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TAXATION OF PARNERSHIPS OUTLINE
Introduction This course uses Cunningham & Cunningham’s The Logic of Subchapter K. Run, do not walk, and get yourself a copy of this little book; it is about as clear as a text can be on partnership taxationBasics Partnership tax is covered by Subchapter K of the Code (§§ 701-761) Generally speaking, the partnership isn’t taxed directly – it is a pass-through for income to flow to the partners individually. Partnership tax can get pretty complicated because sometimes it becomes necessary to treat the partnership as an entity instead of a conduit This leads to two competing theories – “entity theory,” which treats the partnership as a separate taxable entity, and “aggregate theory,” which treats the partnership as a bunch of individual taxpayers
Terminology from the basic tax course Capital Asset – anything except inventory, copyrights & other intellectual property created by the taxpayer’s efforts, and accounts receivable/notes receivable §1231 Property – depreciable equipment & real estate used in a trade or business
Abbreviations P/S – Partnership; Ptr. – Partner (Also, in examples, ABC will be P/S, and A, B, C, will represent individual partners) IB – Inside Basis; OB – Outside Basis g/l – gain/loss; CG – Capital Gain; CL – Capital Loss; OI – Ordinary Income; OL – Ordinary Loss. ST – short term; LT – long term SEE – substantial economic effect; BV – book value MG – Mark Gergen
Partnerships vs. Corporations Why Use a Partnership? Partnerships are the vehicle of choice for small transactions Avoids double taxation of income; top individual tax rate is 39.6% with a top capital gain rate of 20%, while corporate rate is 34-35% with no favorable capital gain treatment Caveats: can avoid double tax if corp. pays salary and interest (but this is limited by the code); also the “accumulation & bailout game” (letting retained earnings accumulate and bail out in some sneaky way – no passive loss rules for corporations)
Why Use the Corporate Form? Publicly traded entities are always taxed as corporations (§7704) Complexity of partnership tax; dislike of Form K-1 Poor advice upon business formation!
Partnership Classification A P/S is a P/S for tax purposes if the “box is checked” – the rules are very liberal on what qualifies as a partnership. However, it may be classified as a corporation if 3 of these 4 characteristics are met: Continuity of life Centralized management Limited liability Free transferability of ownership interests (also note that “associates” and “business objective with profit sharing” are also included, but are always met by both P/S and corp.)
From most liability to least liability: Ordinary P/S, LP, LLP, LLC.
Formation of a Partnership Contribution of Property General Rule: no recognition of gain/loss for contributions of property (except for certain investment P/S) (§721) Ptr. takes interest in P/S = adj. basis in contributed property (§§ 722, 723); his basis in his interest is called outside basis (OB) Contrast OB to his capital account, which will be valued at the FMV of the contributed property
P/S takes basis = to contributing ptr.’s basis; holding period also carries over; basis in the property is called inside basis (IB) Generally, contributions of services ¹ property (interest received for services is income to taxpayer); however, just “what is property” is often a fuzzy issue (Stafford – letter of intent is property) Also, different treatment if services are given for a profits (rather than capital) interest; this is discussed later
Pre-contribution/Built-In Gain or Loss A ptr. must be allocated any pre-contribution gain or loss upon sale of the property he contributed Thus, if A contributes $100 property with basis $70, the following results: A takes P/S basis of $70, P/S takes $70 basis in property If the property increases in value to $120 and the P/S sells it, $30 of the $50 gain (120-70=50) must be allocated to A because it represents pre-contribution (or built-in) gain; the remaining $20 may be allocated in any way
Holding Period & Character Holding period “tacks on” (P/S takes ptr.’s period) if property is a capital asset or is §1231 property Character (capital vs. ordinary) is determined at the entity level, unless §724 applies (see below)
Special Rules (§724) Unrealized Recievables – g/l is always ordinary Inventory Items – ordinary if g/l is recognized by P/S within 5 years of contribution Capital Loss Property – capital if g/l recognized by P/S within 5 years of contribution (and thus can only offset CG); this only applies to built-in losses
Contribution of Encumbered Property (Liabilities) (§ 752) General Rule: each ptr. is deemed to have contributed cash in an amount equal to his share of P/S liabilities Note this increases the partner’s OB By the same token, a decrease in a ptr.’s share of liabilities also decreases his OB
Allocation Recourse liabilities – according to who bears the risk of economic loss Nonrecourse liabilities – by same means as profits are shared
Contribution of A/R and A/P (Assignment of Income Doctrine) The assignment of income doctrine basically says that income inherent in A/R must be taxed to the contributing ptr.; he cannot “assign” it away via the P/S Traditional rule (the “unrealized receivable” approach): When A/R (or A/P) are contributed, the income interest in the receivable (or deduction for A/P) must be taxed to the ptr. This is done by: Treating A/R as property for §721 (nonrecognition of g/l on contributed property) Giving the P/S a zero basis in the receivables under §723 (P/S’s basis) Characterizing income received by the P/S upon collection as ordinary under §724 (character of g/l) Allocating income to the contributing ptr. under §704(c) (Ptr.’s distributive share)
However, note the approach in Schneer – you can assign the right to unearned income if it is from a source similar to the P/S activity. Which rule is the correct one is unclear.
