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Chapter 4 Calculation of Partnership Taxable Income. Introduction. Code Sec. 702(a) requires that the partnership separately state its net amounts from the following sources: Long-term capital gains and losses Short-term capital gains and losses Code Sec. 1231 gains and losses
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Introduction • Code Sec. 702(a) requires that the partnership separately state its net amounts from the following sources: • Long-term capital gains and losses • Short-term capital gains and losses • Code Sec. 1231 gains and losses • Charitable contributions • Dividends that are taxed as net capital gains or are eligible for the dividends received deduction • Income taxes paid to foreign countries • Other items required by the regulations
Introduction (Cont.) • Examples of items that the regulations add are: • Recoveries of bad debts and taxes • Gains from wagering • Nonbusiness expenses • Medical and dental expenses • Items specifically allocated • Any amount that, if separately taken into account by any partner, would result in a different income tax liability for that partner than if the item was not separately taken into account.
Both Entity and Aggregate Rules Apply • Sometimes the partnership is treated as a group of aggregate partners (for example, when income is taxed not at the partnership level but at the individual level) and sometimes it is treated as an entity (for example, when the combined net income is reported on Form 1065). • Partnerships are treated as entities for purposes of making most elections that affect the computation of pass-through items, and for certain procedural purposes. • For other purposes, it is treated as an aggregation of individual owners.
Both Entity and Aggregate Rules Apply (Cont.) • In some cases, the partnership can choose to use the entity rule or the aggregate rule. • Examples of the aggregate approach to taxation: • Requirement to file a tax return • Application of 6 year statute of limitations for omitting more than 25% of gross income • Tax imposed on S corporations with excessive investment income and termination of their election • Partners are required to report their share of the profits or loss, regardless of whether it is paid to them or the partnership • The character of the income, gain, loss, etc. is passed on to the partner from the partnership level. • Co-inventors of a patent are still considered its “holders” if they make a partnership and transfer the patent to the partnership
Both Entity and Aggregate Rules Apply (Cont.) • Elections made at the partner level include: • Code Sec. 901 election • Election to deduct mining exploration expenses • Election related to cancellation of indebtedness income • Elections related to nonresident and foreign corporation investments on US rental realty
Both Entity and Aggregate Rules Apply (Cont.) • Examples of the entity approach to taxation: • An S corporation shareholder may deduct his or her share of losses only to the extent of his or her basis in the stock and the basis he or she has in loans made to the corporation. • Partnership income is computed at the entity level • The partnership files a tax return reporting its taxable income • The partnership has its own accounting method • The partnership has its own taxable year
Both Entity and Aggregate Rules Apply (Cont.) • Elections made at the entity level include: • Depreciation elections • Inventory method • Election to roll over involuntary conversion gains • Election to expense a limited amount of depreciable basis in the year of acquisition • Election not to use the installment method for reporting installment sales • Election to amortize organizational expenses • Election to adjust the basis of partnership assets following certain distributions or transfers of interest in the partnership • Election to apply self-charged interest deduction rule
Both Entity and Aggregate Rules Apply (Cont.) • Code Sec. 1244 Stock • Code Sec. 1244 allows the owner of qualifying stock a limited amount of ordinary loss when the stock is worthless or is sold at a loss. • If the partnership distributes the stock to its partners, they do not qualify for an ordinary loss because Code Sec. 1244 treatment applies only to original holders of the stock. • The partnership, not the partners themselves, is viewed as the original owner. • Prepaid Expenses • Prepaid expenses are deductible only if, after taking the deduction into account, income is clearly reflected.
Calculation of the Amount of the Partnership’s Taxable Income (Cont.) • The general rule is that income is reported by the partnership if it is reasonably associated with the partnership’s business activity. • The partner must report outside service income to himself even if the income is from services similar to services rendered by the partnership. • If a partner is personally responsible for an expense and not entitled to reimbursement, the partner (not the partnership) is entitled to the deduction.
Payments to a Partner • If payments are made to a partner acting in a nonpartner capacity, it’s governed by Code Sec. 707(a). • If payments are made to a partner acting like a partner, but without regard to partnership profits, they are governed by Code Sec. 707(c). • Code Sec. 707(a) and (c) payments are part of the partnership’s aggregated nonseparately stated taxableincome calculation unless they are specially allocated.
Payments to a Partner (Cont.) • A partnership generally classifies its payments to a partner in 1 of 3 categories: • Code Sec. 707(a) payments • Tends to treat the payment as if it’s made to a nonpartner • Code Sec. 707(c) “guaranteed” payments • Treated as distributive shares for some purposes and a payment to a nonpartner for other purposes • A distributive share of the partnership’s income
Payments to a Partner (Cont.) • Payments to Partners as Compensation for Services or Property Not Required as a Condition of Partner Status • Payments made to partners for the use of the partner’s money or property, or for “support services, are normally deductible by the partnership. These are generally known as Code Sec. 707 (a) payments. • Support services are services not required by the partnership agreement or because of his or her partner status.
