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Chapter 10

Chapter 10. Partnerships: Formation, Operation and Basis. The Big Picture (slide 1 of 3). For 15 years, Maria has owned and operated a seaside bakery and cafe´ called The Beachsider. Maria would like to expand and has talked to her landlord, Kyle about it.

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Chapter 10

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  1. Chapter 10 Partnerships: Formation, Operation and Basis

  2. The Big Picture (slide 1 of 3) For 15 years, Maria has owned and operated a seaside bakery and cafe´ called The Beachsider. Maria would like to expand and has talked to her landlord, Kyle about it. The Beachsider is one of several older buildings on 3 acres of a 10-acre parcel that Kyle’s family has owned for years. The remaining 7 acres are undeveloped. Kyle and Maria talked to Josh, a real estate developer, and he proposed an expansion to The Beachsider and upgrades to the other buildings.

  3. The Big Picture (slide 2 of 3) The parties agreed to form a partnership to own and operate The Beachsider and to improve and lease the other buildings. Under the plan, Kyle and Maria will each contribute ½ of the capital needed. Kyle’s real estate is valued at about $2 million. Maria’s bakery equipment and the cafe´ furnishings are valued at about $500,000. The improvements will cost about $1.5 million, which Maria has agreed to contribute to the partnership.

  4. The Big Picture (slide 3 of 3) Josh will not contribute any capital to the partnership. Instead, he will manage the construction and the operation of the partnership in exchange for 5% of the capital and 20% of the ongoing profits. His capital interest is valued at $200,000. What are the tax consequences if the trio forms Beachside Properties as a partnership to own and operate the shopping center? What issues might arise later in the life of the entity? Read the chapter and formulate your response.

  5. Partnership Definition An association of two or more persons to carry on a trade or business Contribute money, property, labor Expect to share in profit and losses For tax purposes, includes: Syndicate Group Pool Joint venture, etc

  6. Entities Taxed as Partnerships (slide 1 of 4) • General partnership • Consists of at least 2 general partners • Partners are jointly and severally liable • Creditors can collect from both partnership and partners’ personal assets • General partner’s assets are at risk for malpractice of other partners even though not personally involved

  7. Entities Taxed as Partnerships(slide 2 of 4) • Limited liability company (LLC) • Combines the corporate benefit of limited liability with benefits of partnership taxation • Unlike corporations, income is subject to tax only once • Special allocations of income, losses, and cash flow are available • Owners are “members,” not partners, but if properly structured will receive partnership tax treatment

  8. Entities Taxed as Partnerships (slide 3 of 4) • Limited partnership • Has at least one general partner • One or more limited partners • Only general partner(s) are personally liable to creditors • Limited partners’ loss is limited to equity investment

  9. Entities Taxed as Partnerships (slide 4 of 4) • Limited liability partnership (LLP) • An LLP partner is not personally liable for malpractice committed by other partners • Popular organizational form for large accounting firms • Limited liability limited partnership (LLLP) • An extension of the limited partnership form • All partners, whether general or limited, are accorded limited liability

  10. The Big Picture – Example 1Types Of Partnerships(slide 1 of 2) Return to the facts of The Big Picture on p. 10-1. When Beachside Properties is formed, Kyle, Maria, and Josh must decide which type of partnership to utilize. With a general partnership, Kyle, Maria, and Josh would each be jointly and severally liable for all entity debts. With a limited partnership, one of the partners would be designated as a general partner and would be liable for all entity debts. Because all 3 partners want to have limited liability, they decide not to use a general or limited partnership.

  11. The Big Picture – Example 1 Types Of Partnerships(slide 2 of 2) They do not consider a limited liability partnership because that entity form is typically reserved for service-providing entities. With a limited liability company (or, if their state permits, a limited liability limited partnership), each partner’s losses will be limited to the partner’s contributed capital. Therefore, Kyle, Maria, and Josh decide to form Beachside Properties as an LLC.

  12. “Check-The-Box” Regs • Allows most unincorporated entities to select their federal tax status • If 2 or more owners, can choose to be treated as: • Partnership, or • Corporation • Permits some flexibility • Not all entities have a choice • e.g., New publicly traded partnerships must be taxed as corporations

  13. Election Out of Subchapter K • Some entities can elect to be excluded from partnership treatment if organized for certain activities • Owners simply report their share of operations on their own tax return • Such elections are not common

  14. Partnership Taxation (slide 1 of 3) • Partnership is not a taxable entity • Flow through entity • Income taxed to owners, not entity • Partners report their share of partnership income or loss on their own tax return

  15. Partnership Taxation (slide 2 of 3) • Generally, the calculation of partnership income is a 2-step approach • Step 1: Net ordinary income and expenses related to the trade or business of the partnership • Step 2: Segregate and report separately some partnership items • If an item of income, expense, gain or loss might affect any 2 partners’ tax liabilities differently, it is separately stated • e.g., Charitable contributions

  16. Partnership Taxation (slide 3 of 3) • Electing large partnerships can net some items that would otherwise be separately stated • Must have at least 100 partners and elect simplified reporting procedures • Such partnerships separately report less than a dozen categories of items to their partners • e.g., Combine interest, nonqualifying dividends, and royalty income into one amount, and report the net amount to partners