Organization & Syndication Expenses (§709) Organization costs Defined – lawyers and accountants actually creating the P/S (as opposed to startup costs such as investigating business opportunities), licensing and filing fees, etc. Treatment – may be treated as a “deferred deduction” – essentially, the expense is amortized over no less than 60 months (5 years); amortization period begins when business operations begin; Each ptr.’s share of OB reduced by amortization amount each year. (can also treat in same manner as syndication expenses)
Syndication expenses Defined – costs of marketing P/S to investors; includes broker fees, cost of tax opinions, etc. Treatment – Never amortized or deducted; they must be capitalized (and thus only recognized upon dissolution)
Partnership Operations Basic Rules Taxable Year and Method of Accounting On the last day of the P/S’s tax year, each ptr. is treated as receiving his share of P/S income. A partnership must have a valid business reason for its taxable year or else it must use the “required year.” (And mere convenience or desire for deferrals is not a valid business reason!). The “required year” is determined in the following order (if not #1, then #2, etc.): If one or more ptrs. with > 50% interest (in profits and capital) use the same tax year, then use that year If all principle ptrs. (>5% of profits or capital) have the same tax year, use that year The year with the “least aggregate deferral” (aggregate deferral = sum of each ptrs. deferral that year) (see example p. 24)
Opting out of required tax year Can opt out (of course) if a valid business reason; no definite rules here, but you can definitely do it if ³ 25% of income is in the last 2 months of the tax year Can also do a §444 election – but only if the tax year chosen is within 3 months of the required year, and you must prepay estimated tax for the deferral period
Method of Accounting – Can choose any method, but are limited by partners – must accrue if C corp is a ptr., P/S is a §461(i) tax shelter, or had > $5M in income for three years
Income Computation & Items Omitted or Separately Stated Each ptr. must account separately for items listed in §702(a)(1-7): (Note this is a reporting rule that has nothing to do with how things are actually divided up) STCG / STCL LTCG / LTCL §1231 g/l charitable contributions dividends with deduction under subchapter B §901 taxes paid to foreign countries & US territories other income, g/l, deduction or credit items determined by regulation Listed in TR §1.702-1(a)(8)(i); includes wagering, medical expenses, alimony, intangible drilling costs, etc., etc. Also: TR §1.702-1(a)(8)(ii) – “variable effect” items (item that would give ptr. different liability if not accounted for separately)
taxable income/loss, exclusive of other items requiring separate computation under this subsection
Computation of P/S Income (§703(a)): Omit separately-stated items No “inappropriate deductions” – e.g., personal exemptions, itemized deductions No deductions whose benefits pass directly to the ptrs. (ex.: no NOL deductions b/c benefit flows directly to ptrs.)
Elections and Character Elections are handled at the P/S level; all ptrs. must agree – no one can opt out. (a few exceptions in §703(b)) Podell – character of income (capital or ordinary) is determined at the P/S level side note: Podell would be subject to the self-employment tax since he isn’t a limited ptr.
