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Partnership Tax
Villanova University School of Law
Maule, James Edward

PARTNERSHIP TAXATION
 
Villanova University – Spring 2012
Professor Maule
Fundamentals of Partnership Taxation (Eight Edition)
Lind, Schwartz, Lathrope, Rosenberg
 
 
CHAPTER 1: INTRODUCTION
 
o    Entity Approach (partnership treated as separate entity)
§  Would resemble the treatment of corporations in Subchapter C of the Code.  Transactions between corporations and SHs generally are treated as if they were entered into by independent TPs. 
§  Since a corp is a separate entity, distributions of corporate profits are taxable to the SHs. 
 
o    Aggregate Approach (look through the partnership)
§  A partnership would not be recognized as an independent taxable entity.  The partnerships income and deductions would be treated as directly earned or incurred by the partners. 
§  Distributions would be nontaxable bc the partners would be viewed as receiving income which was previously taxed. 
 
o    Subchapter K
§  Does not exclusive use either approach.  Partnerships are considered entities for some tax purposes and aggregates for others. 
§  A partnership is a conduit through which income is taxed directly to the partners under an aggregate approach. 
§  But partnerships are treated as entitles for purposes of determining and characterizing partnership income, filing of informational returns and auditing by the IRS.
 
o    LLC
§  Can be structured as either an association or a partnership depending on the flexibility provided by state law and the desires of its members. 
 
o    Subchapter K
§  §701-777 of the Code (Subchapter K) contains the federal income taxation of partner and partnerships. 
§  Partnership Operations: §701-§709
§  Contributions to Partnership: §721-§724
§  Distributions from a Partnership: §731-737
§  Transfers of Partnership Interests: §741-§743
§  Multiple Applications: §750s
§  §751 – ordinary income assets (“hot assets”)
§  §752 – liabilities
§  §753 – income in respect of a deceased partner
§  §754 – election for basis adjustment
§  §755 – allocations of basis adjustments
 
o    Partnership Operations
§  Although a K is not subject to income tax, it is treated as a separate entity for accounting purposes.  Items of income, gain, loss and deduction from partnership operations for each taxable year are initially determined at the partnership level; these items are allocated among the partnership and are passed through to them as distributive shares. 
§  Distributive Shares: refers not to actual distributions, but rather to each partner’s allocable share of partnership items that must be reported.  Both the amount and character of items included in a partner’s distributive share are determined at the partnership level but are taxed to the partner on his individual return. 
 
o    Inside and Outside Basis
§  A partner’s basis in his K interest (outside basis) is separate and distinct from the K’s basis in its assets (inside basis).
§  §722 – a partner’s outside basis is initially determined by reference to his investment in the K (ie. the basis of any property and cash contributed in exchange for a K interest) 
§  §723 – the K takes a substituted basis in contributed property equal to its basis in the contributing partner’s hands. 
§  §705 – a partner’s outside basis in adjusted upward for his distributive share of income and any additional capital contributions, and is adjusted downward for his distributive share of K losses and any distributions from the K. 
 
o    Contributions and Distributions
§  §721: The transfer of property by a partner to a partnership is a disposition of property.  BUT, under §721, when a TP contributes cash or other property (but not services) to the K in exchange for a partnership interest, this is generally tax free both to the K and the contributing partner.  Any gain or loss is deferred. 
§  This rule applies regardless of whether the K is being created or is already in existence.      
§  If the K subsequently disposes of contributed property, §704(c) requires that any built-in gain or loss be allocated to the contributing partner. 
§  Distributions of cash or property from a K to a partner are also tax free, unless the distribute partner receives cash in excess of his outside basis.
 
o    Transfer of K Interests
§  §741 – a partner who sells his K interest generally recognizes capital gain or loss equal to the difference between the AR and his outside basis. 
§  §742 – a purchaser of a K interest takes a cost basis in the acquired interest.
 
o    Adjustments to Inside Basis
§  Generally, the transfer of a K interest does not trigger any adjustment to the basis for the K assets. 
§  BUT, if the K has a §754 election in effect, a purchaser of a K interest is entitled to a special adjustment to his share of the K’s inside basis to reflect his cost basis in the acquired K interest.     
 
