Chapter 21 Partnerships 2012 Cengage Learning All Rights

Chapter 21 Partnerships © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1

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 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’s family has owned for years. – 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. 2

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. 3

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. 4

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 5

Entities Taxed as Partnerships (slide 1 of 4) • General partnership – Consists of at least 2 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 6

Entities Taxed as Partnerships (slide 2 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 7

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 8

Entities Taxed as Partnerships (slide 4 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 9

The Big Picture – Example 1 Types Of Partnerships (slide 1 of 2) • Return to the facts of The Big Picture on p. 21 -2. • 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. 10

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. 11

“Check-The-Box” Regs (slide 1 of 2) • 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 12

“Check-The-Box” Regs (slide 2 of 2) • Some entities can be excluded from partnership treatment if organized for: – Investment (not active trade or business) – Joint production, extraction, or use of property – Underwriting, selling, or distributing a specific security • Owners simply report their share of operations on their own tax return 13

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 14

Partnership Taxation (slide 2 of 3) • 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 15

Partnership Taxation (slide 3 of 3) • 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 16

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 17

Conceptual Basis for Partnership Taxation (slide 1 of 2) • 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 18

Conceptual Basis for Partnership Taxation (slide 2 of 2) • 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 19

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 20

Inside and Outside Bases • Inside basis – Refers to adjusted basis of each partnership asset – 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 21

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 22

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 23

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 24

Partnership Formation Transaction 25

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 26

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 27

WST Partnership Formation Example (slide 1 of 2) • William contributes cash – Amount $20, 000 • Sarah contributes land – Basis – FMV $ 6, 000 $20, 000 • Todd contributes equipment – Basis – FMV $22, 000 $20, 000 28

WST Partnership Formation Example (slide 2 of 2) Gain or loss Partner Recognized Basis in Interest Partnership’s Property Basis William Sarah Todd $20, 000 $ 6, 000 $22, 000 $-0$-0$-0 - Neither the partnership nor any of the partners recognizes gain or loss on the transaction 29

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 30

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 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 31

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 • Payment may be viewed as a purchase of the property by the partnership 32

Exceptions to Tax-Free Treatment on Partnership Formation (slide 4 of 4) • Receipt of partnership interest in exchange for services rendered to partnership – Services are not treated as “property” – Partner recognizes ordinary compensation income = FMV of partnership interest received • 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 33

The Big Picture – Example 15 Contributions To The Partnership (slide 1 of 2) • Return to the facts of The Big Picture on p. 21 -2. • Kyle and Maria make the following capital contributions to the newly formed LLC. – Kyle contributes real estate, basis $600, 000, FMV $2 million. – 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). 34

The Big Picture – Example 15 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. • To the extent that the buildings and other land improvements are depreciable, the LLC ‘‘steps into Kyle’s shoes’’ in calculating depreciation deductions. • Because Josh receives his 5% capital interest in the LLC in exchange for services, the $200, 000 is taxable to him. – Beachside Properties either capitalizes or expenses the cost of the services, depending on their nature. • Josh’s 20% profits interest will be taxed to him as profits are allocated to him. 35

Tax Issues Relative to Contributed Property (slide 1 of 3) • 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 36

Tax Issues Relative to Contributed Property (slide 2 of 3) • 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 37

Tax Issues Relative to Contributed Property (slide 3 of 3) • 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 38

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 39

Elections Made by Partnership (slide 2 of 2) • Optional basis adjustment (§ 754) • § 179 deduction • Nonrecognition treatment for involuntary conversions • Election out of partnership rules 40

Organizational Costs (slide 1 of 2) • For organization costs incurred after October 22, 2004, the partnership may elect to deduct up to $5, 000 of the 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 • For organization costs incurred before that date, the taxpayer could elect to amortize the amount over 60 months 41

