Essentials of taxation 2016 cengage chapter 14

Entities Taxed as Partnerships slide 3 of 4 • Limited partnership – Has at least one general partner • One or more limited partners – Only general partners are personally liable to cred

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Essentials of Taxation

Chapter 14

Partnerships and Limited Liability Entities

The Big Picture (slide 1 of 3)

• For 15 years, Maria has owned and operated a seaside

bakery and cafe called The Beachsider

– Maria would like to expand and has talked to her landlord,

Kyle about it.

• The Beachsider is one of several older buildings on 3

acres of a 10-acre parcel that Kyle inherited 30 years ago

– The remaining 7 acres are undeveloped.

• Kyle and Maria talked to Josh, a real estate developer,

and he proposed an expansion to The Beachsider and upgrades to the other buildings

The Big Picture (slide 2 of 3)

• The parties agreed to form a partnership to own and

operate The Beachsider and to improve and lease the other buildings

• Under the plan, Kyle and Maria will each contribute

½ of the capital needed

– Kyle’s real estate is valued at about $2 million

– Maria’s bakery equipment and the cafe furnishings are

valued at about $500,000

– The improvements will cost about $1.5 million, which

Maria has agreed to contribute to the partnership.

The Big Picture (slide 3 of 3)

• Josh will not contribute any capital to the partnership

– Instead, he will manage the construction and the operation

of the partnership in exchange for 5% of the capital and

20% of the ongoing profits

– His capital interest is valued at $200,000.

• What are the tax consequences if the trio forms

Beachside Properties as a partnership to own and

operate the shopping center?

– What issues might arise later in the life of the entity?

• Read the chapter and formulate your response.

Partnership Definition

• An association of two or more persons to carry on a trade or

business

– Contribute money, property, labor

– Expect to share in profit and losses

• For tax purposes, includes:

Entities Taxed as Partnerships

(slide 1 of 4)

• General partnership

– Consists of at least 2 general partners

– Partners are jointly and severally liable

• Creditors can collect from both partnership and

partners’ personal assets

• General partner’s assets are at risk for malpractice of

other partners even though not personally involved

Entities Taxed as Partnerships

(slide 2 of 4)

– Combines the corporate benefit of limited liability

with benefits of partnership taxation

• Unlike corporations, income is subject to tax only once

• Special allocations of income, losses, and cash flow are

available

– Owners are “members,” not partners, but if

properly structured will receive partnership tax

treatment

Entities Taxed as Partnerships

(slide 3 of 4)

• Limited partnership

– Has at least one general partner

• One or more limited partners

– Only general partner(s) are personally liable to

creditors

• Limited partners’ loss is limited to equity investment

Entities Taxed as Partnerships

(slide 4 of 4)

• Limited liability partnership (LLP)

– An LLP partner is not personally liable for

malpractice committed by other partners

– Popular organizational form for large accounting

firms

• Limited liability limited partnership (LLLP)

– An extension of the limited partnership form

– All partners, whether general or limited, are

accorded limited liability

Partnership Taxation

(slide 1 of 2)

• Generally, the calculation of partnership income is a 2-step

approach

– Step 1: Net ordinary income and expenses

related to the trade or business of the

partnership

– Step 2: Segregate and report separately

some partnership items

– If an item of income, expense, gain or loss might affect any 2

partners’ tax liabilities differently, it is separately stated

– e.g., Charitable contributions

Partnership Reporting

• Partnership files Form 1065

– On page 1 of Form 1065, partnership reports ordinary

income or loss from its trade or business activities

– Schedule K accumulates information to be reported to

partners

• Provides ordinary income (loss) and separately stated items in total

– Each partner (and the IRS) receives a Schedule K-1

• Reports each partner’s share of ordinary income (loss) and

separately stated items

Key Concepts in Partnership Taxation

(slide 2 of 3)

• Involves 2 legal concepts:

– Aggregate (or conduit) concept—Treats

partnership as a channel with income, expense, gains, etc flowing through to partners

• Concept is reflected by the imposition of tax on the

partners, not the partnership

Key Concepts in Partnership Taxation

(slide 3 of 3)

• Involves 2 legal concepts (cont’d):

– Entity concept—Treats partners and partnerships

as separate and is reflected by:

