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Chapter 10 Partnership Taxation

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Title: Chapter 10 Partnership Taxation


1
Chapter 10Partnership Taxation
  • Income Tax Fundamentals 2010
  • Gerald E. Whittenburg
  • Martha Altus-Buller

2
Partnership Accounting PeriodsChapter 7 pg 7-2
through 7-4
  • Tax year must be the same tax year as 50 of
    partners
  • If majority of partners tax years are different,
    must use tax year of principal partners
  • Principal partner defined as partner with at
    least 5 share in profits or capital
  • If principal partners have different tax years,
    partnership generally required to use least
    aggregate deferral method
  • Note Partnerships dont pay tax as an entity

3
Accounting Periods
  • Partnerships/S-Corporations may elect to adopt a
    different fiscal tax year from the one prescribed
    on previous slide, but only
  • If entity can demonstrate that natural business
    cycle easily conforms to fiscal year other than
    calendar year
  • Such as golf course (natural cycle in Denver ends
    in October)
  • Note S-Corporations dont pay tax as an entity

4
Required Tax Payment
  • Even though S-Corporations and partnerships dont
    pay tax, the entity must make an estimated
    payment if choosing to use a fiscal year-end
    different from calendar year-end
  • Estimated taxes are calculated as
  • Estimated deferral period taxable income
  • x
  • (Highest individual tax rate 1)
  • Estimate deferral period taxable income by using
    average monthly income from preceding fiscal year

5
Required Tax Payment Example
  • Example
  • San Juan River Expeditions Inc., an S-Corp, has
    taxable income of 360,000 for the year ended
    9/30/09 with a three-month deferral period. The
    company made a 15,000 payment last year. Whats
    their current required tax payment?

6
Solution
  • Example
  • San Juan River Expeditions Inc., an S-Corp, has
    taxable income of 360,000 for the year ended
    9/30/09 with a three-month deferral period. The
    company made a 15,000 payment last year. Whats
    their current required tax payment?
  • Solution
  • The required tax payment
  • (Estimated taxable income in deferral period x
    36) - prior years tax payment
  • Deferral period is 3 months (October
    December)
  • (360,000/12) x 3 months 90,000
    (90,000 x 36) 32,400
  • (32,400 - 15,000) 17,400 estimated tax
    payment due in current year

7
Tax Year for Personal Service Corporation
  • A Personal Service Corporation (PSC) is a
    corporation with shareholder-employee(s) whom
    provide a personal service, such as architects or
    dentists
  • Generally must adopt calendar year
  • However, can adopt a fiscal year if
  • Can prove business purpose
  • or
  • Fiscal year results in a deferral period of less
    than 3 months and
  • Shareholders salaries for deferral period are
    proportionate to salaries received during rest of
    the period or
  • Corporation limits its salaries deduction

See next slide
8
PSC Limit on Salaries Deduction
  • Purpose is to keep the PSC from deducting one
    years salary in first nine months
  • If salaries dont remain constant, the PSC can
    only deduct pro rata amount
  • Based on a required formula

9
Short Period Taxable Income (TI)
  • If taxpayer has a short year (other than
    first/last year of operation), tax is calculated
    based on following example
  • In 2009, Flo-Mex changes from a calendar year to
    tax year ending 9/30. For the short period 1/1/09
    9/30/09, Flo-Mexs taxable income 20,000.
  • Calculate tax for the short period
  • Annualize TI 20,000 x 12/9
    26,667
  • Tax on annualized TI 26,667 x 15
    4,000
  • Allocate tax to short period 4,000 x 9/12
    3,000
  • Individual taxpayers rarely change tax years
  • Chapter 1, page 1-3

10
Nature of Partnership TaxationChapter 10
  • Partnerships must file an informational tax
    return
  • Form 1065
  • But partnership itself does not pay tax
  • 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)

