Big Picture – Example 24 Substantiality In Example 23, assume instead that the $30,000 special allocation was awarded to Maria in year 2 simply to allow Maria to utilize her personal expiring NOL carryover An offsetting $30,000 special allocation of deductions would be made to Maria the following tax year. Even though the LLC’s allocations meet the “economic effect” tests, they would not be permitted because there is no substantial nontax economic reason for the allocations. The allocations over the two-year period serve only to reduce the LLC members’ combined income tax liability.

Partnership Allocations (slide 4 of 4) 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

The Big Picture – Example 25 Precontribution Gain or Loss (slide 1 of 2) Return to the facts of The Big Picture on p. 21-1. When Beachside Properties, LLC, was formed –Kyle contributed land (value of $800,000 and basis of $600,000) and buildings (value of $1,200,000 and basis of $0). –Maria contributed equip. & furnishings with FMV $500,000, basis $0 and $1.5 million cash. 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.

The Big Picture – Example 25 Precontribution Gain or Loss (slide 2 of 2) For example, if Beachside sells the land contributed by Kyle for $1.1 million, the gain would be calculated and allocated as follows: § 704(b) ___Tax_ Amount realized$1,100,000 $1,100,000 Less: Adjusted basis800,000 600,000 Gain realized$ 300,000 $500,000 Built-in gain to Kyle –0– 200,000 Remaining gain (allocated proportionately)$ 300,000 $ 300,000 For tax purposes, –Kyle would recognize $320,000 of the gain [($300,000 X 40%) + $200,000] –Maria would recognize $120,000 ($300,000 X 40%), and –Josh would recognize $60,000 ($300,000 X 20%).

The Big Picture – Example 26 Schedule K-1 (slide 1 of 4) Continue with the examples on Beachside Properties and the Form 1065 excerpts. Maria is allocated the first $30,000 of ordinary income from operations, plus a 40% share of the remaining ordinary income. –She is also allocated 40% of all separately stated items.

The Big Picture – Example 26 Schedule K-1 (slide 2 of 4) Continue with the examples on Beachside Properties and the Form 1065 excerpts. On her Form 1040, Maria includes $90,000 of ordinary income $2,400 charitable contributions $4,800 short-term capital gain $120,000 passive rental income $1,600 qualified dividend income –Note that the specially allocated income simply increases Maria’s amount on line 1 and decreases the amounts allocated to the other members.

The Big Picture – Example 26 Schedule K-1 (slide 3 of 4) Continue with the examples on Beachside Properties and the Form 1065 excerpts. –On the first page of Form 1040, Maria lists her $840 share of tax-exempt interest. – She must also consider the $120,000 guaranteed payment she received. –In determining her AMT liability (if any), Maria takes into account a $7,290 positive adjustment.

The Big Picture – Example 26 Schedule K-1 (slide 4 of 4) In her personal tax return, Maria combines the partnership’s amounts with similar items from sources other than Beachside. –For example, if Maria has a $3,000 long-term capital loss from a stock transaction, the overall net short-term capital gain calculated on Schedule D of her 1040 is $1,800. For each LLC item, the sum of the allocated amounts on Josh’s, Kyle’s, and Maria’s K–1s will equal the totals on Beachside Properties’ Schedule K.

The Big Picture – Example 27 Guaranteed Payments Continue with the facts of Example 26. In addition to their allocations of ordinary income and separately stated items –Kyle and Josh will report as ordinary income their guaranteed payments of $60,000, and –Maria will report her $120,000 guaranteed payment.

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

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)

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

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

Basis Example (slide 2 of 2) With BasisWithout 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

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

Basis Limitation A partner’s basis in the partnership interest can never be negative

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

Allocation of Partnership Liabilities Two types of partnership debt –Recourse debt—The partnership or 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

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 to restore negative balance to 0 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)

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)

The Big Picture – Example 32 Basis In Partnership Interest (slide 1 of 4) Return to the facts of The Big Picture on p. 21-1. 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.