Bayse – can’t assign income (or character of income) away; income is taxed to he who earns it (here, medical P/S is taxed even though the compensation was directed to an unsecured trust) Transmutation of Character Rules CL à OL – if ptr. contributes what would be CL property in his hands to P/S, it remains CL property to the extent of built-in CL if sold within 5 years (partial taint) (§724(c)) Note you measure built-in CL at date of contribution; thus, contribution of CL property with basis 400 & FMV 500; P/S sells for 350; result is $50 CL even though it is less than ptrs’ basis
OI à CG – same rule; retains OI character – key difference is that the entire gain is OI (not just extent of built-in OI) if sold within 5 years (total taint) (§724(b))
Adjustments to Outside Basis (OB) (§705) Principle: income is taxed once and only once – “preserve the exemption or the sting of the denial” Basic Rules: Increase OB for: Contributions Taxable Income Allocated to Ptr. Tax-Exempt Income Allocated to Ptr.
Decrease OB for: Distributions Losses (including expenses and NOL’s) allocated to Ptr. Nondeductible, noncapitalized expenses (e.g., penalties, political contributions, charitable contributions) (except for capitalization expenses – why? who knows!)
Don’t decrease OB below zero!
Partnership Accounting This involves the “financial accounting” of keeping a P/S’s books; it helps to have had some basic accounting courses. Gergen’s “8 Propositions” (memorize) Assets = Liabilities + Equity [e.g., the basic accounting formula] Equity should equal the amount a partner receives on liquidation if the assets are sold for book value (BV) BV = Historical cost (or FMV on contributions/revaluations) - Book depreciation Ptr.’s capital account = Increases by value (not basis!) of contributions + his share of book (not tax) income Decreases by value (not basis!) of distributions + his share of loss
Assets are revalued in connection with contributions or distributions in consideration for an interest in the P/S i.e., a change in interest = revaluation
Asset basis = cost (or basis on contribution) - tax depreciation Assets’ tax basis often deviates from BV Ptr.’s tax basis often deviates from the value of his capital account; it represents his share of built-in g/l from contributed property
Capital Account Accounting Rules (TR §1.704-1(b)(2)(iv)(b)) (same as #d above) Increase for: Contributions – of cash, or by FMV (net of liabilities) of contributed property Operations – by share of P/S income
Decrease for: Distributions – by cash or FMV of property distributed First recognize and increase each partner’s capital account for his share of any unrecognized inherent g/l in distributed property!
Operations – by share of P/S losses (or any other asset decrease that doesn’t affect liabilities)
A few additional notes Liabilities are separately stated and are not reflected in capital accounts
Transactions Resulting in Tax and Book Cap Acct. Disparities Contributions There will be a disparity if a ptr. contributes property with a different basis and FMV (e.g., contrib. of property with basis 100, FMV 150) Ex: A contrib land (b 100, FMV 150); AB contrib cash of 150; following balance sheet results: Assets Cash 150 b 150 BV Land 100 b 150 BV Total 250 300
(No Liabilities) Capital Accounts A 100 tax 150 BV B 150 tax 150 BV Total 250 300
Note that in the example, total tax capital account = P/S IB; each ptr.’s tax capital = his “share” of IB (i.e., his contribution to IB); and each ptr.’s tax capital also = his OB [this relationship will be complicated later by liabilities] We will see later that if the P/S was to sell the land, the $50 gain must be allocated to A (§704(c)) This example illustrates why we keep separate tax and book accounts – to help keep track of §704(c) allocation problems
Revaluations (i.e., “booking up”) Some transactions permit a partnership to “book up” (or down) its assets to current FMV. These include: New or existing ptr. makes a contribution for an interest in the P/S, and Upon a distribution that liquidates a ptr.’s entire interest [but not upon a ptr.’s sale of his entire interest!]
Upon revaluation, the book capital account is altered, while the tax capital account remains the same
Partnership Allocations Policing Special Allocations General Rule: the P/S agreement controls how taxable income is allocated (§704(a)) HOWEVER, §704(b) permits the IRS to reallocate if the agreed-upon method of sharing does not have substantial economic effect (SEE) Thus, in Orrich, there was no SEE for agreement that allocated all depreciation deductions to ptr. with lots of taxable income because “gain chargeback provision” (which would, on a sale of asset, allocate gain representing depreciation to O; the remaining gain would be split equally)
In absence of P/S agreement (or if no SEE) the Code dictates each ptr. allocation according to each ptr.’s interest in P/S – i.e., what would happen upon liquidation This is sometimes called PIP – for “ptr.’s interest in P/S” - see below
3 Ways to Sustain an Allocation The allocation meets the SEE definition (TR §1.704-1(b)(2)); see below for details (Safe Harbor Provision) The allocation is in accordance with ptr.’s interest as described in TR §1.704-1(b)(3) The allocation is governed by special rules of TR §1.704-1(b)(4)
Determining Economic Effect (the “EE” of “SEE”) The “Big 3” Tests (must answer “yes” to each) Are capital accounts properly kept? Are liquidations made according to capital accounts? After liquidation, is there an unconditional obligation for ptrs to restore their deficits, if any?