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 42

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 43

Start-up Costs (slide 2 of 2) • Partnership may elect to deduct up to $5, 000 of startup 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 • For start-up costs incurred before October 23, 2004, the taxpayer could elect to amortize those costs over 60 months 44

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 45

Method of Accounting (slide 2 of 2) • New partnership may adopt cash, accrual or hybrid method (cont’d) – C Corp partner does not preclude use of cash method if: • Partnership has average annual gross receipts of $5 million or less for preceding 3 year period • C corp partner(s) is a qualified personal service corp, or • Partnership is engaged in farming business 46

Required Taxable Year • Partnership must adopt tax year under earliest of following tests met: – Majority partner’s tax year (partners with same tax year owning >50%) – Principal partners’ tax year (all partners owning 5% or more) – Least aggregate deferral rule 47

Least Aggregate Deferral Example (slide 1 of 2) • • George owns 50% and has June 30 year end Henry owns 50% and has October 31 year end Neither partner owns a “majority” (>50%) Both are “principal partners” (5% or more), but do not have same year end – Must use least aggregate deferral test to determine required taxable year 48

Least Aggregate Deferral Example (slide 2 of 2) 1. Test June 30 as possible year end: Partner. Year End % George June 50% Henry October 50% Total weighted deferral 2. Test October 31 as possible year end: George June 50% Henry October 50% Total weighted deferral Mo. Deferral 0 4 8 0 Weight 0. 0 2. 0 4. 0 0. 0 4. 0 June has the least aggregate deferral so it is the tax year for partnership. 49

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, noninterest-bearing deposit of estimated deferred taxes – • Elect a 52 - to 53 -week taxable year 50

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 51

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 52

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 53

Examples of Separately Stated Items (slide 1 of 2) • • • 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 54

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 55

The Big Picture – Example 22 Income Measurement (slide 1 of 4) • • Return to the facts of The Big Picture on p. 21 -2. In its 2 nd year of operations, Beachside Properties, LLC, reports income and expenses as follows: Sales revenue Cost of sales Salaries to employees Cost recovery deductions Utilities, supplies, and repairs Taxes and licenses (including payroll taxes) Contribution to art museum Short-term capital gain Net income from rental real estate Qualified dividends received Exempt income (bond interest) AMT adjustment (cost recovery) Payment of medical expenses on behalf of partner Kyle • $600, 000 200, 000 100, 000 60, 000 40, 000 20, 000 6, 000 12, 000 300, 000 4, 000 2, 100 5, 000 4, 000 The LLC experienced a $20, 000 net loss from operations last year, its first year of business. 56

The Big Picture – Example 22 Income Measurement (slide 2 of 4) • Refer to Form 1065 in Appendix B. Beachside’s ordinary income is determined and reported on the partnership return as follows: Nonseparately Stated Items (Ordinary Income)—Form 1065, Pages 1 and 4 Sales revenue Cost of sales Salaries to employees Cost recovery deductions Utilities, supplies, and repairs Taxes and licenses (including payroll taxes) Ordinary income (Form 1065, page 1, line 22, and Form 1065, page 4 [Schedule K], line 1) $600, 000 (200, 000) (100, 000) (60, 000) (40, 000) (20, 000) $180, 000 57

The Big Picture – Example 22 Income Measurement (slide 3 of 4) • Beachside is not a allowed a deduction for last year’s $20, 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 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. 58

The Big Picture – Example 22 Income Measurement (slide 4 of 4) • Beachside’s separately stated income and deduction items are: Separately Stated Income and Deductions (Schedule K) Net income from rental real estate (Line 2) $300, 000 Qualified dividends received (Line 6) 4, 000 Short-term capital gain (Line 9 a) 12, 000 Contribution to art museum (Line 13 a) 6, 000 • The LLC reports the following additional information that the partners must report or utilize in preparing their tax returns: Additional Information (Schedule K) AMT adjustment—cost recovery (Line 17 a) Tax-exempt income—bond interest (Line 18 a) $5, 000 2, 100 59

