Chapter 4-Partnership Taxation

Question 1

what is a partnership?

Answer 1

• an association between two or more persons to operate a business as co-owners for profit.
• informal creation since all partners have unlimited liability (everything at risk)
• cash or property are tax free exchanges and have a carry over basis & carry over holding period (holding period of a partnership interest acquired in exchange for a contributed property: for capital assets or section 1231 (non-current business) assets: includes period held by the partner; all other property: when partnership interest acquired)
• services are taxable at FMV of services provided

Question 2

what is the tax treatment for a partnership?

Answer 2

• must file an information tax return annually, since is a flow through entity form 1065, and is due on 4/15.
• extensions are 5 months instead of 6
• tax year must be the same as the partners, or a majority of partners
• accounting is similar to an S Corporation
• the annual informational return reports partnership income and the allocation of that income to the various partners.
• since the items will be reported on the tax returns of the partners, the partnership must segregate items that have special treatment on individual tax returns.
• the partnership prepares a schedule k that summarizes the partnership ordinary income and then separately lists all items that are not ordinary.
• a schedule k-1 is prepared for each partner showing that partners allocated share of all of the items on the schedule k.

Question 3

what is an outside basis in a partnership?

Answer 3

partner basis in the partnership

Question 4

what is an inside basis in a partnership?

Answer 4

partnership basis in their “assets”

Question 5

what is a guaranteed payment in a partnership?

Answer 5

like a salary in an S Corp

• taxable to partner receiving payment; subject to SE tax is considered a separately stated item to the partner receiving the payment
• deductible to partnership as ordinary expense; not a separately stated item to the partnership but is to the partner receiving the payment
• not based on income, should be for services or use of capital.

Question 6

what are the operations of a partnership?

Answer 6

Initial Outside Basis
\+Income
-Loss
\+muni bond interest
-distributions received from partnership
\+your % of partnership liabilities 
-liabilities contributed to partnership
=ending outside basis

Question 7

what is the partners basis?

Answer 7

refers to the amount the partner has at risk in the partnership. a partners basis is NOT identical with the partners Equity/Capital in the business since the amount a partner has at risk (BASIS) includes the partners share of partnership liabilities to creditors. A partners basis INCREASES as a result of each of the following:

• contributions of assets by the partner to the partnership
• borrowings and other debts incurred by the partnership
• allocation of partnership income (distributive share) to the partner

a partners basis DECREASES as a result of each of the following:

• distribution of assets from the partnership to the partner
• allocation of partnership losses (distributive share) to the partner
• repayments and other reductions of debts of the partnership

Question 8

what happens when a partnership is created?

Answer 8

the partners normally make contributions in cash or property. when a partner contributes cash, their basis is increased by the amount paid. when a partner contributes property, their basis is increased by the partners tax basis in the contributed asset (FMV is ignored). if the asset being contributed is subject to a liability, the partners net contribution is reduced because of the contributed liability, but then each partners basis is increased by their individual shares of the liability the partnership has assumed.

• under no circumstances can a partners basis ever be reduced below zero. if a loss would have reduced the partners basis of the distributed asset or in the case of cash distributions report a gain from the distribution.
• **loss reducing basis below zero is not deductible
• **cash distribution exceeding basis results in gain.
• **contributed asset subject to higher liability results in gain by the amount of the NET negative value that the liability created. so basically you take the difference in the initial outside basis + the % of liability assumed less the total liability. if this amount is negative that is the amount of the gain recorded by the partner.

Question 9

when a partner renders services in exchange for an interest in the business, how is that treated?

Answer 9

the partner reports ordinary income equal to the fair market value of the partnership interest being granted, and the partners basis is increased by the same amount.

Question 10

what is the capital account also known as equity accounts?

Answer 10

represents the partners shares of partnership of equity (partnership minus liabilities). a separate capital account for each partner is maintained & the partnership keeps track of each partners capital account and presents and analysis of the capital account on schedule K-1. The capital account is different than the partners adjusted basis. ex. the capital account DOES NOT include a partners share of partnership liabilities, where as the basis does.