Alternative test (usually for LP’s) a & b of the basic test above There is a Qualified Income Offset (QIO) provision i.e., if there is a cash distribution to a ptr that creates a deficit for that ptr, the next item of income must be allocated to that ptr. to get him back to zero
Allocation doesn’t create a deficit in excess of ptr’s obligation to restore it
Determining Substantiality (the “S” of “SEE”) Essentially, a material non-tax reason for the allocation Generally, something is substantial if there is a reasonable possibility the allocations will substantially affect pretax dollars It is generally not substantial if there is a strong likelihood that after-tax present value consequences to one ptr will improve and that present value consequences to no other party will not be worse (a.k.a. the After-Tax Exception)
It is subjective, but there are guidelines; for example: Shifting Tax Consequences – no SEE if: Negligible net effect on capital accounts, and Tax liability of all ptrs is less than without the allocation
Transitory Allocations If P/S has both original and offsetting allocations, and when the allocations become part of the P/S agreement it is likely that the net effect of both allocations is negligible, and the ptrs total tax liability is reduced, then there is no SEE
Substantiality is presumed if: 5 Yr. Rule – if item is not offset within 5 years, presume substantiality Value = Book Value Rule – assume tax depreciation = real depreciation (rule only applies to allocation of depreciation deductions)
What happens if there is no SEE? There must be a re-allocation of the offending item according to PIP (§1.704-1(b)(3)) Assume a per-capita allocation Look to facts & circumstances to determine each ptrs interest to rebut per-capita presumption (see also ex. 7 in the TR above) Special rule for ptrs violating rule 3 on EE (compare what each ptr would receive if P/S liquidated in current year to what each would receive if liquidated previous year)
MG hates special allocation rules; he thinks they are too complex and should be pro-rata. Fundamental flaws include: Overbroad – ptrs should be able to allocate who holds what; after all, they could do so outside a P/S Underbroad – some allocations are troubling because of their EE (rather than their lack of same)
Family Partnerships Even if a P/S complies with §704(b), its allocation still might not be respected if it is a family P/S “Assignment of Income Doctrine” – Income must be taxed to the earner; it cannot be shifted away (Lucas v. Earl) §704(e) overrules prior interpretations on when to recognize family P/S if P/S has capital as a material income-producing factor If a person has a capital interest, they are a ptr regardless of how that interest was acquired (i.e., a right to capital upon liquidation) However, if that interest was received as a gift or purchase from a relative, donee can only report his share if donor has received adequate compensation for services to P/S
For service P/S – only treat as ptr if you actually perform services; distributive share cannot exceed reasonable compensation for those services
Allocation of Nonrecourse Deductions A sale of property with outstanding nonrecourse loan means outstanding loan balance must be included as an asset received from the sale Tufts – P/S gets $1.8M non-recourse loan, buys apt. complex; later sells complex for $1.4M when economy busts. Basis at time of sale is $1.455M. P/S claims $.055M loss. Ct. says NO – must include outstanding loan balance in sale price (here, $.4M), so actually a $400k gain Court’s theory: when property is transferred subject to a nonrecourse liability, the liability is treated as an amount realized; result: CG except for depreciation recapture
Alternative theories: Tax Benefit – gain because of tax benefit; result: all inc. ordinary Cancellation of Debt – result: $455 OI, $55 OL
Allocation of “built-in” gain or loss (§704(c)) (on a sale) Normally, tax must follow book; however, there is a problem when there is either: A contribution of §704(c) property (i.e., property where FMV ¹ basis, yielding “built-in” g/l) A revaluation via §1.704-1(b)(2)(iv)(f)
There are three ways to handle this: traditional, traditional with curative allocations, and remedial allocations Remember: the basic goal of §704(c) is to prevent the shifting of built-in (i.e., pre-contribution) gain or loss to other partners Any of the below methods may be chosen for a particular asset BUT note the anti-abuse rule – can’t choose method that will shift g/l
The Traditional Method (with Ceiling Rule) (§1.704-3(b)) Noncontributing ptr is treated as if he purchased an undivided interest in the property for its FMV, with allocations for tax purposes made consistent with that treatment Ceiling rule: a P/S can only allocate g/l to the extent of g/l, income, or deduction that the P/S actually recognizes Ex.: AB P/S; A contributes land (60 b, 100 FMV), B $100 If P/S sells land for $100, none of $40 tax gain is allocated to B since she sustained no book gain; A recognizes $40 gain
