1 / 63

Partnership Allocation

Partnership Allocation. Partnership Agreement. Flexibility Allocating profits/losses Amount & timing of distributions Compensation paid to partners Receipts upon liquidation. Partnership Agreement. Determines distributive share of income, gain, loss, deduction (§704(a))

brier
Download Presentation

Partnership Allocation

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Partnership Allocation

  2. Partnership Agreement • Flexibility • Allocating profits/losses • Amount & timing of distributions • Compensation paid to partners • Receipts upon liquidation

  3. Partnership Agreement • Determines distributive share of income, gain, loss, deduction (§704(a)) • §704(b) governs allocations where partnership agreement is silent as well as special allocations • Special allocation = differ from partners’ respective interests in partnership capital

  4. Section 704(b) – In General • General Rule: A partner’s income, loss, deductions, credits & other items are determined in accordance with the partnership agreement or other special allocation • If partnership agreement is silent or special allocation fails: • Allocate in accordance with the partner’s interest in the partnership taking into account all facts & circumstances

  5. Section 704(b) – In General • Interests are equal unless they can be proven otherwise considering: • Relative contributions of partners • Interests in economic profits & losses if they differ from interests in taxable income • Interests in cash flow & other nonliquidating distributions • Rights to distribution of capital upon liquidation

  6. Section 704(b) – Special Allocation • Substantial economic effect: 2-part test • Economic effect = allocation must be consistent with the economic business deal of the partners • Substantiality = reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences • Applied on an annual basis

  7. Economic Effect • The partner to whom the allocation is made must receive the benefit or bear the burden • Primary test – The Big Three • Alternate economic effect • Economic effect equivalence

  8. Economic Effect • The Big Three • Capital accounts must be determined & maintained in accordance with the rules of Section 1.704-1(b)(2)(iv) of the regulations • Upon a liquidation of the partnership, or of any partner’s interest, liquidating distributions must be made in accordance with the positive capital account balances of the partners • If a partner has a deficit balance in his capital account following the liquidation of his interest in the partnership, he must be unconditionally obligated to restore the deficit by the later of: (a) the end of the taxable year of the liquidation of the partner’s interest, or (b) 90 days after the date of the liquidation

  9. Economic Effect • The Big Three • Ensures that special allocations for tax purposes are allowed only if the partners will eventually receive the economic benefit of that income • Thus, allocations must be reflected in capital accounts & distributions must be made based on positive capital accounts

  10. The Big Three – Maintenance of Partners’ Capital Accounts • Capital Account • Identifies amounts the partners would be entitled to receive if & when their interests were liquidated • “Book value” – may differ from basis • Contributions & distributions valued at FMV when contributed or distributed instead of adjusted tax basis

  11. The Big Three – Maintenance of Partners’ Capital Accounts • Increased by • Money contributed by partner • FMV of property contributed by partner (net of liabilities) • Allocations to partner of partnership income & gain, including tax-exempt income

  12. The Big Three – Maintenance of Partners’ Capital Accounts • Decreased by • Money distributed to partner • FMV of property distributed to partner (net of liabilities) • Allocation of partnership expenditures neither deductible in computing taxable income nor properly chargeable to capital account • Allocations of partnership loss & deduction

  13. The Big Three – Example A and B each contribute $30,000 to form the AB general partnership. The partnership uses this $60,000 to purchase a piece of machinery. The partnership agreement states that all depreciation deductions will be specially allocated to A

  14. The Big Three – Example #1 • After depreciation of $15,000, AB liquidates and distributes the $45,000 proceeds from the sale of its machinery to A and B • Partners’ capital accounts • A: $30,000 - $15,000 = $15,000 • B: $30,000 - $0 = $30,000 ***The $45,000 must be allocated in accordance with the partners’ capital accounts ($15,000 to A and $30,000 to B)

  15. The Big Three – Example #2 • After depreciation of $45,000, AB liquidates and distributes the $15,000 proceeds from the sale of its machinery to A and B • Partners’ capital accounts • A: $30,000 - $45,000 = ($15,000) • B: $30,000 - $0 = $30,000 ***A must contribute an additional $15,000 upon liquidation so that B can receive his full $30,000 distribution.