The Big Picture – Example 23 Book-tax Reconciliation • Continue with the facts in Example 22 and consider the book-tax reconciliation. • 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 and the 4 separately stated amounts in Example 23 to arrive at ‘‘net income’’ of $490, 000. • This amount is shown on line 1 of the Analysis of Income (Loss) and is the amount to which book income is reconciled on Schedule M– 1, line 9. 60

The Big Picture – Example 24 Maria’s Reported Amounts • • • Assume the same facts as in Example 22, but now consider the effect of the LLC’s operations on one of its members. Maria, a 40% owner, will receive a Schedule K– 1 from Beachside Properties, on which she is allocated a 40% share of ordinary income and separately stated items. Thus, on her Form 1040, Maria includes: Ordinary income Charitable contribution Short-term capital gain Passive rent income Qualified dividend income • • $72, 000 $2, 400 $4, 800 $120, 000 $1, 600 Maria will disclose her $840 share of tax-exempt interest on the first page of Form 1040. In determining her AMT liability (if any), Maria will take into account a $2, 000 positive adjustment. 61

Partnership Allocations (slide 1 of 3) • 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 62

Partnership Allocations (slide 2 of 3) • 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 63

Partnership Allocations (slide 3 of 3) • 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 64

The Big Picture – Example 27 Precontribution Gain or Loss (slide 1 of 2) • Return to the facts of The Big Picture on p. 21 -2. • When Beachside Properties, LLC, was formed – Kyle contributed property FMV $2 million, basis $600, 000. – Maria contributed equip. & furnishings with FMV $500, 000, basis $0. • For § 704(b) book accounting purposes, Beachside records the land 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. 65

The Big Picture – Example 27 Precontribution Gain or Loss (slide 2 of 2) • For example, if Beachside sells the land contributed by Kyle for $2. 3 million, the gain would be calculated and allocated as follows: Amount realized Less: Adjusted basis Gain realized Built-in gain to Kyle Remaining gain (allocated proportionately) § 704(b) $2, 300, 000 2, 000 $ 300, 000 – 0– Book Tax $2, 300, 000 600, 000 $1, 700, 000 1, 400, 000 $ 300, 000 • For tax purposes, – Kyle would recognize $1, 520, 000 of the gain [($300, 000 X 40%) + $1, 400, 000] – Maria would recognize $120, 000($300, 000 X 40%), and – Josh would recognize $60, 000($300, 000 X 20%). 66

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 67

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) 68

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 69

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 70

Basis Example (slide 2 of 2) With Basis Adjustment $ 35, 000 Without Basis Adjustment $35, 000 Selling Price(A) Less: Basis in interest Beginning basis 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 71

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 72

Basis Limitation • A partner’s basis in the partnership interest can never be negative 73

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 74

Allocation of Partnership Liabilities • Two types of partnership debt – Recourse debt—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 75

Constructive Liquidation Scenario • • 1. 2. 3. 4. Partnership assets deemed to be worthless Assets deemed sold at $0; losses determined Losses allocated to partners under partnership agreement Partners with negative capital accounts deemed to contribute cash • 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) 76

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) 77

The Big Picture – Example 33 Basis In Partnership Interest (slide 1 of 4) • Return to the facts of The Big Picture on p. 21 -2. • 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. 78

The Big Picture – Example 33 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. • On December 31, the LLC distributes $20, 000 cash to her. • Maria’s share of Beachside’s income, gain, and deductions is as described in Example 25. 79

The Big Picture – Example 33 Basis In Partnership Interest (slide 3 of 4) • Maria’s basis at year-end calculated using the ordering rules shown in Figure 10. 3. is as follows: Beginning basis Contributions, including increase in share of liabilities: Share of net increase in LLC liabilities [40% X ($600, 000 - $500, 000)] Cash contribution to LLC capital Maria’s basis in noncash capital contribution Share of LLC income items: Ordinary LLC income LLC’s net passive income from rental real estate Tax-exempt income Short-term capital gain Qualified dividend income Distributions and withdrawals: Capital withdrawal Share of LLC deduction items: Charitable contribution Ending basis $1, 600, 000 40, 000 100, 000 – 0– 72, 000 120, 000 840 4, 800 1, 600 (20, 000) (2, 400) $1, 916, 840 80