o    Capital Accounts
§  A K maintains capital accounts which reflect the value of each partner’s equity interest in the K. 
§  Assets = the sum of liabilities and capital (ie. partners’ equity). 
§  If all K assets were sold for FMV and all liabilities were paid, the remaining cash would be equal to the partners’ equity in the K.  If the K were then to wind up its business, those partners with positive capital account balances would be entitled to receive liquidating distributions equal to their capital account balances. 
§  K Contributions – when a partner contributed property to a K, his capital account must be credited with the FMV (or “book value”) of the contributed property, less any liabilities secured by the property.  Reg. §1.704-1(b)(2)(iv)(b). 
§  The tax basis of the contributed property does NOT affect the contributing partner’s “book” capital account, since the partner’s respective rights upon liquidation depend on the FMV (not the tax basis) of the K property.
§  BUT, the K must keep track of any differences between the tax basis and book value of contributed property for purposes of tax accounting. 
§  The K will be required to maintain 2 sets of capital accounts – a tax capital account and a book capital account – whenever property is contributed with a tax basis different from its FMV.   
 
 
o    Partnership Status
§  §761(a) and §7701(a)(2) both define a K to include any syndicate, joint venture or other unincorporated org (other than a corp, trust or estate) through which any business is carried on. 
§  Generally a K exists only if 2 or more co-owners conduct a business for profit. 
§  Classification of an org as a separate entity for federal tax purposes is governed by federal law.  Reg. §301.7701-1(a)(1). 
§  A joint venture or other contractual arrange may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation or venture and divide the profits therefrom. Reg. §301.7701-1(a)(2).  Thus, existence of a separate entity is a threshold issue in classifying an arrangement as a partnership.  
§  Mere co-ownership of property that is maintained, kept in repair, and rented or leases does NOT give rise to a separate entity for federal tax purpose. 
§  Joint Profit Motive – generally partners must intent to share profits for a partnership to exist. 
§  §761(a) – permits certain unincorporated organizations to elect to be excluded from the application of Subchapter K.  The election is available with respect to:
§  Investing Ks
§  Joint operating agreements for production, extraction or use of property
§  Certain short-term arrangem

olding period in the K interest is fragmented in proportion to the FMV of the portion of the interest received for the property to which the holding period relates divided by the FMV of the entire interest.    
§  A K interest is a capital asset. 
§  NOTE: Recapture gain (under §1245) is treated as a separate asset which is not a capital or 1231 asset.  
§  The Partner:
·         Capital asset or hotchpot §1231 asset: A partner’s holding period for his K interest includes the period that he held any contributed property that was a capital asset or a hotchpot §1231 asset.  (the partner’s holding period in the asset is tacked onto the holding period of his K interest) 
·         Cash or ordinary income assets: The holding period for a K interest received for other property (cash or ordinary income assets) begins on the date of the exchange. 
·         Hotchpot §1231 asset – depreciable property and real property (land) used in a trade or business that the TP has held for more than 1 year. 
o    Does NOT include inventory or property held for sale to customers.
o    A hotchpot gain become a long-term capital gain
o    A hotchpot loss becomes an ordinary loss.
·         Capital assets – include everything (land, machinery, equipment, vehicles, furniture, buildings), whether or not  except the following:
o    Inventory
o    Property held primarily for sale to customers in the ordinary course of the TPs trade or business
o    Depreciable property used in TPs trade or business
o    Real property used in TPs trade or business
o    Certain copyrights
o    Accounts receivable acquired in the ordinary course of the TPs trade or business
o    Supplies used in the TPs trade or business
§  The Partnership:
·         The K can tack the partner’s holding period in an asset onto the K’s holding period.  However, there is no distinction between the various types of assets; the holding period for ALL asset tack. 
 
 
o    Partnership Accounting and Balance Sheet
§  Left side (“Book Value”) – partnership assets are listed, starting with the most liquid.  Both the AB (inside basis) and FMV of each asset are listed.  Book value does not change until some event occurs that warrants a revaluation of K assets.   
§  AB = K’s basis (inside basis) in each asset.
§  FMV = value of asset upon contributions, minus depreciation that has been taken by the partnership.
§  Right side (“Capital Accounts”) – represent a partner’s equity in the K.  Identifies what each partner is entitled to receive upon liquidation of his interest in the K.   
§  Capital Account = cash + FMV of property contributed to K.
§  Increased by the partner’s share of the profits of the K and decreased by the partner’s share of K losses and the amount of cash and FMV of property distributed to the partner. 
§  Example: Finney and Garth formed a K.  Finney contributed $2,000 cash and land with a basis of $4,000 and FMV of $8,000.  Garth contributed $5,000 cash and equipment with a basis of $2,000 and FMV of $5,000.