Question 11

what are organizational cost?

Answer 11

a partnership may deduct up to 5,000 of organizational expenditures for the tax year in which the partnership begins business, with any remaining expenditures deducted ratably over the 180-month period beginning with the month in which the partnership begins business. the fees include the following:

• partnership filings
• fees for legal and accounting
• start-up costs such as training
• advertising and testing incurred before the start of active trade or business.

Question 12

how do any items always included in the gross income of an individual without restrictions or limitation need to be treated for a partnership?

Answer 12

they need not be separately stated.

Question 13

what are some separately stated items on the schedule k for a partnership and the reason they are not included in ordinary income?

Answer 13

• capital gains and losses (limit on the deductibility of net capital losses)
• section 1231 gains and losses (classification of net gain as capital gain)
• dividends and interest (needed for investment interest limitations)
• passive activities (passive activity loss limitations)
• charitable contributions (must itemize to deduct / up to 50% of AGI)
• section 179 depreciation election (dollar limit on use of election per year)
• tax credits (limited to tax liability)

Question 14

what are the items included in a partnership ordinary income?

Answer 14

• sales
• depreciation
• supplies
• salaries

Question 15

what are guaranteed payments to partners?

Answer 15

payments that are not based on the amount of partnership income or loss but on separate contractual relationships between the partnership and a partner, such as for services rendered or for the use of capital.

the most common example of a guaranteed payment is a salary allocated to a partner who works actively in the conduct of the business, as long as the salary is to be paid regardless of partnership income.

These payments are included in the determination of the ordinary income of the partnership which reduces the ordinary income because they are considered deductions. they must also be separately stated on the schedule k-1 of each partner receiving such payments, so that the partner will include the income received on their individual return.

Question 16

Per IRC 706 (a) what does it require a partnership to adopt in regards to a fiscal year end?

Answer 16

the same tax year as that of the partners (or a majority of partnership interests). ex. if the partners are all individuals that report income using calendar years, the partnership itself should have a calendar year end as well.

Question 17

what is the section 444 election?

Answer 17

when a partnership is allowed to use a tax year other than the normally required year if it has a valid business reason for doing so; it is allowed to select one of the 3 months PRIOR to the required year end like September 30, October 31, November 30. This allows for the deferment of partnership income for the last 3 months into the following year before being taxed on the returns of the partners.

Question 18

how are transactions between a partner and the partnership treated?

Answer 18

they are considered as occurring between two completely independent entities unless the partner owns a majority of the interest in the partnership.

Question 19

how are losses from a sale of property between the controlling partner and the partnership handled?

Answer 19

they are not allowed because it is considered a related party transactions.

Question 20

how are gains from a sale of property between the controlling partner and the partnership handled?

Answer 20

they are characterized as ordinary income. this does not matter whether the interest is owned directly or indirectly.

Question 21

when a partner transfers a capital asset to a partnership in exchange for a partnership interest, what is it considered?

Answer 21

-a nontaxable exchange, the partners’ basis in the asset is the same as the partners tax basis and the holding period begins at the beginning of the partners holding period in order for any gains or losses on disposal to retain their character.

Question 22

how are partnership distributions handled?

Answer 22

they reduce that partners basis in the partnership. Several factors by which the partnership is reduced is based on the following things:

• *non-liquidating (current distributions) the partner continues in the business after the distribution
• *liquidating (the distribution is in the settlement of the partners entire interest in the business
• distributions to a retiring partner are generally treated as received in exchange for that partners interest in the partnership property, and as such are generally treated under the rules that apply to liquidating distributions. payments made by a personal service partnership to a retired partner that are determined by partnership income are treated as income by the retired partner for tax purposes.

Question 23

what are the affects on non-liquidating distributions?

Answer 23

it normally reduces the partners basis in the partnership by the tax basis of the distributed assets in the partnership. however, a partnership basis cannot be reduced below zero.

