CPA Review

1. CPA Review Partnership Tax

2. Partnerships • File 1065 Information • partnership pays no taxes • tax items flow through to partner’s income tax returns • nature and character of items remain the same (e.g. ordinary, capital gain)

3. Consequences of Partnership Formation • General Rule: No gain or loss to partner • No gain or loss to partnership • Partner’s basis in partnership interest = substituted basis of contributed property

4. Partnership Formation • Partnership’s basis in property received = carryover of partner’s basis • Gain deferred until taxable disposition of: • property by partnership, or • partnership interest by partner

5. Partnership Formation • Exception: Partner must recognize gain : • If property is contributed subject to a liability and reduction in partner’s liability exceeds his partnership basis • generally capital unless depre. recap. • If partnership interest is received in exchange of services • If partnership would be investment company if incorporated

6. Basis Issues Outside Basis Inside Basis Partner’s basis Partner’s basis in partnership in share of interest partnership assets General rule: when partnership is formed, inside basis = outside basis

7. Partner’s Outside Basis • Original Basis • + subsequent capital contributions • + share of ordinary income, capital gains , other income items • + share of tax exempt income • + share of excess depletion • - money and property distributions • - share of ordinary loss, special expense items, nondeductible items

8. Partner’s Outside Basis • Changes in liabilities affect basis • Increase in share of partnership’s liabilities increases partner’s basis • Decrease in share of partnership’s liabilities decreases partner’s basis • Increase in partner’s individual liability increases partner’s basis • Decrease in partner’s individual liability decreases partner’s basis

9. Partnership Income (Loss) • Partnership income and deductions must be segregated into ordinary and special items • Ordinary income and deductions include • Sales less COGS • Business expenses • Depreciation (not Sec. 179) and amort. • Sec. 1245, 1250, etc. recapture • Guaranteed payments to partners

10. Partnership Income (Loss) • Special items include • Capital gains and losses • Sec. 1231 gains and losses • Charitable contributions • Sec. 179 expense (ltd to $18,000 for 1997) • Interest, dividend and royalty income • Interest expense on investment indebt. • Net income or loss from rental real estate • Net income or loss from other rental • Foreign income taxes

11. Partnership Income or Loss • Character of gain or loss determined by nature of property in hands of partnership • Exception for contributed property: • Disposition of unrealized receivables is ordinary • Disposition of inventory within 5 years is ordinary • Capital asset disposed of at loss w/in 5 yrs is capital loss to extent of partner’s unrecognized loss (only applies to losses)

12. Limitation of Partnership Loss • Limited to partner’s basis • Loss is last item allocated to basis • Unused losses are carried forward • Limited to amount of “at risk” basis • Nonrecourse liabilities are not included unless from qualified real estate financing • If passive, limited to passive income • Includes non-material participation and rental activities • Limited partners fail material part. • Must own at least 10% for active part. in rental real estate for $25,000 exception

13. Distributive Share of Income or Loss • Special Allocations • must have substantial economic effect, not tax avoidance • Income(loss) related to contributed property • Precontribution gain must be allocated to contributing partner first • If distributed to different partner w/in 7 yrs. contrib. partner recognizes precontri gain • can avoid if like-kind distributed to contributing partner w/in 180 days or due date of tax return

14. Distributive Share of Income or Loss • Change in ownership • Distributive shares of interest, taxes and payments for services or for use of property must be allocated by day • Income and guaranteed payments • Deemed to pass through on last day of partnership’s tax year • Not employee for fringe benefits

15. Family Partnerships • If primarily service business to be partner, family member must share in management or perform services • If capital is a material income producing factor , family member must own a capital interest • When interest is gifted and donor retains control over the partnership interest, the donor is taxed on the distributive share

16. Transactions with Controlled Partnerships • No losses are deductible from sales of property between a partnership and a person owning (directly or indirectly) more than 50% of the capital or profits interests in the partnership • Loss can be used to offset subsequent gain • If related person not owning directly or indirectly more than 50%, transaction is deemed between the related person and individual partners • Gain on sale between person owning more than 50% and partnership is not capital gain if property not capital asset in hands of partnership

17. Partnership Tax Year • 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% must have same tax year) • Least aggregate deferral rule • Can use different year if valid business purpose established & IRS permission • At least 25% gross receipts last 2 mos. • Satisfied for 3 consecutive years

18. Least Aggregate Deferral • 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%), but do not have same year end • Must use least aggregate deferral test to determine required taxable year

19. Least Aggregate Deferral Example 1. Test June 30 as possible year end: Partner.Year End%Mo. DeferralWeight George June 50% 0 0.0 Henry October 50% 4 2.0 Total weighed deferral 2.0 2. Test October 31 as possible year end: George June 50% 8 4.0 Henry October 50% 0 0.0 Total weighed deferral 4.0 June has the least aggregate deferral so it is the tax year for partnership.

20. Tax Year • Can elect fiscal year if deferral period < 3 months • Must make “required payment” (Deferred income x 40.6%) • Taxable year does not close with death, entry, sale or liquidation of partner’s interest • But partnership year ends with respect to partner whose entire interest is sold or liquidated • For years after 1997, partnership tax year closes with respect to deceased partner as of date of death • A partnership and its taxable year will terminate for all partners if a sale of 50% or more of total interests

21. Sale of Partnership Interest • Generally, capital gain or loss • Exception: Gain is ordinary to extent attributable to: • unrealized receivables • includes recapture under 1245,1250,1252 • appreciated inventory • includes all assets except capital and 1231

22. Pro Rata Distributions from Partnership • Partnership recognizes no gain or loss • If distribution of multiple items of property partner’s basis is reduced in this order: • Money • Unrealized receivables and inventory • Other property • Partner recognizes gain only to extent money exceeds the partner’s basis • Relief of liabilities is deemed money distribution • Gain is capital except attributable to unrealized receivables and substantially apprec. inventory

23. Pro Rata Distributions from Partnership • If property other than money is received, gain is not recognized until disposition of property • Partner recognizes loss only upon complete liquidation through receipt of money, unrealized receivables or inventory • Loss is partner’s basis less money and partnership’s basis in unreal rec and inventory • Generally a capital loss • No loss can be recognized if other property is distributed

24. Pro Rata Distributions from Partnership • Partner’s basis in property distributed • generally carryover basis • limited to partner’s outside basis less any money received

25. Liquidating Distribution Pro Rata • In general: • No gain or loss is recognized • Partner reduces basis in partnership interest by basis in property received at each level using Ordering Rules: 1. Cash, including relief of liabilities 2. Unrealized receivables and inventory 3. Other assets • Basis is allocated to assets within a category based on adjusted basis to partnership • Partner’s entire basis in interest will be absorbed by distributed assets

26. Exception to Liquidating Distribution Rules • Gain is recognized if: • Cash exceeds partner’s basis • Precontribution gain exceptions • Disproportionate distribution • 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

27. Liquidating distribution Example 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

28. Liquidating Distribution Example 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-

29. Liquidating Distribution Example 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