  16. Alternate Economic Effect • If the agreement fails to include an unconditional deficit make-up provision • Deemed to have economic effect if: • Does not create or increase a deficit in the partner’s capital account

  17. Economic Effect Equivalence • If the agreement fails both the primary & alternate tests • Deemed to have economic effect if: • Partnership agreement ensures that a liquidation of the partnership will produce the same economic results as if The Big Three were satisfied

  18. Substantiality • Pass this test unless: • An allocation benefits one or more partners after taxes without adversely affecting any partner • Comparing the results from the allocation with the results if no allocation was made • Tax consequences must be considered

  19. Substantiality – Example • Partner A: 30% tax bracket; allocated 90% tax-exempt interest • Partner B: 15% tax bracket; allocated 10% tax-exempt interest & 100% dividends • $10,000 of tax-exempt interest & $10,000 of dividends distributed

  20. Substantiality – Example • Partner A: $9,000 TE interest • Partner B: $10,000 dividends - $1,500 tax = $8,500 + $1,000 TE interest = $9,500 • Without this allocation • Partner A: $5,000 dividends - $1,500 tax = $8,500 • Partner B: $5,000 dividends - $750 tax = $9,250 • Because both A and B benefit from the allocation, it fails the substantiality test and is disallowed

  21. Shifting Allocations • Shifting various types of losses from one partner to another in a single year in order to minimize total taxable income • Capital accounts unaffected • “Strong likelihood” that this result will occur when allocation made • Lack economic effect

  22. Transitory Allocations • Possibility within five taxable years that an original allocation will be largely offset by one or more offsetting allocations • “Strong likelihood” that partners’ capital accounts will emerge unaffected • Partners enjoy reduction in total tax liability for period involved • Lack economic effect

  23. Depreciation Recapture • Depreciation recapture merely changes the tax character of an item – thus it cannot have substantial economic effect • Partner’s share is equal to the lesser of: • Partner’s share of total gain from disposition of property • Total depreciation previously allocated to partner with respect to property

  24. Depreciation Recapture • This prevents a partner from being allocated depreciation recapture gain without ever having been allocated depreciation deductions on that property • The partner that suffers the loss should also enjoy the benefit

  25. Depreciation Recapture – Example The AB Partnership purchases a piece of equipment for $5,000. A and B agree that depreciation deductions will be allocated 90% to A and 10% to B. Gain on sale of property will be shared equally between A and B. After one year, AB sells the equipment for $5,200.

  26. Depreciation Recapture – Example • A and B will split the $1,200 gain • Of that amount, how much will be classified as depreciation recapture? • A: Gain recognized = $600 Depreciation allocated = $900 Depreciation recapture = $600 • B: Gain recognized = $600 Depreciation allocated = $100 Depreciation recapture = entire remaining $400 because A’s recapture was limited to $600

  27. Tax Credits • Cannot have economic effect because not included in partners’ capital accounts • Allocated in accordance with partners’ interests in the partnership

  28. Contributed Property • In exchange for partnership interest • Recognize neither gain nor loss • Basis in contributed property carries over to partnership for tax purposes • Record at FMV on partnership books

  29. Contributed Property • Built-in gain = FMV > Partner’s adjusted basis at the time of contribution • Built-in loss = FMV < Partner’s adjusted basis at the time of contribution

  30. Contributed Property Example The AB Partnership is formed with A contributing Gainacre, a capital asset, with an adjusted basis of $12,000 and a FMV of $20,000, and B contributing $20,000 in cash. A and B agree to allocate profits according to their equal 50% interests in the partnership. AB subsequently sells Gainacre for $20,000.

  31. Contributed Property Example – Continued 1 – No book gain is realized. 2 – Because the $8,000 tax gain is allocated equally to A and B in accordance with the partnership agreement, A effectively shifts $4,000 of his built-in gain to B 3 – A’s basis: $12,000 + $4,000 = $16,000 B’s basis: $20,000 + $4,000 = $24,000

  32. Contributed Property – Example Continued ***704(a) thus enables partners to shift income or loss for tax purposes without any corresponding economic benefit or burden ***704(c) governs allocation of gain or loss in these situations

  33. Sales & Exchanges – The Traditional Method • Allocate any built-in gain or loss to the contributing partner for tax purposes • Gainacre sold for $20,000 = $8,000 built-in gain allocated to A • Gainacre sold for $35,000 = $8,000 built-in gain allocated to A; remaining $15,000 accrued gain allocated to A and B based on their partnership interests • Required to keep two sets of accounts – one for “book” and one for “tax”

  34. The Ceiling Rule • Total gain or loss allocated to the partners may not exceed the tax gain or loss realized by the partnership • Gainacre sold for $15,000 • $5,000 book loss (Both A and B receive $2,500) • B receives no corresponding tax loss to this book loss because the partnership realized a tax gain • A receives entire tax gain of $3,000 = $15,000 - $12,000 (instead of actual economic gain of $5,500 = $8,000 precontribution gain - $2,500 book loss) • This shifts income and loss among partners

  35. Sales & Exchanges – Traditional Method with Curative Allocations • Curative allocation – an allocation made solely for tax purposes that differs from the partnership’s allocation of the corresponding book item • To correct ceiling rule distortions • No economic effect • Not reflected in partners’ capital accounts

  36. Sales & Exchanges – Traditional Method with Curative Allocations • Reasonable if: • Does not exceed amount necessary to offset the effect of the ceiling rule • The income or loss allocated has the same character & the same tax consequences as the tax item affected by the ceiling rule

