Chapter 1: What is a Partnership

A partnership is an association between two or more persons who carry on a trade or business for profit as co-owners.

Classification of Partnerships

• General Partnership: every partner has unlimited liability for the debts of the partnership.

• Limited Partnership: at least one partner’s liability for the debts of the partnership is limited to that partner’s investment in the partnership.

• Limited Liability Partnership (LLP): type of general partnership in which all of the partners (all of which are general partners) are protected at a minimum from personal liability for negligent acts committed by other partners or by employees not under his or her direct control.

Classification of Partnerships (Cont.)

• Limited Liability Company (LLC): owners can all participate in the management of the business, but who also are all given protection from the liabilities of the LLC (except to the extent of their investment in the LLC).– Not legally a partnership, but treated as a partnership

for tax purposes.

Classification of Partnerships (Cont.)

• There are 3 general sets of regulatory rules that classify entities as a partnership for tax purposes:– “Check-the-box” classification rules

• Allow taxpayers to choose whether to treat partnerships and other unincorporated entities which are not partnerships (e.g., LLCs) as corporations or partnerships for federal income tax purposes.

Incorporation / Disregarded Entities

A business activity incorporated under the law of any state, federal, or foreign jurisdiction must be treated as a corporation for federal tax purposes.

Unincorporated entities may elect to be a corporation for tax purposes. If it does not elect to be treated as a corporation, the

entity is by default treated as a partnership for tax purposes.

A single member unincorporated entity is treated as a “disregarded entity” unless it elects to be a corporation. Example: a single member LLC.

Advantages of Partnerships

• Flow-through Taxation: The partnership is not taxable. Income flows through to the partners and is then recognized by them.– 2 positive effects:

• 1) Income is only taxed once (on the partner level) as opposed to the double taxation that corporations shareholders experience.

• 2) If a loss occurs, the partner will be able to deduct his share of the loss. Corporate shareholders are not allowed to deduct a portion of the corporation’s loss.– Exception: Since S-Corporations are flow-through

entities, an S-Corporation shareholder would be able to deduct his portion of the loss.

Advantages of Partnerships (Cont.)

• Property Distributions: Generally, distributions of property from a partnership are tax-free.– However, distributions of cash can result in gain to a

partner.

• Distributions of property from a corporation, however, are dividend income to the shareholder, and will result in taxable gain to the corporation if the assets distributed are appreciated.

Advantages of Partnerships (Cont.)

• Tax-free Formation: Generally, for a corporation to be tax free, property must be contributed, stock must be received, and 80-percent control must be owned by the contributors after the contribution.– No such requirements exist for partnerships.

• Contributions to partnerships are generally tax-free unless the net liabilities the partner is relieved of due to the contribution exceed the partner’s basis in their partnership interest.

Advantages of Partnerships (Cont.)

• Special Allocations: Partnerships can specially allocate items of income or deduction to different partners.– Example: All depreciation can go to just one partner.

• Liabilities of a partnership increase a partner’s basis.– Corporations can not use special allocation.

– Easy to Form: No filing with the state and no necessary paperwork

Disadvantages of Partnerships (Cont.)

• Self-employment Income: Any trade or business income is taxed to the general partners as self-employment income (which is subject to the self-employment tax).

• Guaranteed payments for services provided by limited partners is also treated as self-employment income.

• Income of a corporation is not subject to self-employment tax, although the shareholders will be subject to FICA taxes.

Other Disadvantages

• 1) More difficult to transfer ownership.• 2) More difficult to raise capital.• 3) A partner’s deduction of losses from a

partnership are limited by basis, at-risk amounts, and the passive activity loss rules.

• Unlimited Liability in the case of general partnerships.

LLC Tax Implications

1) Definition of a limited and general partner: No member is legally a limited or general partner. All members resemble limited partners from a limited

liability standpoint. All members who are managers resemble general

partners from an operational standpoint.

LLC Tax Implications (Cont.)

