Partnership Operations Module learning objectives • Describe how a partnership's income, deductions, gains and losses are taxed and reported • Determine a partnership's taxable income • Determine the amount of a partner's distributive share of partnership income, deductions, gains and losses Module learning objectives • Identify and distinguish between organizational syndication and startup costs • Determine the required year-end of a partnership The partnership agreement • Includes all agreements among the partners or between partners and the partnership • Can be written or oral • Governs the economic arrangement among the partners • May be modified up to the original due date of the partnership's tax return • See §761(c) and Reg. §1.704 – 1(b)(2)(ii)(h) Partnership’s tax reporting • Partnerships are tax-reporting entities, not tax-paying entities. • Form 1065, U.S. Return of Partnership Income • Form K-1, Partner's Share of Income, Credits, Deductions, etc. Partnership’s tax reporting • For example: – RST, an equal partnership of R, S and T, has operating income of $345,000 and a long- term capital gain of $30,000. – Because RST is a tax-reporting and not a taxpaying entity, it will pay no income tax on the ordinary income or the capital gain. – Instead, each partner will report one-third of his or her share of the partnership income and pay the related income tax. Separately stated items • Section 702(a) provides the following items must be separately stated: – Net short-term capital gains/losses – Net long-term capital gains/losses – Section 1231 gains/losses – Charitable contributions – Dividends eligible for dividends-received deduction – Taxes paid to foreign country or US possession – Any other items provided by regulations that, if not separately stated, would result in different tax liability for a partner Example Computing taxable income • XYZ, a calendar-year partnership, has operating income for the year of $50,000, operating expenses of $37,000, and a charitable contribution of $10,000. • What is the taxable income of the partnership? Partner’s distributive share • Each partner's distributive share of gain, loss, income or deduction generally is determined according to the partnership agreement. • For example: – John and Ted form a partnership, with each partner contributing $5,000. – An oral agreement to split the profits and losses of the company (60% to John and 40% to Ted) will be binding on the partnership and its partners. – However, the burden of proof that this agreement exists will be borne by John and Ted. Partner’s distributive share (cont.) • If partner profit- and loss-sharing ratios are different: – The partnership's taxable income or loss for the year is first computed to determine whether net profit or net loss has been earned. – The appropriate percentage (profit-sharing if the partnership realized taxable income, or loss-sharing if the partnership incurred taxable loss) is applied to each class of income. Example • The XYZ Partnership reports a net short- term capital loss for the year of $30,000 and ordinary income from operations of $20,000. Jane, a partner, shares in 20% of the profits and 30% of the losses. • How much of the ordinary income will be allocated to Jane? Organizational costs - Section 709 • A partnership may deduct organizational costs, in the taxable year in which the partnership begins, in an amount of equal to the lesser of: – The amount of organizational expenses with respect to the partnership or – $5,000, reduced (but not below zero) by the amount by which such organizational expenses exceed $50,000 • The partnership may deduct the remainder of such organizational expenses ratably over the 180-month period, beginning with the month in which the partnership begins business. Organizational costs - Section 709 • Organization costs include • Costs incident to the formation of the partnership • Costs that ordinarily would be subject to capitalization • Costs that normally would be amortized over the life of the partnership • Examples of organization costs are: Legal fees for drafting the partnership agreement, accounting fees for setting up the accounting records and state franchise fees Syndication fees • Costs incurred to promote the sale of (or to sell) an interest in a partnership • No deduction allowed by the partnership or its partners – Examples: • Expenses of issuing and marketing partnership interests, including registration of brokerage fees • Accounting fees and legal fees relating to opinions, including in offering materials • Printing costs of offering materials Startup expenditures – Section 195 • A partnership may deduct start up expenses, in the taxable year in which the partnership begins, in an amount of equal to the lesser of: – The amount of start up expenses with respect to the partnership or – $5,000, reduced (but not below zero) by the amount by which such organizational expenses exceed $50,000 • The partnership may deduct the remainder of such start up expenses ratably over the 180-month period, beginning with the month in which the partnership begins business. Startup expenditures – Section 195 • Start up expenses are amounts paid or incurred in connection with: • Investigating the creation or acquisition of an active trade or business • Creating an active trade or business • Any activity engaged in for profit before the day on which the active trade or business begins or in anticipation of such activity becoming an active trade or business – Only amortizable if the