The Big Picture – Example 33 Basis In Partnership Interest (slide 4 of 4) • As will be explained later in this chapter, 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. 81

The Big Picture – Example 34 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) 196, 840 Withdrawals and distributions (20, 000) Ending capital account $1, 676, 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. 82

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 83

Loss Limitations (slide 2 of 2) Section 704(d) 465 469 Description Basis in partnership interest At-risk limitation Passive loss limitation • Limitations are applied successively to amounts which are deductible at all prior levels 84

Loss Limitation Example (slide 1 of 2) Meg's basis in interest $50, 000 At-risk amount $35, 000 Passive income, other sources $25, 000 Share of partnership losses (passive) $60, 000 85

Loss Limitation Example (slide 2 of 2) Provisions Deductible loss 704(d) $ 50, 000 465 35, 000 469 25, 000* Suspended loss $ 10, 000 15, 000 10, 000 *Amount deducted on tax return: $25, 000 -passes all three loss limitations 86

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 87

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 88

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 89

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 90

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 91

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 92

Partners as Employees • A partner usually does not qualify as an employee for tax purpose 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 93

The Big Picture – Example 45 Self-employment Tax Of Partners (slide 1 of 2) • Return to the facts of The Big Picture on p. 21 -2. • Josh is the managing member of Beachside Properties, LLC. – He has the sole authority to contract for the LLC and works 1, 000 hours per year in the business. • Maria works 1, 000 hours per year in the cafe. • Kyle has generally not been involved in the LLC’s operations. • Kyle and Josh each receive a guaranteed payment of $5, 000 per month from the LLC. – Josh’s payment is for services. – Kyle’s is for use of his $2 million of land. – Maria receives a guaranteed payment of $10, 000 per month. • $5, 000 is for services, and • $5, 000 is for the use of her $2 million of capital. 94

The Big Picture – Example 45 Self-employment Tax Of Partners (slide 2 of 2) • If Beachside follows the Proposed Regulations, the members’ distributive shares and guaranteed payments will be treated as follows: * Under the Proposed Regulations, Maria’s distributive share is not SE income for two reasons: (1) she is a general partner by virtue of working more than 500 hours per year; and (2) Kyle, a ‘‘limited partner, ’’ has an interest with identical rights to Maria’s. 95

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 96

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 97

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 98

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 99

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 100

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 101

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 102

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 103

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 Cash $15, 000 Land—basis N/A $ 6, 000 (Fair mkt value) N/A $10, 000 Accts rec—basis N/A (Fair mkt value) N/A C. $ 5, 000 N/A -0$16, 000 104

Proportionate Nonliquidating Distribution Examples (slide 2 of 6) A B C . Basis in interest $30, 000 Cash distributed Basis after cash Acct. rec. distrib. Basis after A. R. Land Distrib. Basis after all dist. ( 15, 000) 15, 000 N/A $15, 000 (15, 000) 15, 000 N/A 15, 000 ( 6, 000) $ 9, 000 (5, 000) 25, 000 (-0 -) 25, 000 N/A $25, 000 105

Proportionate Nonliquidating Distribution Examples (slide 3 of 6) Basis in p’ship int. Basis in cash Basis in land Basis in A/R Total basis A $15, 000 N/A $30, 000 Sale of non-cash assets at FMV: Selling price N/A Basis N/A Gain N/A B $9, 000 15, 000 6, 000 N/A $30, 000 C. $25, 000 N/A -0$30, 000 $10, 000 (6, 000) $4, 000 $16, 000 (-0 -) $16, 000 106