Timing of Income and Deduction for a Code Sec. 707(a) Payment • The rules are meant to prevent a tax deferral resulting from the deduction of the payment (by the partnership) occurring in a year prior to the recognition of income from the payment (by the partner). • To claim a deduction for a Code Sec. 707(a) payment, two requirements must be satisfied.
Timing of Income and Deduction for a Code Sec. 707(a) Payment (Cont.) • The amount must be currently deductible under the partnership’s method of accounting. • Ex: A cash method partnership must have paid the amount to the partner. • The partnership generally cannot claim a deduction for a payment to a partner until the day the partner must report the payment as income.
Guaranteed Payments • Guaranteed payments are those payments made to a partner for acting in his or her capacity as a partner when the amount is determined independent of the partnership’s operating results. • These are known as Code Sec. 707(c) payments. • They can represent either payments for services rendered or payments for the use of the partner’s capital.
Guaranteed Payments (Cont.) • The amount of the payment is determined by reference to the value of the services or property provided rather than by reference to the partnership profits. • Guaranteed payments for use of a partner’s capital are similar to interest payments, but the partnership has no duty to repay the principal at a specified date. • These amounts are paid to partners in consideration for their continued investment in the partnership.
Guaranteed Payments (Cont.) • If the partner has both the right and duty to perform the services under the partnership agreement as opposed to a separate contract between the partner and partnership, it is a guaranteed payment under Code Sec. 707(c).
Timing of Income and Deduction of a Guaranteed Payment • Timing of the deduction to the partnership is governed by the partnership’s accounting method alone. • The partner must include the agreed upon payment as income on the last day of the partnership’s year in which the partnership takes the payment into account. • In all cases a guaranteed payment results in ordinary income to the partner.
Timing of Income and Deduction of a Guaranteed Payment (Cont.) • A Code Sec. 707(c) guaranteed payment generally will not affect the computation of a partner’s distributive share of partnership income other than ordinary income. • Complications arise when the partner is entitled to the greater of a specified guaranteed salary payment or a fixed percentage of partnership income computed before the guaranteed payment is taken into account. • In that case, the guaranteed payment under Code Sec. 707(c) will be the excess of the fixed minimum dollar amount over the amount the partner would have been allocated based on his or her profit/loss sharing ratios (their distributive share).
Timing of Income and Deduction of a Guaranteed Payment (Cont.) • If the partner is to receive a certain fraction of all of the income (not just the ordinary income) of the partnership, subject to a minimum amount, complications may arise. • Under these circumstances, the guaranteed payment is the minimum amount less the partner’s total distributive share of all partnership income. • The guaranteed payment must then be subtracted from the partnership ordinary income, and the remaining ordinary income and other income of the partnership will be allocated among the partners based on the fraction of total remaining income that each partner is due to receive.
Timing of Income and Deduction of a Guaranteed Payment (Cont.) • A guaranteed payment is: • Not a share of profits for purposes of identifying the partnership’s required taxable year. • Not a share of profits for the special rules on the taxation of sales between a partnership and its partners. • Not a share of profits for purposes of the partnership’s technical termination upon the sale of interests in that partnership. • Not subject to income or payroll tax withholding.
Timing of Income and Deduction of a Guaranteed Payment (Cont.) • Subject to the tax on self-employment income unless: • The partnership is not engaged in a trade or business, or • The payment is a guaranteed payment for the use of capital paid to a limited partner. • Earned income for purposes of contributions to a qualified deferred compensation plan. • Nonpassive interest income for purposes of the Code Sec. 469 passive loss rules if paid for the use of capital. • Nonpassive compensation income for purposes of the Code Sec. 469 passive loss rules if paid for services.
Timing of Income and Deduction of a Guaranteed Payment (Cont.) • Premiums a partnership pays for accident and health insurance coverage on behalf of its partners are deemed guaranteed payments for services to the partners provided: • The premium payments are paid for services rendered as a partner, and • The payments are determined without regard to partnership income.
Summary: Is This “Much Ado About Very Little”? • The timing of the partnership’s deduction and the partner’s income will be the same if: • Both parties are using the cash method of accounting. • Both parties use the calendar year as their taxable year. • The payment is made to the partner during the same year the services or capital is provided by the partner to the partnership.
Accounting Method • Under Code Sec. 448, partnerships that either (1) have a C corporation as a partner or (2) are tax shelters are not allowed to use the cash basis accounting method even when it otherwise properly reflects income. • This rule does not apply to partnerships with a corporate partner if the partnership does not meet the $5,000,000 gross receipts test for all preceding years. • A partnership meets this test if its average gross receipts for that year and the preceding 2 years does not exceed $5,000,000.