The Big Picture – Example 32 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. Maria’s share of Beachside’s income, gain, and deductions is as described in a prior example.

The Big Picture – Example 32 Basis In Partnership Interest (slide 3 of 4) Maria’s basis at year-end calculated using the ordering rules shown in Figure 21.3. 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 90,000 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 -0- Share of LLC deduction items: Charitable contribution (2,400) Ending basis $1,954,840

The Big Picture – Example 32 Basis In Partnership Interest (slide 4 of 4) As will be explained later, 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.

The Big Picture – Example 33 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) 214,840 Ending capital account $1,714,840 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.

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

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

Loss Limitation Example 34 (slide 1 of 2) Megan's basis in interest $50,000 At-risk amount $35,000 Passive income, other sources $25,000 Share of partnership losses (passive) $60,000

Loss Limitation Example 34 (slide 2 of 2) ProvisionsDeductible lossSuspended 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

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

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

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

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

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

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

Partners as Employees A partner usually does not qualify as an employee for tax purposes 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

The Big Picture – Example 36 Self-employment Tax Of Partners (slide 1 of 2) Return to the facts of The Big Picture in Examples 18 and 27. If Beachside follows the Proposed Regulations, the members’ distributive shares and guaranteed payments will be treated as follows:

The Big Picture – Example 36 Self-employment Tax Of Partners (slide 2 of 2) * Under the Proposed Regulations, Maria’s distributive share is not SE income. –She is not personally liable for the LLC’s debt, and she is not authorized to contract on behalf of the LLC. –Even though she works for the LLC more than 500 hours per year, another LLC member (Kyle) has the same rights as Maria. Because Kyle would be classified as a limited partner, Maria is also classified as such.

The Big Picture – Example 37 Self-employment Tax Of Partners (slide 2 of 2) * Under the Proposed Regulations, Maria’s distributive share is not SE income. –She is not personally liable for the LLC’s debt, and she is not authorized to contract on behalf of the LLC. –Even though she works for the LLC more than 500 hours per year, another LLC member (Kyle) has the same rights as Maria. Because Kyle would be classified as a limited partner, Maria is also classified as such.

Distributions from a Partnership (slide 1 of 4) A payment from a partnership to a partner is not necessarily treated as a distribution –e.g., Partnership may pay interest or rent to a partner, make a guaranteed payment, or purchase property from a partner If a payment is treated as a distribution, it will fall into one of two categories: –Liquidating distributions –Nonliquidating distributions Depends on whether the partner remains a partner in the partnership after the distribution

Distributions from a Partnership (slide 2 of 4) A liquidating distribution occurs when either: –Partnership itself liquidates and distributes all its property to the partners, or –Ongoing partnership redeems interest of one of its partners e.g., Partner retires

Distributions from a Partnership (slide 3 of 4) A nonliquidating distribution is any distribution from a continuing partnership to a continuing partner –Two types of nonliquidating distributions Draw –Distribution of partner’s share of current or accumulated profits Partial liquidation –Reduces partner’s interest in partnership capital but does not liquidate partner’s interest

Distributions from a Partnership (slide 4 of 4) Distributions from a partnership may be either: –Proportionate—Partner receives his or her share of certain ordinary income-producing assets –Disproportionate—Partner’s share of certain ordinary income-producing assets increases or decreases

Proportionate Nonliquidating Distributions (slide 1 of 3) In general, neither partner nor partnership recognizes gain or loss on proportionate nonliquidating distributions –Partner usually takes a carryover basis in assets distributed –Basis in partnership interest is reduced by amount of cash and basis of property distributed

Proportionate Nonliquidating Distributions (slide 2 of 3) –Partner recognizes gain to extent cash received exceeds partner’s adjusted basis (outside basis) in partnership interest Reduction in partner’s share of partnership debt is treated as a distribution of cash –First reduces partner’s basis in partnership –Any reduction in excess of partner’s basis in partnership results in taxable gain to the partner –Partner cannot recognize loss on a proportionate nonliquidating distribution

