Partnership Tax-Fall 2012
Professor Roberts
Book Value of Assets = FMV of asset at time of contribution
· What p-ship received in exchange for delivery of partnership interest to partner
· Net A/R & A/P contributed
Inside Basis of Assets = Basis in hands of contributing partner § 723
· Basis of Partnership in its assets
Outside Basis (On Formation)= A/B of Property Contributed + Cash Contributed – Liabilities Shed + Share of Liabilities Assumed by P-ship
· Each Partner’s basis in its p-ship interest
Tax Capital = A/B of Assets – Liabilities assumed by p-ship
· Each partner’s contribution to tax basis
Book Capital = Value of Assets Contributed – Liabilities assumed by p-ship
· Each partner’s equity in p-ship
Outside Basis =
· Contributions
o Amount of Cash
o Basis of Contributed property
· + Share of liabilities
o Is the liability
§ Recourse
§ Non-Recourse
o Is the partnership
§ General
§ Limited
· § 705 Adjustments
o + Distributive Share
§ Taxable income
§ Tax-exempt income
o – (but not below zero) Distributive Share
§ Losses
· Losses cannot be deducted if they bring outside basis below 0.
§ Non-deductible expenditures
· Look for Gain/Loss On Distribution
o Loss
§ Liquidating: Loss to extent of money (cash/mkt securities) + unrealized receivables + inventory in excess of O/B if those are only property distributed.
· If receive property, it receives basis = O/B – money distributed
§ Non-liquidating: Loss is suspended until have O/B to decrease
o Gain: Only recognized if money (cash/mkt securities) distributed exceeds O/B
Choice of Entity
Entity Classification
· Two Pronged approach:
o 1. Is there an entity?
§ 301.7701-1(a)(2)- in order for their to be an entity there must be BOTH:
· 1. Business Activity; and
· 2. Sharing of Profits.
§ If just an investment entity then it is not a business entity. Must satisfy both.
· May be excluded from p-ship laws (§ 761(a)):
o if for investment purposes only & not active conduct of business
o for joint production, extraction, or use of property but not for the purpose of selling services or property produced or extracted; or
o by dealers in securities for a short period for purpose of underwriting, selling or distributing a particular issue of securities.
o IF income of members may be adequately determined w/o computation of partnership taxable income.
§ Can file under 1.761-2(b) to get Secretary to recognize you are not a business entity
· If investment joint venture this is how you avoid the risk of being taxed as a partnership.
§ Business Entity = any entity recognized for feferal tax puroses that is not a trust
o 2. Is the entity partnership, trust, estate or corporation?
§ Under §761 if an entity is not a corporation, trust or estate then it is a partnership
Partnership-§761(a)- includes a syndicate, group, pool, join venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation, and the term “partner” includes a member in such syndicate, group, pool, joint venture, or organization.
o Trust-301.7701-4
o Corporation- 301.7701-2(b)- includes associations, joint-stock companies & insurance companies, if publicly traded or organized under local law as corporation.
o If single member entity- this entity is disregarded for federal tax purposes
§ i.e. single member p-ship
Check the Box Rules
Once you classify as a business senity under the Regulations you will be subject to Subchapter K unless you elect out.
· Basic Test for P-ship under IRS
o 1. Is it a business entity?
o 2. Has it elected to be a corporation or treated as one? If no, then
o 3. Is there more than one member?
§ If yes then taxed as partnership, 301.7701-2(c), -3(b)(1)(i)
§ If no then disregard entity
· If the ownership interest of the entity are publicly traded, the entity will be taxed as a C Corporation even if a p-ship for local law purposes. If organized as corporation under local law then it is a C Corp unless eligible & elects to be an S corp.
· All other entities w/ 2 or more members, will be taxed as partnerships unless they make an affirmative election to be taxed as a C Corp.
Reasons to Elect Out- certain elections must be made by the p-ship & like kind property exchange under § 1031 will not work; exchanging p-ship interest for property.
Reasons For Choosing a Form of Entity
1. TAX REASONS- single level of tax in partnerships & LLCs b/c pass-through
2. Pass-thus of Losses
a. Negative Factor w/ respect to C Corps NOLS- may expire unused and carry-forwards are subject to TVM.
b. Limitations on Uses of Passed-Thru Losses- Partners may not pass thru losses in excess of their basis in their p-ship interests. Certain limitations on losses due to NRD.
i. S Corps v. Partnerships- P-ship borrowing increases outside basis in partnership interests. This does not happen w/ S Corp stock. Therefore, passed-thru losses are subject to less limitation w/ respect to p-ships that borrow as opposed to S corps that borrow.