If P/S sells land for $120, A must recognize $40 gain; the remaining $20 is split according to the P/S agreement (e.g., both A and B get $10 if they split proceeds equally) If P/S sells land for $70: AB has $30 book loss but $10 tax gain; even thought B has a $15 loss, he cannot claim a tax loss. A recognizes the entire $10 tax gain Note how this screws up the ptrs tax and book accounts: B now has a $85 book capital account, but retains a $100 tax capital account – she has a $15 economic loss that is not recognized by a tax loss Similarly, A had a $40 economic gain upon contribution, offset by a $15 loss upon sale, for a net $25 economic gain – making his book capital account $85 ($100-$15). However, he only recognizes $10 of tax gain (increasing his tax capital account to $70) This result is compelled by the ceiling rule – it will presumably be offset upon liquidation of the P/S (i.e., B gets $85 and thus recognizes a $15 loss; A gets $85 and thus recognizes a $15 gain
Traditional Method with Curative Allocations (§1.704-3(c)) This is the same as the traditional method, but it permits reallocation of other gains for tax purposes to cure disparities (it “cures” the disparities caused by the ceiling rule) The reallocation must not exceed the amount of the ceiling limited item for the tax year, and is of the same character or type as that item
Ex.: Same facts as above (AB P/S; A contributes land [60 b, 100 FMV], B $100) but add: AB invested the $100 in stock The land is sold for $70 ($30 book loss, $10 tax gain); stock is sold for $150 ($50 gain for both tax and book) Again, there is a $15 disparity on the sale of the land as in the example above To prevent this, can allocate $40 of the stock gain to A and $10 to B for their tax accounts. This has the effect of increasing A’s tax account from $70 (balance immediately after the land sale) to $110; it does the same for B, increasing his account from $100 (balance unaffected by land sale) to $110. To illustrate: A B Beg Bal 60 tax 100 book 100 tax 100 book Land Sl. 10 tax (15) book -- tax (15) book Stk Sl. 40 tax 25 book 10 tax 25 book Total 110 tax 110 book 110 tax 110 book
Remedial Allocations (§1.704-3(d)) Basically permits P/S to ignore ceiling rule and “make up” tax allocations to match book allocations Allocate all P/S income or loss to noncontributing ptr until tax = book; if insufficient income or loss to do this because of the ceiling rule, then make up a remedial allocation to the noncontributing ptr and an offsetting allocation to the contributing ptr. Ex: Same facts again (AB P/S; A contributes land [60 b, 100 FMV], B $100) Land is sold for $70. B gets a “made up” tax loss of $15; A gets similar gain. To illustrate capital account effects: A B Beg Bal 60 tax 100 book 100 tax 100 book Land Sl. 10 tax (15) book -- tax (15) book Remed. All. 15 tax 0 book (15) tax 0 book Total 85 tax 85 book 85 tax 85 book
Depreciable Property Depreciation complicates allocations of built-in g/l because g/l must be recognized over the life of the property (instead of just waiting for sale) General Rules P/S steps into contributing ptr’s shoes on depreciation Book depreciation = tax depreciation If basis ¹ FMV, book & tax depreciation occur at the same rate
Depreciation & Traditional Method Generally, the noncontributing ptr is allocated the same amount of depreciation for tax purposes as they are for book; if depreciation exceeds the noncontributing ptr’s share, then the contributing ptr is allocated the balance. Ex: A contributes equipment (80 b, 120 FMV), B contributes $120; on equipment, 10-yr. straight-line recovery pd. with 4 remaining years Note that AB must recover its $80 tax basis over the remaining recovery period of 4 years (i.e., $20/yr.) Also note that AB must recover its $120 book basis over the same recovery period of 4 years (i.e., $30/yr.) Thus: each ptr. suffers an actual economic loss of $15 from book depreciation per year; therefore, out of the $20 tax depreciation available, allocate $15 to B (the noncontributing ptr.); the remaining $5 goes to A Thus, A gets less depreciation and is “overtaxed” each yr.; in this way, he recovers the built-in gain on his contributed property
Variant #1: Same facts, but A’s basis at contribution is only $40 Thus CD has only $40 of tax basis to recover (i.e., $10/yr.) (book recovery remains the same – $30/yr.) Each ptr. again suffers an actual economic loss of $15/yr. from book depreciation; however, only $10 of tax depreciation is available. This is all allocated to B. However, this creates a disparity in B’s capital accounts that will increase by $5 each year. Thus, the ceiling rule will force B to be overtaxed $5 per year for 4 years (thus taxing B on a portion of A’s built-in gain). The disparities will not be resolved until the P/S is liquidated or A or B sells their interests
