Kahn: Partnership Taxation, Fall 2012
PART 1: AN OVERVIEW OF THE TAXATION OF PARTNERSHIPS AND PARTNERS
I. Introduction to Subchapter K
a. Congress’s goals in enacting subchapter K were to provide simplicity, flexibility and equity as btwn partners.
b. Aggregate vs. Entity approaches
i. Entity: p’ship viewed as separate legal entity
ii. Aggregate: p’ship is merely the relationship btwn individuals (no separate identity) (think “family” to describe a group of people)
iii. Subchapter K takes a hybrid approach (i.e., it employs both); takes an aggregate approach, unless doing so would be too complicated
1. E.g., aggregate – p’ship not treated as a separately taxable entity
2. E.g., entity – p’ship must have its own taxable year and method of accounting
II. Tax Classification of Business Enterprises
a. In General
i. Corporation vs. Partnership Taxing Regimes
1. Corporations
a. Subchapter C
i. Separately taxable entity (entity approach), double taxation
ii. Example: GI = $100 (w/ no deductions)
1. Corporation: $100 TI * 35% = $35 tax
2. SH: $65 dividend * 15% = $10 tax
b. Subchapter S
i. Subchapter K-like
ii. Restrictions on sub-S election (e.g., c/n have more than 100 SHs, no non-resident alien SHs). See § 1361(b).
2. Partnerships (Subchapter K)
a. Pass-through scheme (aggregate approach)
b. Partners include share of p’ship income in individual income (whether distributed or not)
c. $100 GI * 35% = $35 tax
ii. Classification of Corporations vs. Partnerships
1. Statutory Guidance. The definition of “partnership” is so broad it includes organizations that aren’t regarded as p’ships under state law. See § 7701(a)(2). The definition of “corporation” as an association isn’t helpful. See § 7701(a)(3).
2. Pre-1997: Kintner Regs. If an entity had 2 or fewer default corporate characteristics, it was a p’ship; if it had more than 2 it was classified as a corporation. Default corporate characteristics are continuity of life, centralized management, transferrable interests, and limited liability
3. Today. Check-the-box regs. See Reg. § 301.7701.
b. Corporations and Partnerships
i. “Check-the-Box” Regulations
1. STEP 1: Separate Entity. Is the activity/entity an entity separate from its owners? See I.b.ii. Existence of a Separate Entity for Federal Tax Purposes, infra.
a. If no, not subject to classification regulations
b. If yes, move on to the next question
2. STEP 2: Business Entity. Is the entity regarded as a business entity? See Reg. § 301.7701-2(a) (not a trust or subject to special treatment).
a. If no, the entity is classified as:
i. A trust under Reg. § 301.7701-4 or
ii. Subject to special tax treatment (e.g., a qualified settlement fund under § 468B)
b. If yes, move on to the next question
3. STEP 3: Eligible Entity. Is the entity an eligible entity under Reg. § 301.7701-3(a)? That is, is the entity classified as a corporation under Reg. § 301.7701-2(b)(1), (3)-(8)?
a. If yes, the entity is a corporation for federal tax purposes (a “per se corporation”), taxed under Subchapter C or S
b. If no, move on to the next question
4. STEP 4: ≥2 Members. Are there 2 or more members?
a. If yes, the entity can elect to be a partnership OR a corporation
b. If no, the entity can elect to be a corporation or disregarded for federal tax purposes
c. Default Rules. Reg. § 301.7701-3(b)(1).
i. 2 or more members: treated as a p’ship
ii. 1 member: disregarded as an entity
5. Note: an eligible entity that chooses to be an S corporation automatically is treated as making the election to be a corporation
6. Rev. Rul. 2004-77. Second Owner Can’t be a Disregarded Entity. Suppose an eligible entity has 2 owners and 1 of the owners is a disregarded entity (e.g., a single-owned LLC). Since the 2d owner is a disregarded entity, there’s really only 1 owner.
a. Same result if the disregarded entity is a limited partner in a general partnership.
b. There would be 2 owners if the 2d entity is recognized for federal tax purposes.
ii. Existence of a Separate Entity for Federal Tax Purposes
1. Matter of Federal Tax Law. Whether an activity/entity exists as a separate entity is a matter of federal tax law and does not depend on the organization’s status under state law. Reg. § 301.7701-1(a)(1).
2. Undertakings Giving Rise to Entities. A joint venture or other contractual arrangement may create a separate entity if the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom. Reg. § 301.7701-1(a)(2).
a. Joint Profit Motive. Separate entity may exist if co-owners of an apartment building lease space and provide services to occupants. Id.
b. Not Expense Sharing. An undertaking to share expenses doesn’t create a separate entity for federal tax purposes. Id.
c. Not Mere Co-ownership. Mere co-ownership of property that is maintained, rented or leased is not a separate entity for federal tax purposes. Id.
3. Podell v. Commissioner. Podell (P) and Young (Y) agreed that P would provide capital to Y to purchase and renovate property, and they would split the profits. HELD: the agreement gave rise to a joint venture. The key factors considered was the agreement to share profits and a shared right to control. Although P didn’t exercise as much managerial control as Y, he retained the power to approve Y’s actions through his control over continued contributions.
4. Allison v. Commissioner. Acceptance (A) and Investment (I) agreed that A would arrange financing and I would acquire and subdivide property. A received 75 lots. HELD: no joint venture. There was no joint profit motive to sell the 75 lots. A’s receipt of the lots was compensation for its financing obligations.