11
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 on
  • Simply co-owning property does not constitute a
    partnership
  • Note many co-owners of real estate choose to
    operate as a limited partnership or limited
    liability company

12
Partnership Agreement
  • Can form general partnership by simple verbal
    agreement
  • However, prudent to document agreement in writing
  • General partners usually take on risk of legal
    liability for certain partnership actions and
    debts
  • Limited partnerships or Limited Liability
    Companies (LLCs) limit some of that exposure
  • Limited partnerships or LLCs are required to
    register with state in which they are formed

13
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

14
Partnership Formation
  • Partners basis in partnership interest
  • Cash contributed
  • plus Basis of property transferred to
    partnership
  • plus Gain recognized (from prior screen)
  • less Liabilities allocable to other partners
  • Equals Partners initial basis in partnership

15
Example 1 Partnership Formation
  • Example
  • Anna contributes equipment with a 100,000 fair
    market value (FMV) for a 50 interest in JSC
    Partnership. The equipment has an adjusted basis
    of 45,000 and a 12,000 mortgage against it,
    Anna also renders legal services valued at
    13,000. What is Annas basis in the partnership
    interest? Does she recognize any taxable gain on
    this transaction?

16
Solution
  • Example
  • Anna contributes equipment with a 100,000 FMV
    for a 50 interest in JSC Partnership. The
    equipment has an adjusted basis of 45,000 and a
    12,000 mortgage against it, Anna also renders
    legal services valued at 13,000. What is Annas
    basis in the partnership interest? Does she
    recognize any taxable gain on this transaction?
  • Solution
  • Anna must report 13,000 of ordinary income
    because of services performed. The liability
    (mortgage) allocable to other partners (6,000)
    does not exceed the basis of the property
    contributed, so no gain recognition. Her basis
    in the partnership interest equals 52,000.
  • 45,000 13,000 - .50(12,000)

Annas partnership basis adjusted basis in
equipment income recognized - liability assumed
by other partner
17
Example 2 Partnership Formation
  • Example
  • Leisle contributes land with a FMV of 2,000,000
    for 60 interest in Fuel Cell Tech LLP. The land
    has a basis of 450,000 and a mortgage of
    1,200,000. What is Leisles basis in the
    partnership interest and does she have any
    taxable gain on this transaction?

18
Solution
  • Example 2
  • Leisle contributes land with a FMV of 2,000,000
    for 60 interest in Fuel Cell Tech LLP. The land
    has a basis of 450,000 and a mortgage of
    1,200,000. What is Leisles basis in the
    partnership interest and does she have any
    taxable gain on this transaction?
  • Solution
  • Leisle has contributed property with liabilities
    assumed by other partners in excess of basis, so
    her taxable gain is (1,200,000 x 40) -
    450,000 30,000
  • Leisles basis in her partnership interest equals
    0.
  • 450,000 30,000 .40(1,200,000)

Her adjusted basis in land gain recognized -
liability assumed by other partners
19
Changes in Partners Basis
  • Changes occur to partners 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
  • - Share of Net Loss from Operations
  • - Share of Capital Losses/Other Deductions
  • /- Increase/Decrease in Liabilities
  • Basis in Partnership Interest
  • Note Cant take basis below 0 and must comply
    with at-risk limitations

20
Example Basis Adjustments
  • Example
  • Suresh and Kia enter into a partnership, sharing
    equally in the profits and losses. Suresh
    contributed land with a 70,000 basis and
    150,000 FMV . Subsequent to formation, the
    partnership incurred liabilities 130,000 and
    the partnership income for 2009 totaled 42,000.
  • What is Sureshs basis in the partnership
    interest at year-end?