Proportionate Nonliquidating Distributions (slide 3 of 3) Property distributions –In general, no gain recognized on a property distribution If inside basis of property distributed exceeds partner’s outside basis in partnership interest, distributed asset takes substituted basis Assets are deemed distributed and basis applied in a certain order

Ordering Rules 1. Cash 2. Unrealized receivables and inventory 3. All other assets Basis is allocated to assets within a category based on adjusted basis to partnership

Proportionate Nonliquidating Distribution Examples (slide 1 of 6) Bill’s basis in partnership interest: $30,000 Proportionate nonliquidating distributions (independent fact situations): Assets Distributed A B C. Cash$15,000$15,000$ 5,000 Land—basis N/A$ 6,000 N/A (Fair mkt value) N/A$10,000 N/A Accts rec—basis N/A N/A -0- (Fair mkt value) N/A N/A $16,000

Proportionate Nonliquidating Distribution Examples (slide 2 of 6) A B C. Basis in interest$30,000$30,000 $30,000 Cash distributed( 15,000) (15,000) (5,000) Basis after cash 15,000 15,000 25,000 Acct. rec. distrib. N/A N/A (-0-) Basis after A.R. 15,000 15,000 25,000 Land Distrib. N/A( 6,000) N/A Basis after all dist.$15,000$ 9,000$25,000

Proportionate Nonliquidating Distribution Examples (slide 3 of 6) A B C. Basis in p’ship int.$15,000$9,000$25,000 Basis in cash 15,00015,000 5,000 Basis in land N/A 6,000 N/A Basis in A/R N/A N/A -0- Total basis$30,000$30,000 $30,000 Sale of non-cash assets at FMV: Selling price N/A$10,000$16,000 Basis N/A (6,000) (-0-) Gain N/A $4,000$16,000

Proportionate Nonliquidating Distribution Examples (slide 4 of 6) Bill’s basis in partnership interest:$30,000 Proportionate nonliquidating distributions (independent fact situations): Assets Distributed D E F. Cash$40,000 N/A$20,000 Relief of liabilities N/A40,000 N/A Land-basis N/A N/A$30,000 (Fair mkt value) N/A N/A $50,000

Proportionate Nonliquidating Distribution Examples (slide 5 of 6) D E F. Basis in interest$30,000$30,000$30,000 Cash distributed (40,000) N/A (20,000) Relief of liabilities N/A (40,000) N/A Gain recognized 10,000 10,000 N/A. Basis after cash (and deemed cash) dist. -0- -0- 10,000 Land distrib. N/A N/A (10,000) Basis after all distrib. -0- -0- -0-

Proportionate Nonliquidating Distribution Examples (slide 6 of 6) D E F. Basis in p'ship int. -0- -0- -0- Basis in cash 40,000 N/A 20,000 Liabilities relieved N/A 40,000 N/A Basis in land N/A N/A 10,000 Gain recognized(10,000)(10,000) N/A. Original basis 30,000 30,000 30,000 Sale of non-cash assets at FMV: Selling price N/A N/A$50,000 Basis N/A N/A(10,000) Gain N/A N/A$40,000

Effect of Liquidating Distribution In general: –No gain or loss is recognized by partnership –Partner reduces basis in partnership interest by basis in property received at each level using Ordering Rules –Partner’s entire basis in interest will be absorbed by distributed assets

Exceptions to Liquidating Distribution Rules (slide 1 of 2) Gain is recognized if: –Cash distributed exceeds partner’s basis –Precontribution gain exceptions –Disproportionate distribution

Exceptions to Liquidating Distribution Rules (slide 2 of 2) Loss is recognized only if: –Assets received include only cash, unrealized receivables and inventory, and –Outside basis exceeds partnership’s inside basis in distributed property

Proportionate Liquidating Distribution Examples (slide 1 of 4) Bill’s basis in partnership interest: $30,000 Proportionate liquidating distributions (partnership also liquidates) (independent fact situations): G H I. Cash$50,000$10,000$10,000 Unrealized rec. N/A -0- -0- (Fair mkt value) N/A$16,000$16,000 Filing cabinet (1231) N/A N/A 300 (Fair mkt value) N/A N/A 300