• Partnership requirement to file its own information

return

• Treating partners as separate from the partnership in

certain transactions between the two

Partner’s Ownership Interest

– Capital interest

• Measured by capital sharing ratio

– Partner’s percentage ownership of capital

– Profits (loss) interest

• Partner’s % allocation of partnership ordinary income

(loss) and separately stated items

• Certain items may be “specially allocated”

– Specified in the partnership agreement

Inside and Outside Bases

• Inside basis

– Refers to the partnership’s adjusted basis for each

asset it owns

– Each partner “owns” a share of the partnership’s

inside basis for all its assets

• Outside basis

– Represents each partner’s basis in the partnership

interest

– All partners should maintain a record of their

respective outside bases

Basis Issues

(slide 1 of 3)

• Partner’s outside basis is adjusted for income and losses that

flow through from partnership

• This ensures that partnership income is only taxed once

Basis Issues

(slide 2 of 3)

• Partner’s basis is important for determining:

– Deductibility of partnership losses

– Tax treatment of partnership distributions– Calculating gain or loss on the partner’s

disposition of the partnership interest

Basis Issues

(slide 3 of 3)

• Partner’s capital account balance is usually not a good

measure of a partner’s adjusted basis in a partnership interest for several reasons

• e.g., Basis includes partner’s share of partnership

liabilities; Capital account does not

Partnership Formation Transaction

Tax Consequences of

• Usually, no gain or loss is recognized by a partner or

partnership on the contribution of money or property in exchange for a partnership interest

• Gain (loss) is deferred until taxable disposition of:

– Property by partnership, or

– Partnership interest by partner

Tax Consequences of

• Partner’s basis in partnership interest = basis of contributed

property

– If partner contributes capital assets and §1231

assets, holding period of partnership interest

includes holding period of assets contributed

– For other assets including cash, holding period

begins on date partnership interest is acquired

– If multiple assets are contributed, partnership

interest is apportioned and separate holding period applies to each portion

Tax Consequences of

• Partner’s basis in partnership interest = basis of contributed

property

– If partner contributes capital assets and §1231

assets, holding period of partnership interest

includes holding period of assets contributed

– For other assets including cash, holding period

begins on date partnership interest is acquired

– If multiple assets are contributed, partnership

interest is apportioned and separate holding period applies to each portion

Tax Consequences of

• Partner’s basis in partnership interest = basis of contributed

property

– If partner contributes capital assets and §1231

assets, holding period of partnership interest

includes holding period of assets contributed

– For other assets including cash, holding period

begins on date partnership interest is acquired

– If multiple assets are contributed, partnership

interest is apportioned and separate holding period applies to each portion

WST Partnership Formation

Gain or loss Basis in Partnership’s

Partner Recognized Interest Property Basis

William $-0- $20,000 $20,000

Sarah $-0- $ 6,000 $ 6,000

Todd $-0- $22,000 $22,000

Neither the partnership nor any of the partners recognizes gain

or loss on the transaction

Exceptions to Tax-Free Treatment on Partnership

• Transfers of appreciated stock to investment partnership

– Gain will be recognized by contributing partner

– Prevents multiple investors from diversifying their

portfolios tax-free

Exceptions to Tax-Free Treatment on Partnership

• If transaction is essentially a taxable exchange of properties,

gain will be recognized

– e.g., Individual A contributes land and Individual B

contributes equipment to a new partnership;

shortly thereafter, the partnership distributes the

land to B and the equipment to A; Partnership

liquidates

– IRS will disregard transfer to partnership and treat

as taxable exchange between A & B

Exceptions to Tax-Free Treatment on Partnership

– e.g., Partner contributes property to a partnership;

Shortly thereafter, partner receives a distribution from the partnership

• Distribution may be viewed as a purchase of the

property by the partnership

Exceptions to Tax-Free Treatment on Partnership

• Receipt of fully vested partnership interest in

exchange for services rendered to partnership

– Receipt of the partnership interest is generally

taxable to the partner

• Partnership may deduct the amount included in the

service partner’s income if the services are of a

deductible nature

– If the services are not deductible by the partnership, they

must be capitalized to an asset account

Tax Issues Relative to Contributed Property

(slide 1 of 4)

• Contributions of depreciable property and intangible assets

– Partnership “steps into shoes” of contributing

Tax Issues Relative to Contributed Property

(slide 1 of 4)

• Contributions of depreciable property and intangible assets

– Partnership “steps into shoes” of contributing

Tax Issues Relative to Contributed Property

(slide 1 of 4)