Depreciation & Traditional Method + Curative Allocations If there are other resources available to make curative allocations, the P/S can prevent the disparity in the example above Ex: Same facts, but P/S has $20 of income per year (split $10 each between the ptrs) Allocating $5 to B and $15 to A in the tax capital accounts will cure the disparity above (book allocation would remain $10 to each ptr)
Depreciation & Remedial Method P/S adopting this method must use special rule to determine amount of any book item (including depreciation) with respect to that property) Special rule loosely considers that the contributing ptr sold the property on a deferred basis to the P/S on date of contribution for its FMV. To the extent of transferred basis, P/S steps into ptr’s shoes for both book and tax purposes and must use ptr’s depreciation method To the extent FMV exceeds basis (the “balance of value”) is treated for book purposes as though P/S bought the property for this amount; for this latter amount, P/S can use any depreciation method Thus, property is “split in two” and treated as though it were two assets
Ex: Same facts as above (Ex: A contributes equipment (40 b, 120 FMV), B contributes $120; on equipment, 10-yr. straight-line recovery pd. with 4 remaining years; $20 income/yr.) P/S treated as though it received two pieces of equipment, on contributed by A worth $40 and one purchased for $80 With respect to the “contributed portion,” must use A’s depreciation method over remaining life (e.g., $40 straight line for 4 yrs., or $10/yr.) for both book and tax with respect to the “purchased portion,” P/S can choose its own method; presume it chooses a 10-year period. Depreciation is $80 for 10 years, or $8/yr. for book purposes Thus, AB gets book depreciation of $18 (10+8) for the first 4 years, and $8 for the remaining 6 years Thus, for its first 4 years, AB will have $2 of income for book purposes (20 inc. - 18 depr.); it will have $10 for tax purposes (20 inc. - 10 depr.) For these four years, A & B would each be entitled half the $20 income and $18 depr. for book(or $10 and $9 each, for a net of $1 each) and $10 inc. each for tax; however, under the traditional method B would get $9 of depr. and A only $1; thus A would have $1 tax inc. and B $9. This causes A’s book/tax disparity to be reduced and B’s to be unaffected (see p. 94)
This changes in the last 6 years; although $4 of book depr. is allocated to B, the ceiling rule prevents any allocations for tax purposes. Thus, a $4 remedial offsetting decrease must be made to B’s tax account and an offsetting increase to A’s account
Choice of Method If all ptrs in same tax bracket, it makes no difference Otherwise, choose method with most aggregate tax savings; if disparity between ptrs’ brackets is large, this is probably traditional; if small disparity, then probably traditional with curative allocations (if there are no income offsets, then remedial – the traditional with curative allocations is generally better because of the accelerated depreciation) Anti-Abuse Rules (§1.704-3(1)(10)) Can’t choose method with “view to shifting tax consequences of built-in g/l among ptrs in a manner that substantially reduces the present value of the ptrs’ aggregate tax liability Typically arises with the use of accelerated depreciation methods where the asset’s economic life is longer than the cost recovery time
Revaluations Sometimes called “reverse §704(c) allocations,” this permits, upon a change in P/S interests, all built-in g/l’s to be recognized for book purposes and allocated by the P/S agreement terms; the tax items are not recognized; this leads to the same type of disparities from the contribution of property with built-in g/l These disparities are taken care of by the same types of allocations illustrated above
Partnership Liabilities and Loss Limitations Recall that ptr’s share of P/S liabilities is included in OB – changes in a ptr’s share of liabilities are treated as contributions/distributions. Basis Limitation on Loss Allowance (§704(d)) If OB = 0, loss carryforward until ptr has positive basis (from later income, contribution, or P/S borrowing) In other words, a ptr cannot deduct losses in excess of OB Sennet – ptr. sold interest for note in 1968; $240k allocated to loss in same year; $109k contributed in 1969. Loss is unusable in 1968 because of zero basis How to avoid this screw-up? Can make sale in ’69, or make contribution in ’68 (note that contributing a promissory note would not work – no basis in your own note!)
