Chapter 10 Partnership Taxation

1. Chapter 10Partnership Taxation Income Tax Fundamentals 2013 Student Slides Gerald E. Whittenburg Martha Altus-Buller Steven Gill 2013 Cengage Learning

2. Nature of Partnership Taxation • Partnerships must file an informational tax return called Form 1065 • Partnership itself does not pay tax; rather, income/expenses ‘flow through’ to partners • Partnership income taxable to partner, even if he/she does not receive cash!! • Partnerships must make various elections (depreciation and inventory methods, for example) 2013 Cengage Learning

3. What is a Partnership? • A partnership is a syndicate, group, pool, joint venture or other unincorporated organization through which any business, financial operation or venture is carried • Partnerships are legal entities under civil law • In most states they have rights under Uniform Partnership Act 2013 Cengage Learning

4. Partnership Formation • When forming a partnership, individuals contribute assets to partnership in exchange for a partnership interest • No gain/loss is usually recognized • Exceptions include • When services are performed in exchange for partnership interest • When property is contributed with liabilities in excess of basis, then Recognized Gain = Liabilities Allocable to Others – Adjusted Basis of Property Contributed 2013 Cengage Learning

5. Changes occur to partner’s basis due to subsequent activities Beginning Basis + Additional Contributions + Share of Net Ordinary Taxable Income + Share of Capital Gains/Other Income - Distributions of Property or Cash - Share of Net Loss from Operations* - Share of Capital Losses/Other Deductions +/- Increase/Decrease in Liabilities Basis in Partnership Interest *Note: Can’t take basis below 0 and must comply with at-risk limitations Changes in Partner’s Basis 2013 Cengage Learning

6. Partnership Income Reporting • Partnerships do not pay tax • All information flows through to be reported by the partners • Tax return is due by the 15th of the 4th month following close of partnership tax year • Must report each element of income and expense separately on Form 1065 (Partnership Tax Return) • Schedule K-1 shows allocable partnership income/expenses for each partner, based upon the individual ownership percentage • Ordinary income/loss • Special income/deduction items such as charitable deductions, interest, capital gains/losses 2013 Cengage Learning

7. Guaranteed Payments • Amount that a partner receives for services rendered or use of partner’s capital is called a guaranteed payment • Guaranteed payments are made regardless of income/loss situation of partnership • Guaranteed payments are subtracted before partnership taxable income/loss is allocated to partners • Guaranteed payments are taxable ordinary income to partner and deductible by partnership 2013 Cengage Learning

8. At-Risk Limitations • Partners cannot deduct losses from activities in excess of their investment • Losses limited to amounts at risk (AAR) in those activities • Definitions • A “nonrecourse liability” is a debt for which the borrower is not personally liable and doesn’t count towards AAR • “Encumbered property” is the property pledged for a liability and the adjusted basis is includable in AAR if partner is personally liable for repayment of debt • Taxpayers are at-risk for an amount equal to Cash and property contributed to partnership + Liabilities on encumbered properties (recourse debt) + Liabilities for which taxpayer is personally liable (recourse debt) + Retained profits in activity 2013 Cengage Learning

9. Limited Liability Companies • Limited Liability Companies (LLCs) have attributes of both partnerships and corporations • Advantages of LLCs are numerous • Taxable income/loss passes through to owners • No general partner requirement • Owners can participate in management • Owners have limited liability • LLC ownership interest is not a security • Tax attributes pass through to owners • Offer greater tax flexibility than S corporations (single member LLCs are very common) 2013 Cengage Learning

10. Limited Liability Companies • Disadvantages of LLCs • Because of newness, limited amount of case law dealing with limited liability companies • States are not uniform in treatment of LLCs, so potential for confusion if LLC is operating in more than one state LLCs are quickly becoming a major form of business organization in the U.S. 2013 Cengage Learning