Accounting Method (Cont.) • A partnership (even a partnership with a C corporation partner) that meets a $10,000,000 gross receipts test for all prior years will be allowed to use the cash basis. • Tax shelters may never use the cash method. • Tax shelters are: • Enterprises in which interests have been offered for sale in any offering required to be registered under state or federal law. • All partnerships in which limited entrepreneurs are allocated more than 35 percent of the losses for the taxable year. • Any arrangement that has as its principal purpose the avoidance or evasion of the federal income tax.
Organization and Syndication Expenses—Code Sec. 709 • A partnership’s deduction for expenses incurred before operation begins encounters 2 problems: • There is no partnership trade or business so a Code Sec. 162 expense isn’t allowed. • A majority of the expenditure will benefit a future taxable year so it’s potentially a capital expenditure under Code Sec. 263. • Common partnership expenditures that occur prior to operation include:organization, syndication, business investigation, and start-up expenditures.
Code Sec. 709: Organization Expenses • Code Sec. 709(a) disallows all deductions for amounts paid or incurred to organize a partnership. • Code Sec. 709(b) allows a deduction of up to $5,000 for organizational expenses. • Any additional organizational expenses are amortizable over the 180 month period that begins with the inception of the trade or business. • A Code Sec. 709 deduction election is automatically deemed made for the taxable year in which the partnership begins business.
Code Sec. 709: Syndication Costs • Code Sec. 709(a) denies any deduction for amounts paid and incurred “to promote the sale of (or to sell) an interest in such partnership.” • These selling expenses are referred to as syndication expenses. • Examples of syndication expenses include: • Brokerage fees • Registration fees • Legal fees of an underwriter, place management, an issuer for securities advice and for advice pertaining to the adequacy of tax disclosure in the prospectus • Accounting fees for preparation of representations to be included in the offering materials, and • Printing costs of the prospectus, placement memorandum, and other selling and promotional material.
Investigation, Acquisition, and Start-Up Expenses– Code Secs. 195 and 263 • There are 2 categories of Code Sec. 195 expenses: • Investigation expenses • Pre-opening/start-up expenses • Up to $5,000 ($10,000 in 2010) of Code Sec. 195 expenses may be deducted in the taxable year in which the trade or business begins.
Code Secs. 195 and 263: Investigation Expenses • Expenses incurred in expanding a taxpayer’s current business are deductible currently as trade or business expenses. • Expenditures incurred in the investigation of an active trade or business in order to determine whether to enter a new business and which new business to enter are eligible for amortization. • Expenditures incurred to acquire a specific business aren’t eligible for amortization. • Therefore, during the acquisition process there will be a point in time when expenses cease being capitalized and deducted or amortized under Code Sec. 195 and start being capitalized under Code Sec. 263 as cost of acquiring the business itself.
Code Secs. 195 and 263: Investigation Expenses (Cont.) • In the case of expanding an existing business, costs incurred in connection with the acquisition of assets are capitalized under Code Sec. 263. • Factors which could imply expansion of the business would be geographically extending the business or vertical integration. • Factors indicating a new trade or business might include involvement in marketing products that differ significantly from the products currently being marketed or marketing the same products to new and different customers.
Code Secs. 195 and 263: Pre-Opening/Start-Up Expenses • Start-up costs are another type of Code Sec. 195 expense. These include: • Advertising • Wages paid to employees being trained and to instructors • Travel and other expenses incurred in lining up prospective distributors, suppliers or customers, and • Salaries or fees paid or incurred for executives, consultants, and/or similar professional services.
Code Secs. 195 and 263: Pre-Opening/Start-Up Expenses (Cont.) • The start-up period begins with the end of the investigatory phase of whether to enter the business or which business to enter and it ends when the associated trade or business is actively conducted. • Generally, they are considered actively engaged when they begin earning revenue from the trade or business.
Introduction • Generally, a partnership computes its taxable income in the same manner as do individuals. • Items that may have potentially varying tax consequences to particular partners must be separately stated; all other items are aggregated and passed through as one lump sum. • This is then allocated to the partners in accordance with the partnership agreement.
General Rule– Entity Level Characterization • The character of the item (income, loss, deduction, credit, etc…) passed on to the partners is determined by reference to partnership-level factors.
Characterization of the Gain (Loss) on Disposition of Contributed Property • The character of the partnership’s income is determined at the partnership level except as provided by Code Sec. 724. • Code Sec. 724 modifies partnership level characterization for three categories of contributed property: • Unrealized receivables • Inventory items • Capital Loss Property • Substituted basis property received in exchange for such contributed property is treated as if it were the contributed property.