2) Classification of recourse and nonrecourse debt: Generally, recourse debt is allocated to the partners who bear the risk of paying the creditors if the partnership fails to pay them. Nonrecourse debts are allocated among all partners, general and limited. These rules become less clear when applied to LLCs

who don’t have general and limited partners.

LLC Tax Implications (Cont.)

• Except as provided in regulations, no interest as a limited partner in a limited partnership shall be treated as an interest in which the taxpayer actively participates.– An interest in an LLC has sometimes been considered

a limited partnership interest.– It has been argued that manager-members should not

be treated as limited partners for the purposes of the material participation test. In fact, in the Gregg, Thompson, Newell, and Garnett (and other) court cases, the courts found that such LLC members should be treated as general partners.

Tax Implications (Cont.)

• 5) Self-employment taxes: A limited partner’s share of partnership income is not subject to self-employment tax. In an LLC, all partners are considered limited partners.– Proposed regulations hold that an individual will be

treated as a limited partner unless he or she:• Has a person liability for debts of or claims against the

partnership.• Has authority to contract on behalf of the partnership.• Participates in the partnership’s trade or business for

more than 500 hours during the taxable year.

Taxable Year: General Rules

Each partner must include his or her taxable annual taxable income and distributive share of the partnership’s income and guaranteed payments for the taxable year of the partnership that ends with or within his or her own tax year.

The critical date is the date of the partnership taxable year end.

Taxable Year: General Rules (Cont.)

• Standing alone, this rule allows the partner the opportunity to defer up to 11 months of income earned by the partnership from taxation until the next year. Example - year end 1/31/2012

• Code Sec. 706(b)(1) imposes limitations on this opportunity.

• A partnership may adopt a “business purpose” taxable year if they can show that they have a natural business year other than the one provided by the statute.

Taxable Year: General Rules (Cont.)

• In the absence of a business purpose, the partnership’s “required year” is:

1. The taxable year of its partners who have an aggregate interest in partnership profits and capital of greater than 50 percent.

2. The taxable year of all its principal partners, if a year described in 1, above, does not exist.

3. The calendar year or other period (generally the year with the least aggregate deferral of taxable income), if a year described in (1) or (2), above, does not exist. – ACCT 5308 student, please know that the least aggregate deferral method exists but owing to time limitations we will not discuss or Sec. 444 elections this in our course.

Taxable Year: Majority Interest Required Taxable Year

• Under this rule, the partnership must have the same tax year as that of the majority of its partners.o These are the partners having the same tax year and whose

combined interest in partnership capital and profits is greater than 50 percent.

• The majority interest is established on the 1st day of the partnership’s taxable year unless the Secretary of Treasury allows them to test for a majority interest on some other date.o If a partnership is required to change its tax year to that of

its majority partners, it isn’t required to change it again for the following 2 years.

Taxable Year: Principal Partner Required Taxable Year

• If there is no business purpose year-end and no one year-end that a majority of the partners share, the partnership must adopt the same tax year as that of all its principal partners (one who owns at least 5% of partnership capital or profits).

Taxable Year: Year of Least Aggregate Deferral

• If neither the majority interest test or the principal partnership test is met, then the partnership must accept a year end resulting in the least aggregate deferral of income to the partners.

Business Purpose Taxable Year—The Natural Business Year

• To establish a business purpose for a taxable year, the taxpayer must show one of the following:o They have a natural business year.o They have facts and circumstances that support use of

the business taxable year.o They have a non-tax reason to support a business

purpose taxable year, and agree to certain additional terms, conditions, and adjustments that have the effect of neutralizing the tax effects of any resulting substantial distortion of income.

Business Purpose Taxable Year—The Natural Business Year (Cont.)

If the taxpayer’s gross receipts from sales and services for the three immediately preceding taxable years indicate that the taxpayer has a peak and a non-peak period of business, then: The taxpayer’s natural business year is deemed to

end at, or soon after, the close of the highest peak period of business.

Business Purpose Taxable Year—The Natural Business Year (Cont.)

A partnership’s natural business year can also be determined under the“25-percent gross receipts” test. A partnership determined under this test will be

automatically accepted by the IRS.This test is applied to each year of the most

recent 3 year period.