21
Solution
  • Example
  • Suresh and Kia enter into a partnership, sharing
    equally in the profits and losses. Suresh
    contributed land with a 70,000 basis and
    150,000 FMV . Subsequent to formation, the
    partnership incurred liabilities 130,000 and
    the partnership income for 2009 totaled 42,000.
  • What is Sureshs basis in the partnership
    interest at year-end?
  • Solution
  • 70,000 .50(130,000) .50(42,000)
    156,000
  • Beginning balance 50 liabilities 50
    net income

22
Partnership Income Reporting
  • Partnerships do not pay tax
  • All information flows through to be reported by
    the partners
  • Tax return is due by 15th of 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

23
Partnership Income Reporting
  • Income and expenses flow through to individuals
    tax return
  • On the individual partners tax return the
    deductible losses from partnership activities are
    limited to basis in partnership interest
  • Cannot reduce basis below zero
  • Carry forward any unused losses to subsequent
    years (when there may be basis to absorb loss!)

24
Current Distributions
  • Partnerships may make distributions of money or
    other property to partners
  • A current distribution is one that does not
    completely terminate a partners interest
  • No gain recognized by partner, unless partners
    basis in partnership has reached zero
  • Then, only the portion of the current
    distribution that is in excess of partners basis
    is taxed

25
Guaranteed Payments
  • Amount that a partner receives for services
    rendered 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

26
Tax Years Partnerships
  • Unless it can show bona fide business purpose for
    adopting another fiscal year-end, the partnership
    must adopt the same tax year as the majority of
    the partners
  • If this is not possible, it must adopt same tax
    year as majority of the principal partners
  • If neither of these work, partnership must use
    the least aggregate deferral method (see major
    tax service for more information)

27
Transactions Between Partners Partnerships
  • Generally, transactions between partners and the
    partnership are not regarded as related party
    transactions
  • However, if a partner with more than 50 direct
    or indirect ownership sells assets to the
    partnership (or two partnerships with gt 50
    ownership by same partner)
  • And a gain results it is taxed as ordinary
    income
  • And a loss results the loss is disallowed and
    any gain on future sale of asset by the
    partnership is reduced by the deferred loss
  • Note Indirect ownership means through
    spouse, siblings, lineal descendants and
    ancestors

28
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
  • Encumbered property is the property pledged for
    a liability
  • 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

29
At-Risk Limitations
  • Taxpayer allowed a loss deduction allocable to
    business activity to the extent of
  • Income received or accrued from activity without
    regard to amount at risk
  • or
  • Taxpayers amount at risk at the end of the tax
    year

30
Real Estate At-Risk Rules
  • Real estate acquired before 1987 is not subject
    to at-risk rules
  • For real estate acquired after 1986, the
    qualified nonrecourse financing is considered
    to be the amount at risk
  • This is defined as debt secured by real estate
    and borrowed from person who regularly engages in
    the lending of money
  • Does not apply to financing from seller or
    promoter

31
Example Real Estate At-Risk
  • Example
  • Jolene buys a real estate investment and gives
    200,000 cash as a down payment she also borrows
    800,000 which is secured by a bank mortgage on
    the property. What is Jolenes amount at risk?
    Would this answer change if she had obtained the
    mortgage from the seller?

32
Solution
  • Example
  • Jolene buys a real estate investment and gives
    200,000 cash as a down payment she also borrows
    800,000 which is secured by a bank mortgage on
    the property. What is Jolenes amount at risk?
    Would this answer change if she had obtained the
    mortgage from the seller?
  • Solution
  • Jolene has 1,000,000 at risk in this real estate
    investment. If the mortgage had been obtained
    from the seller, her amount at risk would be
    limited to the down payment of 200,000.

33
Limited Liability Companies
  • Limited Liability Companies (LLCs) are a cross
    between a partnership and a corporation
  • Treated generally as a partnership for tax
    purposes
  • Each owner has limited liability (similar to a
    corporation)
  • 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

34
Limited Liability Companies
  • Disadvantages
  • 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 operating in more
    than one state
  • Note Limited Liability Companies quickly
    becoming a major form of business organization in
    the U.S.

35
Thats All
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