  17. Partnership Reporting • Partnership files Form 1065 • On page 1 of Form 1065, partnership reports ordinary income or loss from its trade or business activities • Schedule K accumulates information to be reported to partners • Provides ordinary income (loss) and separately stated items in total • Each partner (and the IRS) receives a Schedule K-1 • Reports each partner’s share of ordinary income (loss) and separately stated items

  18. Conceptual Basis for Partnership Taxation (slide 1 of 2) • Involves 2 legal concepts: • Aggregate (or conduit) concept—Treats partnership as a channel with income, expense, gains, etc. flowing through to partners • Concept is reflected by the imposition of tax on the partners, not the partnership

  19. Conceptual Basis for Partnership Taxation (slide 2 of 2) • Involves 2 legal concepts (cont’d): • Entity concept—Treats partners and partnerships as separate and is reflected by: • Partnership requirement to file its own information return • Treating partners as separate from the partnership in certain transactions between the two

  20. Partner’s Ownership Interest • Each owner normally has a: • Capital interest • Measured by capital sharing ratio • Partner’s percentage ownership of capital • Profits (loss) interest • Partner’s % allocation of partnership ordinary income (loss) and separately stated items • Certain items may be “specially allocated” • Specified in the partnership agreement

  21. Inside and Outside Bases • Inside basis • Refers to adjusted basis of each partnership asset • Each partner “owns” a share of the partnership’s inside basis for all its assets • Outside basis • Represents each partner’s basis in the partnership interest • All partners should maintain a record of their respective outside bases

  22. Basis Issues (slide 1 of 3) • Partner’s outside basis is adjusted for income and losses that flow through from partnership • This ensures that partnership income is only taxed once

  23. Basis Issues (slide 2 of 3) • Partner’s basis is important for determining: • Deductibility of partnership losses • Tax treatment of partnership distributions • Calculating gain or loss on the partner’s disposition of the partnership interest

  24. Basis Issues (slide 3 of 3) • Partner’s capital account balance is usually not a good measure of a partner’s adjusted basis in a partnership interest for several reasons • e.g., Basis includes partner’s share of partnership liabilities; Capital account does not

  25. Partnership Formation Transaction

  26. Tax Consequences of Partnership Formation(slide 1 of 2) • Usually, no gain or loss is recognized by a partner or partnership on the contribution of money or property in exchange for a partnership interest • Gain (loss) is deferred until taxable disposition of: • Property by partnership, or • Partnership interest by partner

  27. Tax Consequences of Partnership Formation(slide 2 of 2) • Partner’s basis in partnership interest = basis of contributed property • If partner contributes capital assets and §1231 assets, holding period of partnership interest includes holding period of assets contributed • For other assets including cash, holding period begins on date partnership interest is acquired • If multiple assets are contributed, partnership interest is apportioned and separate holding period applies to each portion

  28. William contributes cash Amount $20,000 Sarah contributes land Basis $ 6,000 FMV $20,000 Todd contributes equipment Basis $22,000 FMV $20,000 WST Partnership Formation Example (slide 1 of 2)

  29. Gain or loss Basis in Partnership’s PartnerRecognizedInterestProperty Basis William $-0- $20,000 $20,000 Sarah $-0- $ 6,000 $ 6,000 Todd $-0- $22,000 $22,000 Neither the partnership nor any of the partners recognizes gain or loss on the transaction WST Partnership Formation Example (slide 2 of 2)

  30. Exceptions to Tax-Free Treatment on Partnership Formation (slide 1 of 4) • Transfers of appreciated stock to investment partnership • Gain will be recognized by contributing partner • Prevents multiple investors from diversifying their portfolios tax-free

  31. Exceptions to Tax-Free Treatment on Partnership Formation (slide 2 of 4) • If transaction is essentially a taxable exchange of properties, gain will be recognized • e.g., Individual A contributes land and Individual B contributes equipment to a new partnership; shortly thereafter, the partnership distributes the land to B and the equipment to A; Partnership liquidates • IRS will disregard transfer to partnership and treat as taxable exchange between A & B

  32. Exceptions to Tax-Free Treatment on Partnership Formation (slide 3 of 4) • Disguised Sale • e.g., Partner contributes property to a partnership; Shortly thereafter, partner receives a distribution from the partnership • Distribution may be viewed as a purchase of the property by the partnership

  33. Exceptions to Tax-Free Treatment on Partnership Formation (slide 4 of 4) • Receipt of fully vested partnership interest in exchange for services rendered to partnership • Receipt of the partnership interest is generally taxable to the partner • Partnership may deduct the amount included in the service partner’s income if the services are of a deductible nature • If the services are not deductible by the partnership, they must be capitalized to an asset account

  34. Tax Issues Relative to Contributed Property (slide 1 of 4) • Contributions of depreciable property and intangible assets • Partnership “steps into shoes” of contributing partner • Continues the same cost recovery and amortization calculations • Cannot expense contributed depreciable property under §179