Question 24

how are distributions in which the assets basis exceeds the partners basis handled?

Answer 24

-cash distributions (the excess of the cash distribution over the partners basis is reported as a gain on the partners individual tax return).

Question 25

how are cash, inventory and unrealized receivable distributions handled in a partnership in a liquidating distribution?

Answer 25

the total of cash unrealized receivables, and appreciation on inventory distributed to a partner is compared to the partners basis in the partnership before the distribution and any excess is reported as a gain or loss on the partners individual tax return.

Question 26

how are property distributions handled in a liquidating distributions?

Answer 26

the basis of the distributed assets is always equal to the partners basis in the partnership before the distribution. if cash is received also, it is deducted from the partners basis FIRST then the remaining amount is allocated to the property bringing the partners basis to zero.

Question 27

what is a liquidating distribution?

Answer 27

distributions to the partner’s that result in all partners basis being reduced to zero.

Question 28

in a liquidating distribution, how are cash and the receipt of property treated?

Answer 28

do the cash first and the remainder is allocated to the property to liquidate the partnerships basis.

Question 29

how are partnership terminations handled?

Answer 29

the amount realized is the sum of:

cash and property received + relief from debt

Question 30

upon partnership termination what is considered an ordinary gain or loss?

Answer 30

inventory and receivables; everything else is considered a capital gain if it is a gain.

Question 31

other than electing to terminate a partnership for having over a 100 partners what will cause a partnership to terminate?

Answer 31

• the business and financial operations are discontinued
• the business is reduced to one partner
• 50% or more partnership interests change hands within a 12 month period

Question 32

when a partnership terminates what must they file?

Answer 32

a final return that covers the period up to the date of termination. the end of the previous partnership and start of the new business are treated as distributions of all assets from the terminated partnership followed by contributions of all the assets to the new business.

Question 33

if a partnership continues with some new partners what must be filed?

Answer 33

the new business must obtain a different tax identification number and file an initial return that begins from the date of the termination of the previous partnership.

Question 34

what happens if a partnership divides into two or more separate partnerships or if two or more partnerships merge?

Answer 34

the partnership into which a majority of the interest of the old partnership divides into two or more separate partnerships, the partnership into which a majority of the interest of the old partnership transferred is considered continuation of that partnership, and the other partnerships are treated as brand new businesses with new contributions of the transferred assets. if none of the separate partnerships hold a majority of previous interests all are treated as new partnerships and the previous partnership is terminated.

Question 35

what is a limited liability company?

Answer 35

owners generally can be individuals, corporations, other LLC or foreign entities and they are referred to as members. in most all cases members have the right to participate in the management of the LLC and are treated as agents.

Question 36

what type of entities can never be structured as LLC’s (limited liability company’s)

Answer 36

banks

insurance companies

Question 37

unless the members of an LLC elect otherwise, how are they taxed?

Answer 37

• they are taxed as a flow through entity
• **if there is one member, it is considered a disregarded entity and the activities of the LLC are reported on the individuals tax return, using schedule C to report income from a business or profession
• **if there are multiple members, the entity is usually treated as a partnership and is required to file an information return (1065). profits, losses, and other pass through items however may be allocated as the members see fit and not necessarily on the basis of ownership percentages
• **the entity may choose to be taxed as corporation by filing an election (form 8832). it may then elect to be taxed as a C corporation or an S corporation.

Question 38

what are some advantages of LLC’s?

Answer 38

• it is considered an entity separate from its owners
• it (the LLC) can sue or be sued
• each member’s liability is limited to their share in the company. distributions to members that renders the LLC insolvent will cause the members to be personally liable.

Question 39

what is a disadvantage of an LLC

Answer 39

in most states if a member leaves the LLC the business is required to dissolved. the remaining members must fulfill any business obligations and close the business, although they may start a new LLC if they so desire. Another disadvantage is that members of an LLC are considered self-employed and are subject to self employment tax on their share of the entire earnings of the LLC.

Question 40

what is a limited liability partnership (LLP)?

