1 Chapter 9: Partnership Formation and Operation.

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Chapter 9:Partnership Formation

and Operation

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PARTNERSHIP FORMATION PARTNERSHIP FORMATION & OPERATION& OPERATION (1 of 2) (1 of 2)

Partnership definitions Overview of partnership taxation Contributions of Property Partnership elections Ordinary income/loss vs. separately stated

items Partners’ distributive share of items

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PARTNERSHIP FORMATION PARTNERSHIP FORMATION & OPERATION& OPERATION (2 of 2) (2 of 2)

Special allocations Partner’s basis in partnership interest Special loss limitations Guaranteed payments Transactions between partner & partnership Family partnerships

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Partnership DefinitionsPartnership Definitions(1 of 5)(1 of 5)

Tax definition of a partnership– Syndicate, group, pool, joint venture or

other unincorporated organization that carries on a business

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General partnership– Two or more partners– All partners are general partners

»May participate in mgmt»May make commitments on behalf of

partnership»Unlimited liability for partnership debts

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Limited partnership– One or more general partners and– One of more limited partners

»Cannot participate in management»Cannot make commitments for partnership»Liability generally limited to amount invested in

partnership

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Limited liability companies (LLCs)– May be taxed as a partnership or a corp

(using check-the-box regs)

– Allows entity to obtain flow-through and flexibility of partnership allocations while maintaining limited liability of a corp.

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Limited liability partnerships(LLPs)– Used by many professional organizations– May be taxed as a partnership or a corp (using

check-the-box regs)– Partners not liable for failures in work of other

partners or people supervised by other partners Electing large partnership (ELP)

– Non-service partnerships w/ 100 ptrs

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Overview of Partnership Overview of Partnership TaxationTaxation

Partnership profits and losses Partner’s Basis Partnership distributions

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Partnership Profits and Losses (1 of 2)

Partnership files Form 1065– Information return with no tax due

Partners receive a Form K-1 – Reports partner’s share of income or

loss and separately reported items

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Partnership Profits and Losses (2 of 2)

Partners include profit or loss and separate items on their individual return (Form 1040 for individuals)

Loss limitation– Partner’s losses limited to his/her basis in the

partnership– At-risk rules and passive loss rules also

apply

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Partner’s Basis

Partner’s basis increased by share of partnership earnings, additional contributions, & additional assumption of partnership debt

Partner’s basis decreased by losses, distributions, & reduction in partnership debt

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Partnership Distributions

Payment of money to partner usually tax-free because earnings previously taxed

If distributions exceed the partner’s basis, gain may be recognized

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Contributions of PropertyContributions of Property

General rule Exceptions to nonrecogntion rule Contributions of services Basis See Topic Review C9-1 for summary

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General Rule

General rule for property contributions in exchange for partnership interest– No gain or loss

– §721 similar to §351

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Exceptions toNonrecognition Rule

Gains recognition at time of property contribution– Partnership would be investment company if it

were incorporated– Contribution followed by a distribution resulting in

a deemed sale– Liabilities assumed by partnership in excess of

partner’s basis

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Contributions of Services(1 of 2)

Contribution of services in exchange for partnership interest– Income is FMV of services

contributed

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Contributions of Services(2 of 2)

Partnership deducts or capitalizes FMV of services, depending on the nature of the expense– Partnership recognizes gain or loss

»FMV of services – basis in assets allocated to service partner

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Basis

Partner’s basis in partnership equal to money contributed plus partner’s basis in contributed property plus gain recognized on contribution

Partnership’s basis in property is partner’s old basis before contribution– Holding period also carries over

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Partnership ElectionsPartnership Elections

Tax year– Must be same as majority partner or partners

with a 50% or more interest– See Topic Review C9-2

Overall accounting method Inventory valuation method Depreciation method

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Ordinary Income/Loss vs. Ordinary Income/Loss vs. Separately Stated ItemsSeparately Stated Items (1 of 2) (1 of 2)

Separately stated items– Net S-T capital gains and losses

– Net L-T capital gains and losses

– §1231 gains and losses

– Charitable contributions

– Dividends eligible for DRD

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Ordinary Income/Loss vs. Ordinary Income/Loss vs. Separately Stated ItemsSeparately Stated Items (2 of 2) (2 of 2)

Separately stated items (continued)– Foreign or possession taxes– Tax-exempt interest– Any items subject to special allocation

Partnership ordinary income/loss– All items not separately stated

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Partners’ Distributive Partners’ Distributive Share of ItemsShare of Items

Normally determined by terms of partnership agreement– Portion of partnership taxable and nontaxable

income partner agreed to report for tax purposes

– Amount not necessarily same as actual amounts distributed to partner in a particular year

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Special AllocationsSpecial Allocations(1 of 2)(1 of 2)

Pre-contribution gains or losses must be allocated to contributing partner for contributions

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Special AllocationsSpecial Allocations(2 of 2)(2 of 2)

Allocations not related to contributed property must have substantial economic effect– Allocations affect partners’ capital accounts,

and – Partners must make up deficit in capital

account upon liquidation of partnership

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Partner’s Basis in Partner’s Basis in Partnership InterestPartnership Interest (1 of 2) (1 of 2)

Beginning basis – Amount paid for interest OR– Basis of property/ services contributed

Additions to basis– Additional contributions, earnings or

assumption of liabilities Reductions result from withdrawals, losses

or transfer of liabilities

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Partner’s Basis in Partner’s Basis in Partnership InterestPartnership Interest (2 of 2) (2 of 2)

Affect of liabilities on partner basis

Partner’s basis before liabs+ Increases in share of ptrshp liabs- Decreases in share of ptrshp liabs+ Ptrshp liabs assumed by this partner- This partner’s liabs assumed by ptrshp= Partner’s basis in the ptrshp interest

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Special Loss LimitationsSpecial Loss Limitations(1 of 2)(1 of 2)

Loss recognition limitations– Partner’s basis in partnership interest

– Portion of partner’s basis not “at risk”»Amount partner would lose should the

partnership suddenly become worthless.

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Special Loss LimitationsSpecial Loss Limitations(2 of 2)(2 of 2)

Loss recognition limitations (continued)– Designation of partnership interest as a

“passive activity”»“Passive” losses can only be used to offset

“passive” income.»Disallowed losses are suspended, and can be

used to offset future passive income, or when the passive activity is sold

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Transactions Between Transactions Between Partner & PartnershipPartner & Partnership

Loss sales– No loss deducted on sale of property between a

partnership and a 50% owner (direct or indirect)

Gain sales– Gains on sale of property involving a 50%

owner produce ordinary income unless property will be a capital asset in hands of new owner

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Guaranteed PaymentsGuaranteed Payments

Always ordinary income to recipient Deductible by the partnership from

ordinary income Losses due to guaranteed payments

allocated among partners

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Family PartnershipsFamily Partnerships(1 of 2)(1 of 2)

Interest must be a capital interest– Partner has right to receive assets if

partnership liquidates immediately Capital must be a material income

producing factor Family member must be true owner

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Family PartnershipsFamily Partnerships(2 of 2)(2 of 2)

Donor-donee allocations of income– Donor must be allocated reasonable

compensation for services rendered to partnership

– Remaining partnership income must be allocated based on relative capital interest

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Self-Employment IncomeSelf-Employment Income

Individuals who are partners must pay SE tax on the following income from a partnership:– Guaranteed payments– Partnership ordinary income or loss– All separately stated items, except

»Capital and §1231 gains/losses, interest, dividends, and rental income

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1 Chapter 9: Partnership Formation and Operation.

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