This article discusses the taxation of partnerships. As a review, a partnership is an assocation between two persons (but entities could also be involved) who carry on a trade or business for profit. As a matter of liabililty, partners are generally considered liable for the debts of the partnership and other partners.
Entities that are permitted to be taxed as a parternship include: (1) general partnerships, (2) limited partnerships, (3) limited liability partnerships, (4) limited liability limited partnerships, and (5) multi-member limited liability companies.
Reporting
Partnerships do not pay federal income tax. Instead, the income tax flows to the partners, in a process called pass through taxation. That is, the income is reported on the tax returns of the partners, rather than the partnership completing an income return. Instead, the partnership will complete an information return (due March rather than April 15th), telling the IRS how much money the partnership made and how much of that income was allocated to the partners. Income is calculated by ordinary operating income and expenses, then supplemented by separately stated items (such as dividends to the partners).
Basis
The basis of the partners is similar to those of shareholders for corporations. It is a representation of the partner’s basis in the investment of the business.
Basis for the partners is calculated by taking the partners’s capital account in addition to the partner’s share of the partnership debt. To calculate the capital account (basically the equity of the partnership) you take the partner’s equity interest (contributions (FMV for services)), add in income, and subtract losses and distributions.
Throughout the year, the basis and capital accounts can change. To calculate this change take the intial basis in the partnership, add in the contributions to the partnership and any increases in the partnership shares (through debt increases and income items), then subtract distributions and withdrawals and any decreases in the partnership shares (debt decreases and expense and loss items).
In an existing partnership, the basis depends on how the interest was acquired. If the interest was purchased from another partner, then the basis is the amount paid. If the interest was acquired by a gift, the basis is the basis of the donor. Finally, if the interest was acquired through an inheritance, the basis is the fair market value of the interest on the date of death.
Partnerships also have a basis, called inside basis, in the assets used by the partnership.
Taxation of Formation
Usually (except any boot), there is no gain or loss recognized for partnership formation ( See § 721). This is true if the partners contribute property and receive an interest in the partnership in return.
The partner’s basis in the interest received is equal to the basis of the assets changed then added or subtracted based on the change in partner liability in those assets. Any liabilities assumed by the partnership is then reallocated to the partners. If the partner’s basis would be less than 0 after adjusting the net liability change, then the basis becomes 0 and results in a gain.
The partnership’s basis is the partner’s basis plus the recognized gain.
If the partner was depreciating the assets before they were contributed, then the partnership will continue the depreciation as if there was no change (e.g., if the depreciation was in year 7 of 10 when contributed, the partnership would depreciate year 8 of 10 the following year).
A couple other notes:
- If a cash basis partner contributes accounts receivable, then the received income would be taxed as ordinary income.
- If inventory is sold within 5 years, it is taxed as ordinary income.
- Finally, if contributed property has a built in capital loss (FMV is lower than the partner’s basis), and the property was a capital asset by the partner, the property will retain it’s character as a capital loss for the partnership (even if the use is no longer capital). For example, if the partner has investment property with a basis of 100,000 and contributed the property to the partnership when it is valued at 90,000, then the 10,000 capital loss will remain captial. So, if the partnership later uses the property for a business purpose and later sells it for 70,000. The tax implication is is that there is a 10,000 capital loss and a 20,000 ordinary loss.
Start-up and Organizational Cost
The start-up costs of partnerships can be deducted just like the start-up costs of a corporation. That is, the first 5,000 of the cost can be immediately deducted, then the rest is amortized over the next 180 months.
Tax Year
A partnership is required to have a tax year, but there are several different options. For instance, the partnership could choose a tax year based on: (1) the tax year of a majority partner, (2) the tax year of the principle partners (partners owning more than 5%), (3) by following the least aggregate deferral rule (testing each partner’s year end to determine whish has the least impact on other partners), or (4) by following the business purpose (ignoring the first options if there is a valid nontax business purpose for not using the partner’s year end).
Seperatly Stated Items
Items that need to be stated separately are those pieces of income and expenses that would have a disproporionate effect on different partners. For example, dividends distributed are deducted and taxed differently for individuals and corporations. Other examples of seperately stated seperately stated items include charitable contributions and interest expenses.
Allocations
Partnership agreements can decide how partners share capital, profits, and losses. These allocations are mine if the allocation has to have a substantial economic effect. That is, the agreement impacts capital accounts, distributions are based upon the capital account, and any deficits are restored. However, partners who contribute assets with a pre-existing gain or loss will be required to accept the gain or loss once the income is calculated. Note that this is different from the partnership gain (see the example earlier in section “Taxation of Formation”).
Liabilities
Each partner has a share of the partnership liabilities (the basis also increases for those liabilities). However, there may be recourse—partner is personally liable—and nonrecourse—partner is not personally liable—options.
Losses
When a partnership has losses, those are allocated to the partners to deduct on their tax returns. Partners are then permitted to deduct those losses until their basis in the partnership reaches zero. Partners are also not permitted to deduct more than $610,000 for couples married filing jointly, or $305,000 for all other filing options.
Partner Employees
Partners are not employees for tax purposes. This means the partners receive a guaranteed payment not subject to tax withholding (meaning partners are required to pay self-employment tax). However, this means that the partnership cannot deduct for partner’s fringe benefits. Additionally, the partner’s allocative share of ordinary partner income is subject to self-employment tax, even if that is just reinvested.
Guarenteed payments are guarenteed. That is, there is no condition to be profitable. Additionally, the payment is treated as ordinary income (like a salary), so there is no impact on the partner’s basis. The tax rate depends on whether the payment is for services or based on a capital return (preferable tax rate for capital contributions). Partnerships are permitted to deduct the payment.
Proportionate Distributions
There are two types of distributions of cash and property: liquidating (partner is leaving) and nonliquidating.
For nonliquidating, there is no gain or loss recognized unless the partner receives cash in excess of the partner’s basis. Thus, there is no gain or loss on non-cash property distributions. A consequence of taking a distribtuion of property results in a basis being the lesser of the partnership’s inside basis or the partner’s remaining basis in the partnership outside basis. The partner’s remaining basis in the partnership is then calculated by first subtracting cash distribtuions, then “hot assets” (e.g., accounts receivable and inventory) basis, then distributed assets basis.
In liquidating distributions, cash also comes out first, then the hot assets, then the other property. The difference, is that the basis will always result in zero because the partner is required to reduce the outside basis zero to leave the partnership.
Disproportionate Distributions
A disproportionate distribution occurs when the partners do not receive a propertionate share of each asset.
736 Payments (Buyouts)
This is a pyament made to a retiring or deceased partner. If the partner was providing services for the business, then the payment must be split into (1) compensation for their services rendered, (2) payment for their equity (tax-free assuming it doesn’t go above the basis).
Selling the Partnership Interest
If a partner sells their interest to someone else, then the buyer is the new partner. Any gain or loss from the transaction is the amount realized (including any debt relief) minus the partner’s basis as of the transaction date.