Loss limitation may come into play when ptr is allocated a loss from another ptr’s contribution or loan from a 3rd party
Basis Effects of Partnership Liabilities General Rule: Increase in ptr.’s share is treated as a cash contribution Decrease in ptr.’s share is treated as a cash distribution
Ex: AB formed; A contribs property ($70 b, $100 FMV, $80 liab); B contribs $20. Result: P/S IB in prop= 30, BV = 70; A’s OB = 30, book cap. acct. = 20; B’s OB = 60, book cap acct. = 20 Why? A gets a decrease in liability of 40, so he is treated as though he was distributed this amount; B gets an increase in liability, so he is treated as though he contributed this amount
How are recourse liabilities shared? The key is economic risk of loss – whose pocket would the money come from if the P/S went belly up? This is determined by doing a “constructive liquidation” of the P/S; to the extent that any ptr is responsible for repaying a liability, that ptr has the economic risk of loss. Steps to “constructive liquidation” (§1.752-2(b)(1)); the following are deemed to occur: All liabilities become due and payable All assets (including cash) become worthless (except for property held in name only to secure debt) All assets are disposed of in taxable transactions for no consideration (other than satisfying nonrecourse debt secured by the property) P/S allocates all items of income, g/l, etc. for its last taxable year ending on date of constructive liquidation, and The P/S liquidates
Also assume all ptrs live up to their obligations; don’t worry about built-in g/l for purposes of this test Also note: get rid of the nonrecourse liabilities first, before determining who bears the risk on recourse liabilities
See p. 109-113 for examples
How are nonrecourse liabilities shared? (§752 regulations) Because by definition no ptr. bears the economic risk of loss, there must be an alternate way of allocating nonrecourse liabilities Apply following analysis: a ptrs share of nonrecourse liabilities is equal to the sum of: His share of P/S minimum gain i.e., sum of nonrecourse deductions allocated to ptr. + nonrecourse distributions made to her
His share of “§704(c) minimum gain” (the amount allocable to him under §704(c) if the property was disposed of for no consideration other than satisfaction of liabilities) ex.: ABC P/S; C contribs land (300 b, 1,000 FMV, 900 nonrec. liab.) C has $600 minimum gain (900-300)
His share of “excess nonrecourse liabilities”, i.e., those nonrecourse liabilities not allocated under a or b. Can be shared either by profit share, by P/S agreement (so long as arrangement is consistent with some item with SEE) or by nonrecourse deduction allocation By profit shares is most common and is the “default” method; by deduction is next-most common Thus, in the example under (b)(i) above, the remaining 300 (900 - 600 min gain allocation) of the liability would probably be allocated 100 to each ptr (assuming they share profits equally)
Additional Notes All of these could be treated as Tufts-type taxable events; however, they aren’t! (Tufts only for P/S debt forgiveness, not reductions in liabilities stemming from contributions of property) RR 88-77 – accrued expenses ¹ liabilities for §752 purposes; RR 95-26 – short sales = §752 liabilities
General Loss Limitations See chart at end of outline Related Persons §267, §707(b)(1) – no losses allowed on sales to “related persons” (i.e., family, related corps, trusts, tax exempt orgs, etc.) Note that control requirements for “related” corps, etc. is 50% – but is increased to 80% by §1.752-4(b) + anti abuse rule in (b)(2)(4)
At-Risk Rule Pritchett – to deduct loss, must be “at risk” for repaying the liability the loss creates – i.e., can’t be a contingent liability (holding P/S agreement requiring indemnification from LP’s sufficed to make the LP’s “at risk) Also: court will not discount when determining how much ptr. is at risk
Passive Loss Limitations This basically kills tax shelters by disallowing passive losses if they outweigh passive gains (excess is a suspended loss)
Partner-Partnership Transactions Side Arrangements with Partner & Guaranteed Payments The basic question: what is a §704(b) distributive share, a §707(c) pmt., or §707(a) pmt.? Categories §704(b) distributive share = aggregate treatment to pmts for service/capital if amt. is determined with reference to P/S income; use P/S accounting method §707(c) – ptr gets guaranteed pmt. – hybrid approach; for: §§61(a) (income to ptr), 162(a) (deductible to P/S), 263 (capitalization trumps deduction) – treat as though not a ptr all other purposes, treat as distributive share use P/S accounting method
§707(a) – an arm’s length transaction – treat as though not a ptr.; use ptr’s accounting method
Also see chart p. 123 Note in a “minimum guaranteed pmt” situation, if P/S income to ptr. is > than minimum pmt., the whole thing is a distributive share (and not a guaranteed pmt.); if P/S income to ptr. is < than min. pmt., the min. pmt. exceeding ptr’s share of P/S income is a guaranteed pmt.