3. IPOs
4. Reputation Concerns
5. Liability
C Corporation- pay double tax on earnings; accumulate rather than pass through NOLs
S Corporation- Losses limited to basis; basis does not include liabilities
Partnership- No double tax earnings; losses limited to basis but basis includes liabilities; no accumulation of NOLs, losses are immediately available to partners to offset income.
PARTNERSHIP TAX SHELTER:
An investment in a depreciable asset is not likely to function as a tax shelter unless it is debt financed. By borrowing a portion of the funds required for the initial investment in the asset, the investor can claim the depreciation on the full investment, deduct the interest payments on the borrowed funds from taxable income, and pay off the debt when the shelter is disposed of. Investors with the highest marginal tax rates naturally benefit most from the deductibility of interest payments. As the leverage in the deal is increased, the tax losses grow relative to the personal funds contributed by the investor, thereby allowing more of the investor’s other income to be sheltered from taxation for a given depreciable asset. The associated economic cost of leverage is that it also increases the investor’s exposure to risk. Additionally, it is the use of leverage to finance tax-sheltered investments-and the notion that higher leverage might in some cases not actually imply an increase in exposure-that has historically drawn the scrutiny of the Internal Revenue Service (IRS) and motivated congressional reforms such as the passive loss rules.
Aggregate v. Entity- p-ship is treated as entity for some purpose & looked at in aggregate for others.
· Entity Characteristics of P-ships –
o Single Method of Accounting
o Single Taxable Year
o Single Information Return
o Makes elections like §754, defer gain from involuntary conversions, use installment reporting, amortize startup expenses, bonus depreciation
o Choice of Depreciation Convention & Installment Method. 703(b)
· Aggregate Characteristics of P-ships- this is the flow-through notion
o Tax paid only at individual level and partners file own returns
o Partnership agreement spells out how income/losses are distributed.
o Mostly treated as aggregate
Commissioner v. Culbertson
· Facts: Guy sold his herd of cattle to Culbertson & his four sons. Sons paid back loan w/ gift from father & from proceeds from partnership. IRS concerned that father should have claimed all profits b/c the sons provided no substantial capital or vital service to the p-ship.
· Issue: Do you have to split profits or provide vital services before you can be a business entity?
· Holding: The actual intent of the parties to form a p-ship is of primary concern. Whether you have contributed capital, services or property presently. Future intent is not important.
Entity Chart
Form
Liability
Transfer of Ownership
Agency
Taxation
Owner/Employee
Other
Joint venture/ Co-owners
Joint/Several
Must transfer interest in each piece of property
Co-owners are agents for each other
Have a business entity if you must net expanses against income to determine profits. If not BE, then taxed as individuals, if BE, default is Partnership unless election to be taxed as Corp
If hire employees, must net expenses to determine profits. Turns JV Co-ownership into a business entity
Corporation
Limited to interest in shares
Easy; transfer shares
Officers bind corporation
Double taxation on earnings and dividends; Net operating Loss carried back or forward
Owners (taxed on dividends) can be employees (taxed separately on comp). Comp Deductible.
Go public easily; familiarity for foreign investors; dominant form in particular industries
Subchapter S Corp
Limited to interest in shares
Easy; transfer shares; BUT identity (individuals mostly), and number of transferees limited (100); 1 class of stock
Officers bind corporation
May elect pass-through taxation, but proportionate sharing of tax attributes; losses limited to shareholder basis; basis does not include corp liabilities
Owners (taxed on dividends) can be employee (taxed separately on comp). Comp deductible
General Partnership
Joint/ Several
Easy; transfer partnership interests. May be limited by pship agmt
Each partner binds partnership
Partnership; pass-through taxation; can distribute property w/o gain recognition; losses limited to basis; but includes liabilities; no accumulation of net operating losses
Owner/Employee compensation and distributive share taxed under OASDI
Limited Partnership
GP fully liable; LPs limited to interest in partnership
Easy; transfer partnership interests
GP binds partnership; LPs cannot or risk losing limited liability
Partnership; pass-through taxation; can distribute property without gain recognition; losses limited to basis; but includes liabilities; no accumulation of NOLs
GP/Employee compensation and distributive share taxed under OASDI`
LLC
Member liability limited to membership interests
Easy; transfer membership interests
Manager managed; mgr binds partnership; member managed: members vote to
Partnership; pass-thru taxation; can distribute property without gain recognition; losses limited to basis, but includes liabilities; no accumulation of NOLs
Owner/Employee comp and distributive share taxed under OASDI= SOCIAL SECURITY
Problems
1. A & B purchase unimproved land as co-tenants, are they an entity in following cases:
a. Hold for appreciation: No b/c not carrying on trade or business. Must be doing that plititng profits net expenses.