Proportionate Liquidating Distribution Examples (slide 2 of 4) G H I. Basis in interest$30,000$30,000$30,000 Cash distribution(50,000)(10,000)(10,000) Gain recognized 20,000 N/A N/A Basis after cash -0- 20,000 20,000 A/R distrib. N/A -0- -0- Loss recognized N/A(20,000) N/A Basis after A/R -0- -0- 20,000 Filing cabinet N/A N/A(20,000) Ending basis$ -0-$ -0-$ -0-

Proportionate Liquidating Distribution Examples (slide 3 of 4) G H I. Basis in p’ship int.$ -0-$ -0-$ -0- Basis in cash 50,000 10,000 10,000 Basis in A/R N/A -0- -0- Basis in filing cabinet N/A N/A 20,000 Capital (Gain)/loss (20,000) 20,000 N/A. Original basis$30,000$30,000$30,000

Proportionate Liquidating Distribution Examples (slide 4 of 4) Sale of non-cash assets at FMV: Example H: A/R Fil.Cab. Total. Selling price$16,000 N/A$16,000 Basis -0- N/A -0-. Gain/(loss)$16,000 N/A$16,000 (Ordinary) Example I: Selling price$16,000$ 300$16,300 Basis -0- 20,000 20,000 Gain/(loss)$16,000 ($19,700)($3,700) (Ordinary)(May be ord)

Sale of Partnership Interest (slide 1 of 4) Generally, results in gain or loss recognition by selling partner –Gain (loss) = amount realized less partner’s basis in partnership interest –Partnership liabilities assumed by purchasing partner are treated as part of consideration paid for the partnership interest

Sale of Partnership Interest (slide 2 of 4) Partnership tax year closes for selling partner on sale date –Partner’s share of income through sale date is calculated Can prorate annual income or use interim closing of the books –Taxed to selling partner and increases basis in partnership interest

Sale of Partnership Interest (slide 3 of 4) Effect of hot assets –Hot assets include: Unrealized receivables (same as for disproportionate distributions) Inventory –Includes all partnership property except money, capital assets, and §1231 assets

Sale of Partnership Interest (slide 4 of 4) Effect of hot assets (cont’d) –Must allocate sales price of partnership interest between “hot” (ordinary income) assets and “nonhot” (capital gain) components –Selling partner’s gain is classified as a capital gain or loss portion and an ordinary income or loss amount related to the hot assets

Limited Liability Companies A LLC with 2 or more owners is taxed as a partnership –LLC members are not personally liable for debts of the entity Effectively treated as a limited partnership with no general partners –LLCs are relatively new so there is no established body of case law available Makes planning difficult

Limited Liability Partnerships Partners are not personally liable for the malpractice and torts of their partners Taxable as a partnership Conversion of a general partnership into a LLP is not taxable if all of the general partners become LLP partners and hold the same proportionate interest

Refocus On The Big Picture (slide 1 of 4) 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 13). Beachside Properties computes its income as shown in Examples 17 and 19. Beachside determines additional information the members will need (Example 20) and reconciles book and tax income and members’ capital (Examples 21 and 22).

Refocus On The Big Picture (slide 2 of 4) Payments to the members for services or for the use of their capital are treated as guaranteed payments; the amounts are deducted by the LLC and reported as income by the LLC member (see Examples 18 and 27). A portion of ordinary income was specially allocated to Maria under the substantial economic effect rules; precontribution gains will eventually be specially allocated under § 704(c); the remaining income is allocated according to profit-sharing ratios (Examples 23 to 26).

Refocus On The Big Picture (slide 3 of 4) The LLC’s income affects the members’ bases and capital accounts as shown in Examples 32 and 33. An important consideration for the LLC members is whether their distributive shares and guaranteed payments will be treated as self-employment income (see Example 36 and 37).

Refocus On The Big Picture (slide 4 of 4) 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.

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 144 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta.edu SUNY Oneonta

© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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© 2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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