  35. Tax Issues Relative to Contributed Property (slide 2 of 4) • Gain or loss is ordinary when partnership disposes of: • Contributed unrealized receivables • Contributed property that was inventory in contributor’s hands, if disposed of within 5 years of contribution • Inventory includes all tangible property except capital assets and real or depreciable business assets

  36. Tax Issues Relative to Contributed Property (slide 3 of 4) • If contributed property is disposed of at a loss and the property had a ‘‘built-in’’ capital loss on the contribution date • Loss is treated as a capital loss if disposed of within 5 years of the contribution • Capital loss is limited to amount of ‘‘built-in’’ loss on date of contribution

  37. Tax Issues Relative to Contributed Property (slide 4 of 4) Special allocations must be made relative to contributed property that is appreciated or depreciated The partnership’s income and losses must be allocated under § 704(c) to ensure that the inherent gain or loss is not shifted away from the contributing partner Discussed later in the chapter

  38. The Big Picture – Example 13Contributions To The Partnership (slide 1 of 2) Return to the facts of The Big Picture on p. 10-1. Kyle’s and Maria’s capital contributions to the newly formed LLC are as follows Kyle contributes real estate, basis $600,000, FMV $2 million. Maria contributes bakery equipment, basis $0, FMV $500,000. No tax consequences on formation of Beachside Properties, LLC for the LLC, Kyle, or Maria. Kyle does not recognize his $1.4 million realized gain. Maria does not recognize her $500,000 realized gain. Kyle takes a substituted basis of $600,000 for his interest. Maria takes a substituted basis of $1.5 million ($1.5 million for contributed cash + $0 for contributed property).

  39. The Big Picture – Example 13Contributions To The Partnership (slide 2 of 2) Beachside Properties has the following adjusted basis in the contributed property. A carryover basis of $600,000 for the real estate contributed by Kyle. A carryover basis of $0 for the property contributed by Maria. To the extent that the buildings and other land improvements are depreciable, the LLC ‘‘steps into Kyle’s shoes’’ in calculating depreciation deductions. When Josh vests in his 5% capital interest in the LLC in exchange for services, the $200,000 is taxable to him. Beachside Properties will probably capitalize this amount because it relates to construction Josh’s 20% interest in future profits will be taxed to him as profits are earned by the partnership.

  40. Elections Made by Partnership(slide 1 of 2) • Inventory method • Accounting method • Cash, accrual or hybrid • Depreciation method • Tax year • Organizational cost amortization • Start-up expense amortization

  41. Elections Made by Partnership (slide 2 of 2) • Optional basis adjustment (§754) • §179 deduction • Nonrecognition treatment for involuntary conversions • Election out of partnership rules

  42. Organizational Costs (slide 1 of 2) • Partnership may elect to deduct up to $5,000 of organization costs in year business begins • Deductible amount must be reduced by organization costs that exceed $50,000 • Remaining amounts are amortizable over 180 months beginning with month the partnership begins business

  43. Organizational Costs (slide 2 of 2) • Organizational costs include costs: • Incident to creation of the partnership, chargeable to a capital account, and of a character that, if incident to the creation of a partnership with an ascertainable life, would be amortized over that life • Includes accounting fees and legal fees connected with the partnership’s formation • Costs incurred for the following items are not organization costs: • Acquiring and transferring assets to the partnership • Admitting and removing partners, other than at formation • Negotiating operating contracts • Syndication costs

  44. Start-up Costs (slide 1 of 2) • Start-up costs—include operating costs incurred after entity is formed but before it begins business including: • Marketing surveys prior to conducting business • Pre-operating advertising expenses • Costs of establishing an accounting system • Costs incurred to train employees before business begins, and • Salaries paid to executives and employees before the start of business

  45. Start-up Costs (slide 2 of 2) • Partnership may elect to deduct up to $5,000 of start-up costs in the year it begins business • Deductible amount must be reduced by start-up costs in excess of $50,000 • Costs that are not deductible under this provision are amortizable over 180 months beginning with the month in which the partnership begins business

  46. Method of Accounting (slide 1 of 2) • New partnership may adopt cash, accrual or hybrid method • Cash method cannot be adopted if partnership: • Has one or more C corporation partners • Is a tax shelter

  47. Method of Accounting (slide 2 of 2) • C Corp partner does not preclude use of cash method if: • Partnership meets the $5 million or less gross receipts test • C corp partner(s) is a qualified personal service corp, or • Partnership is engaged in farming business

  48. Required Taxable Year • Partnership must adopt tax year under first of the following tests that applies:

  49. Least Aggregate Deferral – Example 16(slide 1 of 2) Crimson, Inc., and Indigo, Inc., are equal partners in the CI Partnership. Crimson uses the calendar year, and Indigo uses a fiscal year ending August 31. Neither Crimson nor Indigo is a majority partner as neither owns more than 50%. Although Crimson and Indigo are both principal partners, they do not have the same tax year. Therefore, the general rules indicate that the partnership’s required tax year must be determined by the “least aggregate deferral rule.” The following computations support August 31 as CI’s tax year.

  50. Least Aggregate Deferral Example 16(slide 2 of 2)

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