  37. Traditional Method with Curative Allocations – Example • In addition to selling Gainacre for $15,000, the partnership also sells stock for $30,000 resulting in a $10,000 long-term capital gain • Each partner receives $5,000 book gain • For tax purposes, A is allocated $7,500 capital gain and B allocated $2,500 capital gain, thus curing the ceiling rule distortion • The curative allocation must be of the same tax character as the income or loss distorted by the ceiling rule

  38. Traditional Method with Curative Allocations – Example A B Tax Book Tax Book On Formation $12,000 $20,000 $20,000 $20,000 Gainacre – Tax Gain 3,000 Gainacre – Book Loss (2,500) (2,500) Stock – Tax Gain 7,500 2,500 Stock – Book Gain 5,000 5,000 Balance $22,500 $22,500 $22,500 $22,500

  39. Sales & Exchanges – Remedial Method • Solely tax allocations with no effect on the partnership’s book capital accounts • If the ceiling rule results in a book allocation to a noncontributing partner that differs from the partner’s corresponding tax allocation, the partnership may make a remedial allocation to the noncontributing partner equal to the full amount of the disparity and a simultaneous offsetting remedial allocation to the contributing partner

  40. Characterization of Gain/Loss • Prevents the conversion of gain or loss from capital to ordinary or vice versa through contribution of property to a partnership • Unrealized receivables – any gain or loss recognized by partnership will be ordinary • Inventory items – remain ordinary income for five years after contribution at which time their character is determined at the partnership level • Capital loss property – built-in loss must retain its character as a capital loss for five years after contribution; any additional loss is characterized at the partnership level

  41. Depreciation – Traditional Method • Tax depreciation on contributed property is allocated first to the noncontributing partner in an amount equal to his share of book depreciation • The balance of tax depreciation is allocated to the contributing partner • Could be affected by ceiling rule

  42. Traditional Method Example • An asset with FMV of $20,000 and carryover basis of $12,000 is contributed to a partnership by A. A and B each have a 50% interest. • Book depreciation = $4,000/yr, five yrs • A & B each receive $2,000 per year • Tax depreciation = $2,400/yr, five yrs • A receives $2,000 (the same as A’s book depreciation) & B receives the remaining $400

  43. Traditional Method Example • After five years: • The tax & capital accounts for A & B are brought back into balance A B Tax Book Tax Book On Formation $12,000 $20,000 $20,000 $20,000 Depreciation (2,000)(10,000)(10,000)(10,000) Balance $10,000 $10,000 $10,000 $10,000

  44. Other Depreciation Methods • Traditional method with curative allocations – curative allocation from another partnership asset or additional ordinary income • Remedial method – tax allocation of additional depreciation to noncontributing partner & simultaneous offsetting allocation of ordinary income to contributing partner

  45. Allocation of Liabilities • Recourse liabilities – allocated in proportion to the partners’ respective shares of partnership losses ( best indication of which partners would be responsible for paying) • Nonrecourse liabilities – allocated by reference to the partners’ respective shares of partnership profits (those debts would be paid from partnership profits or assets)

  46. Allocation of Liabilities • Limited partners • Not liable for partnership losses beyond capital contribution • Share in nonrecourse liabilities • Not allocated partnership recourse liabilities beyond amounts obligated to contribute to partnership or pay to creditor in the future

  47. Recourse Liabilities • A partnership liability is a recourse liability only to the extent that a partner or any person related to a partner bears the economic risk of loss with respect to that debt • To the extent that the partner would ultimately be obligated to pay the debt if the partnership could not pay its own debts • Based on partnership agreement and other legal obligations between partners and creditors

  48. Recourse Liabilities – Example • AB Partnership purchases a building with $70,000 cash ($25,000 contributed each by A and B) and a $20,000 recourse liability. If the building becomes worthless, who bears the economic risk of the $70,000 loss? • A: $25,000 - $35,000 = ($10,000) • B: $25,000 - $35,000 = ($10,000)

  49. Recourse Liabilities – Example #2 • AB Partnership purchases a building with $70,000 cash ($25,000 contributed each by A and B) and a $20,000 recourse liability. Losses are allocated 60% to A and 40% to B. If the building becomes worthless, who bears the economic risk of the $70,000 loss? • A: $25,000 - $42,000 = ($17,000) • B: $25,000 - $28,000 = ($3,000)

  50. Recourse Liabilities – Example #3 • AB Partnership purchases a building with $70,000 cash ($40,000 contributed by A and $10,000 contributed by B) and a $20,000 recourse liability. Losses are shared equally. If the building becomes worthless, who bears the economic risk of the $70,000 loss? • A: $40,000 - $35,000 = $5,000 • B: $10,000 - $35,000 = ($25,000)

More Related