5. Problem 1 (p. 16). Which of the following relationships are likely to constitute a separate entity for federal tax purposes?
a. (a) A, B and C purchase a single parcel of land as tenants-in-common and hold the land as an investment.
i. No separate entity
ii. Reg. § 301.7701-1(a)(2)
1. Mere co-ownership of property isn’t regarded as a separate entity for federal tax purposes.
2. Last sentence: tenants in common leasing farm property is not a separate entity for federal tax purposes.
b. (b) Same as (a), above, except the land is subdivided and A, B and C sell the lots.
i. Separate entity b/c they have a joint profit motive
ii. Joint venture or other contractual arrangement. See Reg. § 301.7701-1(a)(2).
iii. Similar to Podell b/c of the profit-sharing and shared right to control.
c. (c) Litigator and Negotiator are attorneys who share an office and a secretary. Each attorney services and bills his own individual clients.
i. No separate entity
ii. Expense sharing arrangements not recognized as separate from owners. Reg. § 301.7701-1(a)(2).
d. (d) Doctor will locate and purchase a suitable four unit building. Architect will remodel it. When the work is done, the renovated building will be sold by the Doctor-Architect real estate company and Architect will receive 25% of the net profits.
i. Separate entity
ii. Similar to Podell b/c of the profit-sharing and shared right to control.
iii. Allison is distinguishable b/c here there is profit sharing.
e. (e) Would the result in (d), above, be different if Doctor and Architect agreed that Doctor will retain three of the units as rental property and Architect will receive one unit to hold as rental property?
i. Separate entity status not clear.
ii. One unit to Architect may look like compensation. See Allison.
iii. This isn’t really co-ownership of property. See Reg. § 301.7701-1(a)(2).
ii. Federal Income Tax Treatment
1. Corp – Subchapter C or S
2. LP, LLC – Subchapter K is possible
iii. Federal Employment Taxes
1. Partners – all income subject to self-employment tax
2. LLC classified as p’ship, are all earnings subject to self-employment tax? Not clear.
iv. State Taxes. How do states tax entities (e.g., Texas Margin Tax)?
PART 2: FORMATION OF A PARTNERSHIP
I. Contributions of Property
a. General Rules
i. Nonrecognition of Gain or Loss on Contribution. Gains/losses are not recognized to a partnership or a partner for a contribution of property to the partnership in exchange for an interest in the partnership. § 721(a).
1. Rationale. The transfer of property to a p’ship is considered to be a mere change in the form of the partner’s investment.
2. Property. “Property” is broadly defined to embrace money, goodwill, and even intangible service-flavored assets such as A/R, patents, unpatented technical know-how and favorable loan or lease commitments embodied in a letter of intent secured through the efforts of the contributing partner. “Property” does not include services rendered to the p’ship.
3. § 1245 Property. Generally, gains on the disposition of § 1245 property must be recognized. § 1245(a). But, if a partner exchanges § 1245 property for a p’ship interest under § 721, no gain is recognized. See § 1245(b)(3).
4. Installment Obligations. Generally, gain/loss results from the sale of installment obligations. § 453B(a). But, if a partner contributes property to a p’ship under § 721, no gain or loss will result. Reg. 1.453-9(c)(2).
5. Exception: Investment Company. Subsection (a) does not apply to gain realized on a transfer of property to a partnership which would be treated as an investment company (an entity w/ > 80% readily marketable securities) if incorporated. § 721(b).
ii. Partner’s “Outside Basis” in a Partnership Interest. A partner’s outside basis in a p’ship interest is the amount of money and AB of property contributed, increased by any gain recognized under § 721(b). § 722.
iii. Partner’s Holding Period in a Partnership Interest. Generally, the holding period begins the day after the partner contributes property to the p’ship. The period a partner held contributed property is tacked to the holding period of a p’ship interest if (1) the p’ship interest has the same basis as the property contributed and (2) the property exchanged was a capital asset or § 1231 property. § 1223(1).
1. Capital Asset. “Capital asset” means property, but does not include: stock in trade or inventory; depreciable or real property used in trade/business; A/R for services or from sale of inventory; and supplies used in trade/business. § 1221(a).
2. § 1231 Property. § 1231 property means depreciable and real property used in a trade/business held more than 1 year. § 1231(b)(1).
3. Divided Holding Period. The holding period is divided if the partner acquired portions of the p’ship interest in exchange for property resulting in different holding periods. Reg. § 1.1223-3(a)(2). A holding period relates to the fraction: [FMV of portion of p’ship interest received] / [FMV of whole p’ship interest]. Reg. § 1.1223-3(b)(1). See I.a.vi. Problem (pp. 36–37), infra.
iv. Partnership’s “Inside Basis” in Contributed Property. A partnership’s inside basis in contributed property is the AB of such property to the contributing partner at contribution, increased by any gain recognized under § 721(b). § 723.
v. Partnership’s Holding Period in Contributed Property. The period contributed property was held by the partner tacks on to the p’ship’s holding period if such property has the same basis in the p’ship’s hands as it would have in the partner’s. § 1223(2).
Problem (pp. 36–37). A, B, C and D (all individuals) form a general partnership in which they each have an equal interest in capital and profits. All the partners and the partnership are cash method taxpayers. In exchange for their respective partnership