Ask: is ptr. acting as a ptr or as a stranger? If stranger, then arm’s length; then ask, is amount determined with respect to P/S income? If yes, then dist. share; if not, then guaranteed pmt.
Disguised Payments for Services or Use of Property Basic problem: it is advantageous for a P/S to structure compensation for services relating to capital investment as a distributive share Why? Because if arms-length, the service ptr. gets income and the P/S has to capitalize the cost, resulting in yet more tax income for all ptrs. Ex.: ABC P/S has $60 income this year; A is architect, P/S gets him to design building for $60; if arm’s length, A gets $60 of income; ABC must capitalize cost of services, so it can’t offset it’s income with a deduction; thus A, B, and C each have an additional $20 of income to report Contrast above ex. to if transaction is considered a distributive share; A gets his $60 share, and there are no further consequences to P/S or B and C
Several “bad factors” in determining treatment (§707(a)(2)(a) leg. history) Low risk (most imp – ptr’s share risk; independent K’s don’t) Transitory status Pmts are contemporaneous with services Tax benefits Continuing interest is small Does ptr perform similar services for others in similar situations? Disguised fees If ptr performs services, there is a related allocation to ptr, and these two facts taken together = a transaction between unrelated parties, then it is an arm’s length transaction
Exchange of Partnership Interest for Services Services for a Capital Interest Capital interest = one which entitles the holder to a current claim on P/S net assets How to tell if there is a capital interest involved? Do the “liquidation test” -- hypothesize that after service ptr gets his interest, the following occurs; if ptr is entitled to a distribution, it is a capital interest: All P/S assets sold for FMV Resulting g/l are allocated among ptrs according to their agreement All P/S liabilities are satisfied, and Remaining assets are distributed to ptr.’s in accordance with the agreement
Effect Service ptr must include income equal to the FMV of the capital interest received The capital ptr/P/S may get §162(a) deduction (subject to §263) Timing rule is unclear: either §706(a) last day of P/S year, or §83 date of transfer. Important, because that’s the date you assess FMV
Examples In-Kind Exchange A has stock (10 b, 60 FMV); exchanges for services from B A has 50 CG (as though he sold the stock) and bus expense ded. of 60 (as though he used “sale” proceeds to pay B) B has 60 of OI
Transfer of Capital Interest (McDougal) O has horse (10 b, 60 FMV); gives ½ interest to T for services O has 25 CG and 30 bus expense ded.; T has 30 OI What if O has to capitalize? At the end of the day, O has horse worth 30 on which he has a basis of 10, so O should have a 20 gain. Credit O with cost of T’s services before you determine the amount of gain; cost of services is 30, so basis jumps to 40 (from 10)
“Circle of Cash” – permits O to avoid gain from above example O borrows $30 O gives T $30 for services T contributes $30 to P/S P/S distributes $30 to O, who repays the loan
Services for a Profits Interest An exchange of services for a profits interest is not a taxable event Except for narrow exceptions – profits int has fairly certain income stream, interest is in publicly traded P/S, or service partner disposes of his interest within two years of receipt
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