expense would otherwise be deductible if paid or incurred in connection with the operation of an existing active trade or business (in the same field as the trade or business) Partnership tax years • Generally, a partnership must have the same taxable year as that of its majority interest partners. • When there are no majority interest partners with the same tax year, the partnership must adopt the same tax year as that of its principal partners. • If the principal partners have different tax years, the partnership must adopt a year that results in the least aggregate deferral of income to partners. • If none of these periods applies, the partnership defaults to the calendar year. Partnership tax years (cont.) • A natural business year may also be allowed. • A partnership must: – Demonstrate sufficient business purpose • Tax and nontax factors considered • If nonconforming year results in deferral or distortion of income, the nontax factors must be "compelling." – 25% Gross Receipts Test • Last two months' gross receipts greater than 25% of annual gross receipts • Test met for current 12 months and three preceding 12-month periods • Section 444 election • Allows a partnership to retain or adopt any taxable year, provided both that: – The deferral is not longer than three months. – The partnership is not part of a tiered structure. • Form 8716, Election to Have a Year Other Than a Required Tax Year Example • A new partnership is formed by 30 calendar- year individuals, each of whom owns a 2% interest, and by a fiscal-year domestic corporation that owns the remaining 40%. • What tax year must the partnership use? Example • Individual X, Corporation Y and Z Corporation formed the XYZ Partnership on 1 October. The partners made equal contributions of cash in exchange for their partnership interests, and the partnership profits and losses are to be divided equally among the partners. X is on a calendar taxable year. Corporation Y and Z Corporation have fiscal years ending 30 June and 30 September, respectively. The partnership earns approximately the same net income each month so that its income is spread evenly throughout the year. • What tax year must the partnership use? Loss limitations (cont.) §704(d) §465 §469 Losses Deduction Suspended Suspended Suspended Example • Mrs. Allen receives an $85,000 distributive share of ordinary loss as a limited partner in the ABC Partnership. Mrs. Allen's outside basis in her partnership interest is $70,000, which includes her share of a nonrecourse note of $25,000. Mrs. Allen has $10,000 of passive activity income from another business venture. • What is Mrs. Allen's deductible loss from the ABC Partnership? Carryover of suspended losses • Any loss previously disallowed is carried forward to future years and allowable to the extent that the partner's adjusted basis in the partnership interest exceeds zero (before reduction by such loss carryforward) at the end of any such year. • Suspended losses deducted in subsequent tax years maintain the same character as the original loss. Example • In Year 1, Partner C (outside basis of $1,000) receives the following share of distributive items: – Long-term capital loss of $6,000 – Short-term capital loss of $2,000 – Partnership ordinary income of $4,000 • What is the amount of Partner C's deductible capital losses? What are Partner C's loss carryforwards, if any? Carryover of suspended losses • Disposition of a partnership interest – Section 704(d) – Gain is not available to offset any previously suspended losses under §704(d), and suspended losses at the time of sale are not includible in the basis of the partnership interest. – Section 465 – Gain on the sale of a partnership interest that is considered income from the same activity under §465(c) may be used to offset any suspended losses (capital or ordinary) from that same activity. Carryover of suspended losses – Section 469 – Gain on a sale of a partnership interest that produced §469 passive income is also considered passive gain that may be used to offset any previously suspended passive activity losses. If the entire interest in the "passive activity" is disposed of in a fully taxable transaction, any excess loss is treated as a nonpassive loss. Example • In January 1,2009, Mrs. Allen sold her interest in the ABC partnership for $12,000. On this date Mrs. Allen’s outside basis and her at-risk amount in ABC were both zero. • What are the tax consequences of this sale to Mrs. Allen? Varying interests rule – §706(d)(1) • If there is a change in any partner's interest in the partnership during the partnership's tax year, then each partner's distributive share of partnership's tax items must account for the varying interests of the partners in the partnership during the partnership's tax year. – Prohibits retroactive allocations to newly admitted partners – Also applies to changes in the P/S interests of existing partners Varying interests rule – §706(d)(1) (cont.) • Permissible methods for determining partners' distributive shares: – Interim closing of books – Pro rata, such as daily or monthly – Any reasonable method • Combinations of methods must be reasonable • Transferor and transferee must use same method Example • Kate sold her one-fourth interest in JKLM this year on July 31st. The partnership had earned $240,000 as of that date, however, it expects to loose $60,000 over the next five months. Kate’s adjusted basis at the beginning of the year was $40,000. • How much income should she be allocated this year?