Gain (Loss) on Disposition of Contributed Property (Cont.) • Any gain or loss recognized by the partnership on the disposition of an “unrealized receivable” would be ordinary income. • Inventory items retain their ordinary income taint under Code Sec. 724(b) for five years after their contribution to the partnership. • After 5 years, the character of the property is determined at the partnership level. • Appreciation existing at the time of the contribution is taxed to the contributor under Code Sec. 704(c), and the remainder is ordinary income allocated according to the partnership agreement.
Gain (Loss) on Disposition of Contributed Property (Cont.) • “Capital Loss Property” is any capital asset held by the contributing partner which has an adjusted basis in excess of the fair market value immediately before it was contributed to the partnership. • If the partnership sells such property at a loss, Code Sec. 724(c) requires the built-in loss at the time of the contribution to retain its character as a capital loss for a period of five years from the date of the contribution. • Additional loss is characterized at the partnership level.
Preparation of Form 1065, Schedules K and K-1 • Reconciling Partners’ Capital Account Balances • Box L reconciles the partners’ capital account balances. • The total of the partners’ items in box L should agree with the accounting methods employed in preparing the Schedule L balance sheets and the reconciliation with the total partnership capital in Schedule M-2.
Preparation of Form 1065, Schedules K and K-1 (Cont.) • Schedules M-1 and M-2 • Schedule M-1: • Book income + income items on the partners’ K-1s but not on the books (Line 2) + guaranteed payments (Line 3) + expenses for books not on K-1s (Line 4) – Income items on books but not on K-1s including tax-exempt interest (Line 6) – items of deductions on the K-1s but not on the books (Line 7) = Total of the income and deduction items distributable to the partners on their K-1s. • This ties with the net income on Schedule K, Partnership Income or Loss.
Preparation of Form 1065, Schedules K and K-1 (Cont.) • Schedule M-2: • Capital account balances at the beginning of the year + capital contributed during the year (Line 2) + net income per books (Line 3) + other increases (Line 4) – distributions to partners (Line 6) – other decreases (Line 7) = capital account balances at the end of the year. • Partners’ individual capital accounts are reconciled in box L of Schedule K-1. • All the income and deduction effects on the capital accounts are combined and appear in “Current year increase (decrease)” line of box L. • This amount MUST be reported to the partners.
Preparation of Form 1065, Schedules K and K-1 (Cont.) • Schedule M-3 • Any entity which files Form 1065 or Form 1065-B must complete and file Schedule M-3 in lieu of Schedule M-1 if any of the following is true: • The amount of total assets at the end of the year is equal to $10 million or more. • The amount of adjusted total assets for the year is equal to $10 million or more. • This equals the total assets at the end of the tax year before capital distributions, losses, and adjustments that reduce total capital. • The amount of total receipts for the taxable year is equal to $35 million or more. • The partnership has a “reportable entity partner.”
Preparation of Form 1065, Schedules K and K-1 (Cont.) • In Part 1 of Schedule M-3 questions about the partnership’s financial statements must be answered. • A reconciliation of financial statement net income for the consolidated financial statement group to income per the income statement for the partnership is also required. • Parts II and III of Schedule M-3 reconcile financial statement net income (loss) for the partnership (per Schedule M-3, Part I, line 11) to income (loss) per the return on Form 1065 and Form 1065-B, page 4, Analysis of Net Income (Loss), line 1.
Preparation of Form 1065, Schedules K and K-1 (Cont.) • Separately Stated Items • Items Having Special Tax Characteristics • These are separately reported on boxes 1 through 13 on Schedule K-1. Boxes 3-13 can contain regularly allotted items as well. • Items Receiving a Special Allocation • Line 1 represents the partner’s share of the “bottom line” on Form 8825. • Line 2 represents the partner’s share of the “bottom line” on Form 8825. • The allocations on these lines should not include specially allocated items. • Specially allocated items should be reported on Line 11 (income items on Line 11 and loss items on line 13e).
Preparation of Form 1065, Schedules K and K-1 (Cont.) • Separate Reporting • Reg. § 1.702-1(a)(8)(i) requires the separate reporting of any item subject to a special allocation “under the partnership agreement.” • This applies to the mandatory special allocations under Code Sec. 704(c)(1)(A).
Presentation of a Partnership’s Taxable Income • A partnership reports its taxable income differently than an individual. • It separately lists the net amount of any item of income, loss, or deduction that could affect the various partners differently. • The remainder of the partnership’s items of income, loss, and deduction are simply aggregated as one net number.
Separately Stated Items • It is also necessary to inform the partners of their shares of nontaxable income and expenditures that are not deductible by the partnership. • In this case, it reports the amount and nature of the nondeductible expenditure to the partners, and its intermediary status is ignored. • See chapter five and instructions for Form 1065 schedule K and k-1 for more specific information on each separately stated item.