Proportionate Nonliquidating Distribution Examples (slide 4 of 6) Bill’s basis in partnership interest: $30, 000 Proportionate nonliquidating distributions (independent fact situations): Assets Distributed Cash Relief of liabilities Land-basis (Fair mkt value) D $40, 000 N/A N/A E N/A 40, 000 N/A F. $20, 000 N/A $30, 000 $50, 000 107

Proportionate Nonliquidating Distribution Examples (slide 5 of 6) Basis in interest Cash distributed Relief of liabilities Gain recognized Basis after cash (and deemed cash) dist. Land distrib. Basis after all distrib. D $30, 000 (40, 000) N/A 10, 000 E $30, 000 N/A (40, 000) 10, 000 F. $30, 000 (20, 000) N/A. -0 N/A -0 - 10, 000 (10, 000) -0108

Proportionate Nonliquidating Distribution Examples (slide 6 of 6) Basis in p'ship int. Basis in cash Liabilities relieved Basis in land Gain recognized Original basis Sale of non-cash assets at FMV: Selling price Basis Gain D -040, 000 N/A (10, 000) 30, 000 N/A N/A E -0 N/A 40, 000 N/A (10, 000) 30, 000 N/A N/A F. -020, 000 N/A 10, 000 N/A. 30, 000 $50, 000 (10, 000) $40, 000 109

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 110

Exceptions to Liquidating Distribution Rules (slide 1 of 2) • Gain is recognized if: – Cash distributed exceeds partner’s basis – Precontribution gain exceptions – Disproportionate distribution 111

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 112

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 Unrealized rec. N/A -0 -0(Fair mkt value) N/A $16, 000 Filing cabinet (1231) N/A 300 (Fair mkt value) N/A 300 113

Proportionate Liquidating Distribution Examples (slide 2 of 4) Basis in interest Cash distribution Gain recognized Basis after cash A/R distrib. Loss recognized Basis after A/R Filing cabinet Ending basis G $30, 000 (50, 000) 20, 000 -0 N/A $ -0 - H $30, 000 (10, 000) N/A 20, 000 -0(20, 000) -0 N/A $ -0 - I. $30, 000 (10, 000) N/A 20, 000 -0 N/A 20, 000 (20, 000) $ -0 - 114

Proportionate Liquidating Distribution Examples (slide 3 of 4) Basis in p’ship int. Basis in cash Basis in A/R Basis in filing cabinet Capital (Gain)/loss Original basis G H I . $ -050, 000 N/A (20, 000) $30, 000 $ -010, 000 -0 N/A 20, 000 $30, 000 $ -010, 000 -020, 000 N/A. $30, 000 115

Proportionate Liquidating Distribution Examples (slide 4 of 4) Sale of non-cash assets at FMV: Example H: A/R Selling price $16, 000 Basis -0 Gain/(loss) $16, 000 Example I: Selling price Basis Gain/(loss) $16, 000 -0$16, 000 (Ordinary) Fil. Cab. N/A N/A (Ordinary) Total. $16, 000 -0 -. $16, 000 $ $16, 300 20, 000 ($3, 700) 300 20, 000 ($19, 700) (May be ord) 116

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 117

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 118

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 119

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 120

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 121

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 122

Refocus On The Big Picture (slide 1 of 3) • 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 15). • Beachside Properties computes its income as shown in Example 22 and allocates the income as illustrated in Examples 24 and 27. 123

Refocus On The Big Picture (slide 2 of 3) • The LLC’s income affects the members’ bases and capital accounts as shown in Examples 33 and 34. • An important consideration for the LLC members is whether their distributive shares and guaranteed payments will be treated as selfemployment income (see Example 45). 124

Refocus On The Big Picture (slide 3 of 3) 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. 125

If you have any comments or suggestions concerning this Power. Point Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA trippedr@oneonta. edu SUNY Oneonta © 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 126