I. Introduction – An overview of the Taxation of Partnerships and Partners
a. In any business entity:
i. Associates joined together to conduct a business activity and divide the profits from that business. Joint conduct of business.
b. General partnership
i. Don’t have to have an agreement like you do for LP, LLP, or LLC’s, or Corp.
c. Distinguishing a partnership from a corporation:
i. Continuity of life
1. Corporation has an existence apart from its owners, the fact that a shareholder does not affect the existence of the corporation.
2. The death of a partner will dissolve the partnership. The partnership does not have an existence apart from its owners.
ii. Centralization of management
1. Corporation has a centralization of management. Elect officers to bind the corporation. The shareholders do not bind the corporation.
2. Partners do not have a centralized management. Partners bind the partnership.
iii. Limited liability
1. Corporation has limited liability.
2. Partnership has unlimited liability.
iv. Free transferability of interest
1. Corporation has the free transferability of interest
a. However, we often put restrictions on this for closely held corporations. That does not change the form of the corporation.
2. Partners do not have the free transferability of interest. Cannot make someone else a general partner without consent of the other partners.
d. Limited partnership
i. General partner has management responsibility
ii. Limited partners do not have management abilities.
iii. Limited liability for limited partners.
iv. Unlimited liability for general partners.
v. What if your general partner is a corporation and has no other interest other than the partnership interest it has… and the corporation is owned by all the limited partners?
1. This could remove the limited partners’ liability.
i. This is the entity of choice now.
ii. Best of all worlds
iii. Corporate characteristics with partnership for tax purposes.
iv. Corporate protection and partnership taxation.
v. Continuity of life
vi. Can have a centralized management if you want it, but you don’t have to.
1. Can be member-managed or it can be managed by elected managers and officers.
vii. Free transferability of interest
1. Can have it if you want or you can restrict it
f. Check the box regs under §771
i. If you form a business entity that is not formed under a state incorporation act, it is a partnership for tax purposes.
ii. The default is partnership status
iii. If you ever are working with foreign entities, there are special rules that must be followed.
1. Foreign entities cannot use the “check the box” partnership default status generally unless there is one party (entity) that has unlimited liability.
2. If no one has personal liability, then that organization will be taxed like a corporation.
g. You can change your tax status, but you must be careful
i. If you elected corporate status and now you want to change to partnership status
1. This will be deemed to be a corporate liquidation which is a taxable event.
h. What is a partnership? When is an entity formed?
i. Uniform Partnership Act
ii. Association of two or more persons who carry on as co-owners a business for profit.
iii. Looking for business activities and whether these parties intended to share profits.
iv. Example: Two people own property and hold it, but if one person gives up his right to dispose of that property without the consent of the other person, that is a significant factor to determine whether this has become an entity. This is a partnership by default and must file a partnership return.
1. §761: an elect out procedure
a. If you have individuals who join together and have an unincorporated arrangement and what they’ve done is acquire property for investment purposes and they are not actively conducting a business… and can you easily determine their income without having to calculate the taxable income of the entity, then you can elect out of partnership status.
b. This is like a safe guard. If you are worried that you might be a partnership, you can elect out of it.
c. Must be able to ascertain each person’s income without having to file an entity return in order to make this election under §761(a)
d. Mere joint ownership in property will not be a partnership; however, business activities associated with that property could make it be a partnership
e. Holding property together for investment purposes is not a partnership.
f. Service’s concern in co-ownership is one party giving up his individual right to make decisions about the property or to give up the property, etc… that starts to look like a partnership.
i. Example: cannot dispose of the property without the consent of the other parties
g. If spouses own an unincorporated business and file a joint return and both materially participate, they can elect to not be a partnership under § 761(a)
i. Don’t have the ability to allocate certain items in special ways like you can in a partnership under §704.
1. No opportunity to make special allocations of partnership items.
ii. Gives you a better opportunity to classify profits that are not subject to payroll taxes. Classify them
vi. Character of the income is determined at the partnership level by looking at the activities of the partnership.
1. If there wasn’t a partnership, then you’re looking at the character of the income to the individuals.
vii. §751: changes in a partner’s shares in certain types of assets.
viii. Characterization of income is determined at the partnership level. It doesn’t matter what the characterization would have been at the partner level.. it’s recognized based on its character at the partnership level.
ix. When trying to determine whether a partnership actually exists, you are looking for a contribution of services, capital, goods, or property in exchange for a partnership interest.
1. Important distinction: Is a new entering partner getting a right to current capital… or are they just providing services for a right to future profits?
o. The role of debt in these entities:
i. Debt does not have any affect on a shareholder’s basis.
ii. Debt does have an affect on a partner’s basis. It’s treated as a cash contribution by him, increasing his basis in the partnership interest.
1. If the partnership has losses, you can pass through those losses, they can only be used to the extent that they don’t exceed your basis. Therefore, you are more likely to be able to use those losses if your debt is a part of your basis.
2. The entity of choice for passing through losses to your basis are partnerships.
3. Remember, that loss also has to pass the at-risk and passive loss rules.. etc. In other words, you still have to make sure it’s deductible
iii. §752: How debt affects one’s outside basis in the partnership basis.
1. An increase in the partnership’s debt is equivalent to a cash contribution.
2. If his share of debt goes down, he will be treated as receiving a cash distribution.
p. §707: Reclassification as a non-partnership Transaction
i. Example: already have AB partnership… C is an architect… enter into arrangement to give C a temporary (short period of time) partnership interest. This would be a capital expenditure… with no immediate tax benefit. Would have to be added to the basis in the building.
1. give the architect a certain percentage of the rental income for a short period of time.
2. give him a percentage of the income over a few years, then he’s no longer a partner
3. this would cause it to be deductible, EXCEPT… 707 makes this be reclassified as a non-partnership transaction.