Partnership Formation and Operation

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• Chapter 9
• Partnership Formation and Operation

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Partnership Definitions

• Tax definition a syndicate, group, pool, joint
  venture or other unincorporated organization that
  carries on a business
• General partnership two or more partners with no
  specific restriction on duties
• Limited partnership one or more partners have
  restrictions on both duties and liabilities
• Electing large partnership (ELP) non-service
  partnerships with at least 100 partners

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Partnerships

• File 1065 Information
• partnership pays no taxes
• tax items flow through to partners income tax
  returns
• nature and character of items remain the same
  (e.g. ordinary, capital gain)
• partners receive a Form K-1 explaining the income
  or loss and separately reported items

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Loss Limitation

• Losses shown on the partners Form 1040 are
  limited to the amount of the individuals basis
  in the partnership.
• A partners basis may be increased by earnings of
  the partnership, additional contributions or
  additional assumption of partnership debt.

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Normal Distributions

• Payment of money to the partner is usually a
  tax-free distribution because the earnings have
  been previously taxed.
• If distributions exceed the partners basis, a
  gain may be recognized.

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Consequences of Partnership Formation

• General Rule No gain or loss to partner (under
  721)
• No gain or loss to partnership
• Partners basis in partnership interest
  substituted basis of contributed property

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Partnership Formation

• Partnerships basis in property received
  carryover of partners basis
• Gain deferred until taxable disposition of
• property by partnership, or
• partnership interest by partner

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Partnership Formation

• Exception Partner must recognize gain
• If property is contributed subject to a
  liability and reduction in partners liability
  exceeds his partnership basis
• generally capital unless depreciation recapture
• If partnership interest is received in exchange
  of services
• If partnership would be investment company if
  incorporated
• contribution followed by distribution

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Partnership Tax Year

• Earliest of following tests met
• Majority partners tax year (partners with same
  tax year owning gt50)
• Principal partners tax year (all partners owning
  gt 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

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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 (gt50)
• Both are principal partners (gt5), but do not
  have same year end
• Must use least aggregate deferral test to
  determine required taxable year

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Least Aggregate Deferral Example

• 1. Test June 30 as possible year end
• Partner. Year End 0 Mo. Deferral
  Weight
• 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.

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Tax Year

• Can elect fiscal year if deferral period not more
  than 3 months
• Must make required payment (Deferred income x
  40.6) 444
• Taxable year does not close with death, entry,
  sale or liquidation of partners 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

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Partnership Income (Loss)

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

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Partnership Income (Loss)

• Separately reported items include
• Net ST and net LT capital gains and losses
• Sec. 1231 gains and losses
• Charitable contributions
• Sec. 179 expense (limited to 19,000 for 1999)
• Interest, dividend and royalty income
• Interest expense on investment indebtedness
• Net income or loss from rental real estate
• Net income or loss from other rental
• Foreign income taxes
• Dividends eligible for DRD

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Partnership Income or Loss

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

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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 years
  contributing partner recognizes precontribution
  gain
• can avoid if like-kind distributed to
  contributing partner w/in 180 days or due date of
  tax return

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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
  partnerships tax year
• Not employee for fringe benefits

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Basis

• Partners basis in the partnership is equal to
  the money contributed plus the partners basis in
  the contributed property.
• Partnerships basis in the property is the
  partners old basis before the contribution.

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Partners Basis Issues

• Outside Basis Inside Basis
• Partners basis Partners basis
• in partnership in share of
• interest partnership assets
• General rule when partnership is formed, inside
  basis outside basis

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Partners 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

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Partners Outside Basis

• Changes in liabilities affect basis
• Increase in share of partnerships liabilities
  increases partners basis
• Decrease in share of partnerships liabilities
  decreases partners basis
• Increase in partners individual liability
  increases partners basis
• Decrease in partners individual liability
  decreases partners basis

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Limitation of Partnership Loss

• Limited to partners 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

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Other Limitations

• No loss can be deducted on the sale of property
  between a partnership and a more than 50 owner
  (direct or indirect).
• Gains on the sale of property involving a more
  than 50 owner produce ordinary income unless the
  property will be a capital asset in the hands of
  the new owner.

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Guaranteed Payments

• Always ordinary income to the recipient
• Deductible by the partnership from ordinary
  income but not from capital gains
• Can create ordinary losses
• Losses due to guaranteed payments are allocated
  among the partners

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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

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Donor-Donee Allocations

• Donor must be allocated reasonable compensation
  for services rendered to the partnership.
• Remaining partnership income must be allocated
  based on relative capital interest.

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Review

• Partnership formation 721
• Tax Year
• Partnership income or loss
• Distributive share of income or loss
• Partners basis
• Loss limitations
• Guaranteed payments
• Family partnerships