• Contributions of depreciable property and intangible assets

– Partnership “steps into shoes” of contributing

Tax Issues Relative to Contributed Property

(slide 2 of 4)

• Gain or loss is ordinary when partnership disposes of:

– Contributed unrealized receivables

– Contributed property that was inventory in

contributor’s hands, if disposed of within 5 years

of contribution

• Inventory includes all tangible property except capital

assets and real or depreciable business assets

Tax Issues Relative to Contributed Property

(slide 3 of 4)

• If contributed property is disposed of at a loss and the property

had a ‘‘built-in’’ capital loss on the contribution date

– Loss is treated as a capital loss if disposed of

within 5 years of the contribution

– Capital loss is limited to amount of ‘‘built-in’’ loss

on date of contribution

Tax Issues Relative to Contributed Property

(slide 4 of 4)

• Special allocations must be made relative to contributed

property that is appreciated or depreciated

– The partnership’s income and losses must be

allocated under § 704(c) to ensure that the inherent gain or loss is not shifted away from the

contributing partner

– Discussed later in the chapter

The Big Picture – Example 15

• Return to the facts of The Big Picture on p 10-1.

• Kyle’s and Maria’s capital contributions to the newly formed

LLC are as follows

– Kyle contributes real estate, FMV $2 million, consisting of land with

basis = $600,000 and fully depreciated building, basis = $0.

– Maria contributes bakery equipment, basis $0, FMV $500,000

• No tax consequences on formation of Beachside Properties,

LLC for the LLC, Kyle, or Maria.

– Kyle does not recognize his $1.4 million realized gain.

– Maria does not recognize her $500,000 realized gain.

• Kyle takes a substituted basis of $600,000 for his interest.

• Maria takes a substituted basis of $1.5 million ($1.5 million

for contributed cash + $0 for contributed property).

The Big Picture – Example 15

• Beachside Properties has the following adjusted basis in the

contributed property.

– A carryover basis of $600,000 for the real estate contributed by Kyle.– A carryover basis of $0 for the property contributed by Maria

• If the buildings and other land improvements had any

remaining depreciable basis, the LLC would ‘‘steps into the member’s shoes’’ in calculating depreciation deductions.

• When Josh vests in his 5% capital interest in the LLC in

exchange for services, the $200,000 is taxable to him

– Beachside Properties will probably capitalize this amount because it

relates to construction

• Josh’s 20% interest in future profits will be taxed to him as

profits are earned by the partnership.

Elections Made by Partnership

• Organizational cost amortization

• Start-up expense amortization

Elections Made by Partnership

(slide 2 of 2)

• Optional basis adjustment (§754)

• Nonrecognition treatment for involuntary conversions

• Election out of partnership rules

Organizational Costs

(slide 1 of 2)

• Partnership may elect to deduct up to $5,000 of organization

costs in year business begins

– Deductible amount must be reduced by

organization costs that exceed $50,000

– Remaining amounts are amortizable over 180

months beginning with month the partnership

begins business

Organizational Costs

(slide 2 of 2)

• Organizational costs include costs:

– Incident to creation of the partnership, chargeable to a

capital account, and of a character that, if incident to the creation of a partnership with an ascertainable life, would

be amortized over that life

• Includes accounting fees and legal fees connected with the

partnership’s formation

• Costs incurred for the following items are not

organization costs:

– Acquiring and transferring assets to the partnership

– Admitting and removing partners, other than at formation – Negotiating operating contracts

– Syndication costs

Start-up Costs

(slide 1 of 2)

• Start-up costs—include operating costs incurred after

entity is formed but before it begins business

including:

– Marketing surveys prior to conducting business

– Pre-operating advertising expenses

– Costs of establishing an accounting system

– Costs incurred to train employees before business begins,

and

– Salaries paid to executives and employees before the start

of business

Start-up Costs

(slide 2 of 2)

• Partnership may elect to deduct up to $5,000 of start-up costs

in the year it begins business

– Deductible amount must be reduced by start-up

costs in excess of $50,000

– Costs that are not deductible under this provision

are amortizable over 180 months beginning with the month in which the partnership begins business

Measuring Income of Partnership

• Calculation of partnership income is a

2-step approach

– Step 1: Net ordinary income and expenses

related to the trade or business of the partnership

– Step 2: Segregate and report separately

some partnership items

Separately Stated Items

(slide 1 of 2)

• If an item of income, expense, gain or loss might affect any 2

partners’ tax liabilities differently, it is separately stated