Chapter 9 Partnership Formation and Operation 1 PARTNERSHIP

Chapter 9: Partnership Formation and Operation 1

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

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

Partnership Definitions ® Tax definition of a partnership ® General partnership ® Limited liability companies (LLCs) ® Limited liability partnerships (LLPs) ® Electing large partnership (ELP) 4

Tax Definition of a Partnership ® Syndicate, group, pool, joint venture or other unincorporated organization that carries on a business 5

General Partnership ® Two or more partners ® All partners are general partners May participate in management May make commitments on behalf of partnership Unlimited liability for partnership debts 6

Limited Partnership ® One or more general partners and ® One of more limited partners Cannot participate in management Cannot make commitments for partnership Liability generally limited to amount invested in partnership 7

Limited Liability Companies (LLC) ® May be taxed as a partnership or a corporation (using check-the-box Regs) ® When taxed as a partnership, entity obtains flow-through and flexibility of partnership allocations while maintaining limited liability of a corp 8

Limited Liability Partnerships & Electing Large Partnerships ® Limited liability partnerships (LLPs) Used by many professional organizations May be taxed as a partnership or a corporation (using check-the-box Regs) Partners not liable for failures in work of other partners or people supervised by other partners ® Electing large partnership (ELP) Non-service partnerships of 100 ptrs 9

Overview of Partnership Taxation ® Partnership profits and losses ® Partner’s Basis ® Partnership distributions 10

Partnership Profits and Losses (1 of 2) ® Partnership Information ® Partners files Form 1065 return with no tax due receive a Form K-1 Reports partner’s share of income or loss and separately reported items 11

Partnership Profits and Losses (2 of 2) ® Partners include profit or loss and separate items on their individual return (Form 1040 for individuals) ® Loss limitation Partner’s losses limited to his/her basis in the partnership At-risk rules and passive loss rules also apply 12

Partner’s Basis (1 of 2) ® Items that increase basis Partner’s share of partnership earnings, additional contributions, & additional assumption of partnership debt ¬Increase in basis for earnings prevents double taxation of earnings upon subsequent distribution 13

Partner’s Basis (2 of 2) ® Items that decrease basis Partner’s share of losses, distributions, & reduction in partnership debt 14

Partnership Distributions ® Payment of money to partner usually tax-free because earnings previously taxed ® If distributions exceed the partner’s basis, gain may be recognized 15

Contributions of Property ® General rule ® Exceptions to nonrecogntion rule ® Effects of liabilities ® Contributions of services ® Basis ® Organizational & syndication costs ® See Topic Review C 9 -1 for 16

General Rule ® General rule for property contributions in exchange for partnership interest No gain or loss § 721 similar to § 351 17

Exceptions to Nonrecognition Rule ® Gain recognition at time of property contribution if Partnership would be investment company if it were incorporated, Contribution followed by a distribution resulting in a deemed sale, or Liabilities assumed by partnership in excess of partner’s basis 18

Effects of Liabilities ® Two effects of liabilities contributed by a partner to a partnership Basis of each partner (including contributing partner) is increased by her share of liabilities, AND Contributing partner treated as if partnership made cash distribution to the partner, decreasing partner’s basis ¬Gain would be recognized if deemed distribution exceeds partner’s basis 19

Contributions of Services (1 of 2) ® Contribution of services in exchange for partnership interest Income is FMV of services contributed 20

Contributions of Services (2 of 2) ® Partnership deducts or capitalizes FMV of services, depending on the nature of the expense ® Partnership recognizes gain or loss FMV of services less basis in assets allocated to service partner 21

Basis ® Partner’s basis in partnership equal to money contributed plus partner’s basis in contributed property plus gain recognized on contribution ® Partnership’s basis in property is partner’s old basis before contribution Holding period also carries over 22

Organizational and Syndication Costs ® Organization costs are capital expenditures May immediately expense $5 K and amortize the rest over 180 months $5 K immediate expense reduced $ for cumulative organization costs >$50 K 23

Partnership Elections ® Tax year Must be same as majority partner or partners with a 50% or more interest See Topic Review C 9 -2 ® Overall accounting method ® Inventory valuation method ® Depreciation method 24

Ordinary Income/Loss vs. Separately Stated Items (1 of 2) ® Separately stated items include: Net S-T capital gains and losses Net L-T capital gains and losses § 1231 gains and losses Charitable contributions Dividends eligible for DRD Foreign or possession taxes 25

Ordinary Income/Loss vs. Separately Stated Items (2 of 2) ® Separately stated items (continued) Tax-exempt interest Portfolio activities Passive activities U. S. production activities deduction Any items subject to special allocation ® Partnership All ordinary income/loss items not separately stated 26

Partners’ Distributive Share of Items ® Normally determined by terms of partnership agreement Portion of partnership taxable and nontaxable income partner agreed to report for tax purposes Amount not necessarily same as actual amounts distributed to partner in a particular year 27

Special Allocations ® Pre-contribution gains or losses must be allocated to contributing partner ® Allocations not related to contributed property must have substantial economic effect Allocations affect partners’ capital accounts, and Partners must make up deficit in capital 28

Partner’s Basis in Partnership Interest (1 of 2) ® Beginning basis Amount paid for interest OR Basis of property/ services contributed ® Additions to basis Additional contributions, earnings or assumption of liabilities ® Reductions result from withdrawals, losses or decrease in share of liabilities 29

Partner’s Basis in Partnership Interest (2 of 2) ® Effect of liabilities on partner basis Partner’s basis before liabs + Increases in share of ptrshp liabs - Decreases in share of ptrshp liabs + Ptrshp liabs assumed by this partner - This partner’s liabs assumed by ptrshp = Partner’s basis in the ptrshp interest ® See Topic Review C 9 -3 30

Special Loss Limitations (1 of 2) ® Loss recognition limitations Partner’s basis in partnership interest Portion of partner’s basis not “at risk” ¬At risk definition: amount partner would lose should the partnership suddenly become worthless. 31

Special Loss Limitations (2 of 2) ® Loss recognition limitations (continued) Designation of partnership interest as a “passive activity” ¬“Passive” losses can only be used to offset “passive” income. ¬Disallowed losses are suspended, and can be used to offset future passive income, or when the passive activity is sold 32

Transactions Between Partner & Partnership ® Loss sales No loss deducted on sale of property between a partnership and a > 50% owner (direct or indirect) ® Gain sales Gains on sale of property involving a >50% owner produce ordinary income unless property will be a capital asset in hands of new owner 33

Guaranteed Payments ® Always ordinary income to recipient ® Partner treats payment as if made to an outsider Deduct or capitalize ¬If deductible, GP reduces partnership ordinary income, which is allocated based on partnership agreement 34

Family Partnerships (1 of 2) ® Safe-harbor rule under § 704(e) for family partnerships Interest must be a capital interest, ¬Partner has right to receive assets if partnership liquidates immediately Capital must be a material income producing factor, AND Family member must be true owner 35

Family Partnerships (2 of 2) ® Donor-donee allocations of income Donor must be allocated reasonable compensation for services rendered to partnership Remaining partnership income must be allocated based on relative capital interest 36

Self-Employment Income ® Individuals who are partners must pay SE tax on the following income from a partnership: Guaranteed payments Partnership ordinary income or loss All separately stated items, except ¬Capital and § 1231 gains/losses, interest, dividends, and rental income 37

Comments or questions about Power. Point Slides? Contact Dr. Richard Newmark at University of Northern Colorado’s Kenneth W. Monfort College of Business richard. newmark@Ph. Duh. com 38