b. Lease land to Z who uses for farming: possible no entity but if paying taxes & i
c)- is treated as a partner liability for 752 purposes. Not partner or related person bears any risk of economic loss.
o Recourse- partner or related person bears the risk of economic loss.
o Accounts Payable- are not p-ship liabilities for 752 purposes
o 752 Distributions & Contributions are contributions & distributions for all purposes & may be included in taxable income
· Contribution by Partner of Promissory Notes- Partner has 0 basis in note. 0 basis carries over. Contrast w/ Crane—taxable purchase of asset for a note gives purchases FMV basis in asset.
· Contribution of Accounts Receivable- income inherent in the accounts receivable must be taxed to the contributing partner. Property for purpose of 721 but assigned transferred basis of 0 under 723 & characterize as ordinary income under § 724 then allocating under 704(c).
· Contribution of Accounts Payable- not considered p-ship liabilities & under 704(c)(3) p-ship must allocate to contributor/assignor the deduction for the payables when they are paid.
o Prevents recognition of gain on contribution of certain ongoing business to p-ships & equivalent of assigning income
· Net Receivables or Payables- net cash method receivables are booked at their net FMV. Ex: 90 receivables + 50 payables contributed to p-ship. 40 FMV reflected on balance sheet. Pro rata portion of 50 payables are not deemed assumed by partners.***
· Basis of a Purchased P-ship Interest-§742- Cost basis is used. This is different from 722 basis upon contribution.
o Difference between a contribution & purchase: a purchase is entirely external to the p-ship, while a contribution is a transaction between partner & p-ship.
· LOSSES are only allowed to extent of outside basis. No outside basis received from promissory note from yourself. 731(a)(2). Oden.
Equilibrium of Inside & Outside Basis: Generally, the rules of initial & adjusted inside & outside basis keep the two in equilibrium. This should prevent gain or loss from being recognized upon liquidation. Case in which there will not be equilibrium:
· 1. If a 3rd part buys a p-ship interest (can take an FMV outside basis); and
· 2. If a partner recognizes gain upon contribution due to p-ship’s assumption of liabilities encumbering contributed assets in excess of basis. 751, 733, 731******
· Inside Basis & Book Value relate to value of property at time of transfer. Outside basis relates to investment in the p-ship.
Holding Period
§1223- partner’s holding period is tacked to p-ship’s holding period
· Outside Holding Period- tacked if asset contributed is a capital asset
· Split Holding Period- In the case of p-ship interest received in exchange for cash + property or for two or more items of property, there may be a split holding period, b/c, under 1223(1) there has to be a holding period in the property exchanged. 1.1223-3(a). In, such case holding period is allocated to each item of contributed property according to gross FMV. 1.1223-3(b)*****
o Example: B contributes machinery w/ basis of $50 & FMV of $75 and $25 cash. Holding period of partnership interest equals FMV of Machine/Total FMV= ¾ of interest will have tacked holding period & ¼ will have new one.***
o Marketable Securities are treated like cash.***
Character of Gain/Loss
· Character of Gain Upon P-ship disposition of p-ship property- §702(b)- subject to exceptions in § 724, gain or loss upon disposition of p-ship property is determined at the p-ship level.
· Treatment of Built-in Gain or Loss-§704(c)(1)(A)- built-in gain or loss of contributed property must be taken into account by the contributor when disposed of by the p-ship. Any further gain may be allocated among the partners using a different method.
o Built-in Gain- If sold w/in 7 years then GAIN attributed to contributing partner
o Built-in Loss- If sold within 5-years then Loss is allocated to contributing partner.
· Characterization of Gains & Losses from Certain Types of Contributed Property***-§724- if a p-ship disposes of assets that were inventory or dealer proper in hands of contributing partner that are:
o Unrealized Receivables-§§ 724(a), 751(c)- gain is ordinary from the disposition of a p-ship assets which were unrealized receivables in the hands of the contributing partner.
§ Gain from unrealized receivables is always ordinary if they had this characteristic when contributed
o Inventory Items-§ 724(b)- all gain or loss (not just 704(c) gain or loss) recognized by the p-ship within 5 years of contribution of an item that is an inventory item in the hands of the contributing partner is ordinary.
§ If partner contributes inventory & p-ship sells in 5 years then ordinary gain.
o Capital Loss Property-§724(c)- loss recognized by p-ship by disposition of an asset w/in 5 years of contribution by partner w/ respect to whom the asset is a capital asset is capital.
