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Chapter 1: Tax Definition of a Partnership. Partnership. A partnership is an association between two or more persons who join to carry on a trade or business for profit. Types of Partnerships. General Partnership: every partner has unlimited liability for the debts of the partnership.
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Partnership • A partnership is an association between two or more persons who join to carry on a trade or business for profit.
Types of Partnerships • General Partnership: every partner has unlimited liability for the debts of the partnership. • Limited Partnership: at least one partner’s liability for the debts of the partnership is limited to that partner’s investment in the partnership. • Limited Liability Partnership (LLP): type of general partnership in which all of the partners (all of which are general partners) are protected at a minimum from personal liability for negligent acts committed by other partners or by employees not under his or her direct control.
Types of Partnerships Cont. • Limited Liability Limited Partnership (LLLP): a limited partnership that elects to become an LLP as well, thus affording the general partners the same protection from liability as an LLP does. • Limited Liability Company (LLC): owners can all participate in the management of the business, but who also are all given protection from the liabilities of the LLC (except to the extent of their investment in the LLC). • Not legally a partnership, but treated as a partnership for tax purposes.
Classifying Entities • There are 3 general sets of regulatory rules that classify entities as a partnership for tax purposes: • “Check-the-box” classification rules • Allow taxpayers to choose whether to treat partnerships and other unincorporated entities which are not partnerships (e.g., LLCs) as corporations or partnerships for federal income tax purposes. • “Anti-abuse” rules • Allow the IRS to recharacterize something the taxpayer is treating as a partnership as something other than a partnership. • Rules which allow investment joint ventures to choose whether to be partnerships or tenancies-in-common. • Allows simple partnerships that resemble jointly owned investments to elect to treat themselves not as partnerships, but as tenants-in-common for tax purposes.
Incorporation • A business activity incorporated under the law of any state, federal, or foreign jurisdiction must be treated as a corporation for federal income tax purposes. • Unincorporated entities may elect to be a corporation for tax purposes. • If it does not elect to be treated as a corporation, the entity is by default treated as a partnership for tax purposes.
Disregarded Entities • A single member unincorporated entity is treated as a “disregarded entity” unless it elects to be a corporation. • Example: a single member LLC.
Advantages of Partnerships • Flow-through Taxation: The partnership is not taxable. Income flows through to the partners and is then recognized by them. • 2 positive effects: • 1) Income is only taxed once (on the partner level) as opposed to the double taxation that corporations shareholders experience. • 2) If a loss occurs, the partner will be able to deduct his share of the loss. Corporate shareholders are not allowed to deduct a portion of the corporation’s loss. • Exception: Since S-Corporations are flow-through entities, an S-Corporation shareholder would be able to deduct his portion of the loss.
Advantages Cont. • Property Distributions: Generally, distributions of property from a partnership are tax-free. • However, distributions of cash can result in gain to a partner. • Distributions of property from a corporation, however, are dividend income to the shareholder, and will result in taxable gain to the corporation if the assets distributed are appreciated.
Advantages Cont. • Tax-free Formation: Generally, for a corporation to be tax free, property must be contributed, stock must be received, and 80-percent control must be owned by the contributors after the contribution. • No such requirements exist for partnerships. • Contributions to partnerships are generally tax-free unless the net liabilities the partner is relieved of due to the contribution exceed the partner’s basis in their partnership interest.
Advantages Cont. • Special Allocations: Partnerships can specially allocate items of income or deduction to different partners. • Example: All depreciation can go to just one partner. • Often, special allocations are used to make the investment more attractive to high-tax-bracket partners. • Corporations can not use special allocation.
Other Advantages • 1) Easy to Form: No filing with the state and no necessary paperwork. • However, a written agreement is strongly advised. • 2) Liabilities of a partnership increase a partner’s basis.
Disadvantages of Partnerships • Unlimited Liability: General partnerships and limited partnerships don’t shield their general partners from the liabilities of the partnerships. • This is one reason why so many businesses operate as LLCs (where they are generally taxed as partnerships but their owners are shielded from the liabilities of the entity).
Disadvantages Cont. • Self-employment Income: Any trade or business income is taxed to the general partners as self-employment income (which is subject to the self-employment tax). • Guaranteed payments for services provided by limited partners is also treated as self-employment income. • Income of a corporation is not subject to self-employment tax, although the shareholders will be subject to FICA taxes.
Other Disadvantages • 1) More difficult to transfer ownership. • 2) More difficult to raise capital. • 3) A partner’s deduction of losses from a partnership are limited by basis, at-risk amounts, and the passive activity loss rules. • 4) The fringe benefit exclusion is generally not allowed because a partner is not an “employee”. • Health plan premiums are not excludable, and payments are not excludable. Other examples are group term life insurance premiums and meals and lodging. • However, a partner is specifically treated as an “employee”for the purposes of many fringe benefits (education assistance, child care, retirement plans, and others).
LLC Tax Implications • 1) Definition of a limited and general partner: No member is legally a limited or general partner. • All members resemble limited partners from a limited liability standpoint. • All members who are managers resemble general partners from an operational standpoint.
LLC Tax Implications Cont. • 2) Classification of recourse and nonrecourse debt: Generally, recourse debt is allocated to the partners who bear the risk of paying the creditors if the partnership fails to pay them. Nonrecourse debts are allocated among all partners, general and limited. • These rules become less clear when applied to LLCs who don’t have general and limited partners.
LLC Tax Implications Cont. • 3) Passive Loss Limitation Rules: An individual may deduct up to $25,000 of passive activity losses attributable to all real estate activities in which the individual actively participated during the year. • Generally an individual is considered to have materially participated in an activity if he or she meets one of seven tests. • Except as provided in regulations, no interest as a limited partner in a limited partnership shall be treated as an interest in which the taxpayer actively participates. • An interest in an LLC is considered a limited partnership interest. • It has been argued that manager-members should not be treated as limited partners for the purposes of the material participation test.
LLC Tax Implications Cont. • 4) Tax Matters Partner: Tax partnerships are subject to the unified audit and litigation procedures. These procedures require the partnership to appoint a general partner as its tax matters partner. • This is the person that the IRS will deal with in connection to the unified procedures. • An LLC does not have a general partner. • In the case of no general partner, the IRS is authorized to designate a tax matters partner. • Under the regulations in Code Sec. 6231, only member managers of LLCs can be designated as a tax matters partner.
Tax Implications Cont. • 5) Self-employment taxes: A limited partner’s share of partnership income is not subject to self-employment tax. In an LLC, all partners are considered limited partners. • Proposed regulations are that an individual will be treated as a limited partner unless he or she: • Has a person liability for debts of or claims against the partnership. • Has authority to contract on behalf of the partnership. • Participates in the partnership’s trade or business for more than 500 hours during the taxable year.
Tax Implications Cont. • 7) At-risk Rules: Losses incurred by individuals and certain closely held corporations from an activity are deductible only to the extent of the aggregate amount with respect to which the taxpayer is at risk with respect to that activity • Except in the case of “qualified nonrecourse financing, a taxpayer is at risk with respect to amounts borrowed for use in an activity only to the extent that he or she is personally liable for repayment of such amounts, or has pledged property as security for the debt. • At-risk rules describe nonrecourse debt as financing with respect to which “no person (instead of ‘no member’ or ‘related person’) is personally liable for repayment. • The issue was whether recourse debt for which the LLC itself was personally liable could be treated as nonrecourse debt and, therefore, qualified nonrecourse debt if all the requirements were met.
