Partnership Tax Outline

The University of Michigan Law School

J. Phillip Adams, Partnership Tax, Winter 2017

Entity Classification and Overview of Partnership Taxation

Analysis:

Is there a business entity recognized for federal tax purposes (→ Do the participants carry on a trade, business, financial operation, or venture and divide profits therefrom (= business activity + joint profit motive))? (Reg. §301.7701-1(a)(2))

Mere co-ownership of maintained, rented, or leased property does not suffice (Reg. §301.7701-1(a)(2));

Entity exists if co-owners lease space and in addition provide services to tenants directly or through an agent, but not an independent contractor
Entity does not exist if such services provided are customary such as heat, A/C, water, parking, normal repairs, trash, cleaning public area (Rev. Rul. 75-374)

Mere expense sharing does not suffice (Reg. §301.7701-1(a)(2));
Profit in-kind satisfies profit motive (Madison Gas);
Percentage based compensation can be viewed as profit motive or as interest, tipping the scale;

If way less or way more than market interest rate, it indicates business participation
If based on the profits of the enterprise, it is more likely to be an entity; if fixed percentage of the principal amount, it is more likely to be an interest

Participation in the business matters – to what extent do the participants control the business? Who bears the risk? Is there a recourse or non-recourse loan? etc.;
No PS books and no PS tax return indicate no join-profit motive, hence no PS (Allison)

If yes, what kind of entity is it?

Is it an entity described as incorporated, corporation, body corporate, or body politic?

If yes, per se a corporation and no electivity
Exception – S corporation that can elect

Is it a publicly traded PS or other entity publicly owned?

If yes, taxed as corporation
Exception – when at least 90% of profit consists of passive investment income

Is there a single owner?

If yes, disregarded unless elected to be treated as a corporation

Are there two or more owners?

If yes, treated as PS unless elected to be treated as a corporation

Is it a trust?

Ordinary trusts, which serves the purpose of protecting trust property, is not an entity
Business trust, which carries on a profit-making business and has 2+ owners, is treated as PS unless elected to be treated as a corporation

If there is PS that did not elect to be treated as corporation, it can elect not to be treated as entity:

Under §761(a), if (1) the participants can determine their income adequately without computing PS taxable income, and (2) it is availed (i) for investment purposes and not active conduct or business, (ii) for joint production, extraction, or use of property but not selling servicer of property, or (iii) by dealers in securities for purposes of underwriting, selling, or distributing securities
Under §761(f), if a married couple conducts qualified joint venture where both materially participate

Partnership Formation: Transfers to Partnerships

§721 Nonrecognition: Except in case of investment PS, neither PS nor partners recognize gain or loss on the transfer of property (≠ services) to PS in exchange for interest in the PS

Applies to the exercise of non-compensatory options to acquire PS interest (but not to their transfer) and debt-for-equity exchanges
Contributed promissory note does not increase contributor’s OAB (VisionMonitor)

§722 Partners’ OAB: Contributing partner takes as basis in the PS interest amount equal to the sum of AB of all contributed property + cash, and can tack the holding period of capital or §1231 property (≠ money, inventory, or services)

OAB (beginning) = AB of property contributed + cash contributions + increase in partner’s share of PS liabilities + partner’s distributive share of PS income and gains (taxable and tax-exempt) – AB of property distributed – cash distributions – decrease in Partner’s share of PS liabilities – partner’s distributive share of PS losses and deductions (deductible and non-deductible) = OAB (ending)

For property contributed that is encumbered with debt, see below

If partner contributes a mix of capital and ordinary assets, the holding period is split in proportion to FMV

§723 PS IAB: PS takes transferred AB in the contributed property equal to that of contributing partner, and can tack the partner’s holding periods

Partnership Formation: Introduction to Partnership Accounting

C/A = cash contributed + (FMV of property contributed – liabilities encumbering the property) + allocations of PS income and gain including tax exempt income – cash distributed – (FMV of property distributed – liabilities encumbering the property) – allocations of expenditures that are neither deductible in computing TI nor properly chargeable to C/A – allocations of PS loss and deductions (Reg. §1.704-1(b)(2)(iv)(b))
If there is a pre-contribution gain or loss allocable to the contributor under §704(c), i.e. AB ≠ BV, this gain or loss is not reflected on the contributor’s C/A because it is already reflected in the value on the PS books

Ex.: A acquires asset for 40, contributes it when its FMV is 60, and the PS then sells it for 160. Upon the sale, the first 20 gain is allocated to A but his C/A is not adjusted. The remaining 100 is then allocated among partners and their C/As are allocated accordingly (Tax gain = AR – AB; Book gain = AR – BV; only this way IAB matches OAB and BV matches C/A)

If there is a distribution of asset which BV ≠ FMV, such inherent gain or loss, although not recognized for tax purposes, must be taken into account for book purposes.

Ex.: AB PS distributes asset with 150 BV and 200 FMV to A and 200 cash to B. A and B’s C/As are 500. Upon the distribution, A’s and B’s C/As are increased by 50 inherent gain in the asset to 525 each, and then reduced by 200 FMV of asset and 200 cash distributed

Partnership Liabilities: Basic Concepts (contribution of property subject to debt)

Recourse Liabilities

A contributes land (FMV 150; AB 50; mortgage 30) in exchange for 30% interest in AB PS; B contributes 120 cash

A gets basis in his PS interest 50, is treated to have 15 debt relief (30/2) and receiving 15 constructive cash distribution (it’s basically two events: debt relieve of 30 and at the same time getting a share of the PS liability 15 → net -15 subtracted from his AB)
A’s OAB: AB 50 – portion treated as constructive cash distribution 15 = 35 (Adams: 50 – 30 + 15 = 35)
B is treated to have 15 constructive cash contribution
B’s OAB: Cash contributed 120 + portion treated as constructive cash contribution 15 = 135

Recourse Liabilities in Excess of Basis

A contributes land (FMV 150;