Answer 40

an entity formed in which some or all partners depending on the state of jurisdiction have limited liability. it is like a general partnership in that all partners have the right to participate in management of the partnership. Partners in LLP’s are not liable for the misconduct or negligence of other partners. in addition, an obligation of a partnership that is incurred while it is an LLP is the sole obligation of the partnership and the partners are not personally liable.

LLP’s are popular among professionals such as lawyers, accountants, and architects, to provide protection to partners from liability for ill advice that may be given by other partners within the firm.

Question 41

how are limited liability partnerships LLP’s taxed?

Answer 41

similarly to a general partnership

• taxed as a partnership (form 1065) unless the LLP elects to be taxed as a corporation
• if they choose to be taxed as a corporation; the following applies:
• ***a general partner, if there are any is subject to both income tax and self-employment tax
• ***a limited partners share of an LLP’s income or loss is reported as passive income or loss, subject to the passive activity loss limitations.

Question 42

what are some similarities and differences between LLPs and LLC?

Answer 42

formation:

• *both require an enabling statute in the state of formation
• *both are easier to form than a corporation
• *both require filing a certificate with an appropriate state authority such as the secretary of state
• *an LLC may be formed with one or more owners, referred to as members, while an LLP requires 2 or more partners

taxation:

• *both are pass through entities
• *both may report their operations by filing information form 1065 and distributing K-1s to its members or partners
• ——an LLP is always treated as a partnership
• ——an LLC with more than one member/agent is treated as a partnership and those with one member are treated as sole proprietorship’s (schedule c)

liability:

• *both provide owners with some degree of protection
• —–LLC’s generally limit the liability and for contracts of members to their investments plus the costs resulting from their own negligence or malpractice. Unlimited liability for malpractice or negligence
• ——LLP’s (partners) are generally not liable for the actions of co-partners but are generally liable for the obligations and debts of the LLP. limited liability for malpractice or negligence. has unlimited liability for contracts/debts in some states.

Question 43

how can a partnership be considered a large partnership for tax purposes?

Answer 43

by filing form 1065-B and having 100 or more partners in the preceding tax year. a large partnership may be required to pay certain taxes such as a recapture of investment tax credit, but generally all other items of profit and loss pass through to the partners

Question 44

what does the at-risk limitation provision stipulate?

Answer 44

it only applies to individuals and does not apply to entities. the at risk provision may limit a partners deduction for his or her distributive share of partnership losses. the at risk limitations are not applicable to partnerships, so they do not limit a partnerships net operating loss carryover

Question 45

upon termination of a partnership how are payments received by the partners treated as it relates to gains and losses?

Answer 45

take the partnership basis in the corporation less the cash received. the difference will be a gain/loss.

Question 46

guaranteed payments made by a partnership to partners for services rendered to the partnership, that are deductible business expenses under the IRC are what?

Answer 46

1. deductible expenses on the U.S. Partnership Return of Income, Form 1065, in order to arrive at partnership income (loss)
2. included on schedules k-1 to be taxed as ordinary income to the partners.

Question 47

a partnership distributes property to a partner is handled how?

Answer 47

the PARTNERSHIP does not recognize any GAIN OR LOSS. the PARTNER assumes a carryover basis form the partnership and the partner recognizes a gain or loss when the partner subsequently sells or otherwise disposes of the property.

Question 48

cash and property distributions do what to a partners basis in the partnership

Answer 48

a property distribution reduces a partners basis in the partnership by the adjusted basis amount that the partnership is holding the property for. cash also reduces the partner’s basis in the partnership

Question 49

partner receiving a LIQUIDATING distribution

Answer 49

the partner ONLY recognizes gains to the extent of the CASH received EXCEEDS the PARTNERS basis in the PARTNERSHIP. IN LIQUIDATING DISTRIBUTIONS, RECEIPT OF PROPERTY ALONG WITH CASH; THE PROPERTY IS IGNORED AND NOT CONSIDERED PART OF THE GAIN RECOGNIZED BY THE PARTNER.