OVERVIEW OF PARTNERSHIP TAXATION 1. Partnerships are not treated as separate tax entities for Federal income tax purposes.

a. All items of income, gain, loss, deduction, or credit pass through to the partners according to the partnership agreement. b. These pass-through items are reported to each partner on a Schedule K-1. c. The partners report their share of partnership items on their separate tax returns 2. Partnership tax return (Form 1065) is only an information return.

a. However, the partnership makes numerous tax accounting elections on its tax return (e.g., cost recovery methods, whether to amortize business start-up costs, tax year selection, and adopting the cash or accrual method of tax accounting). b. Such elections are important because they affect the timing and amount of items reported by the partner. 3. Partners ownership interest consists of a capital interest and a profits interest.

a. Capital interest represents the partners contribution plus a cumulative share of undistributed partnership profits. It is also the equal to the partners share of the proceeds from liquidating the partnership. b. Profits interest represents the partners share of current and future income earned by the partnership. c. Profits and capital interests do not have to be equal, and the profits interest may not be the same over time. In fact, a profits interest may vary for different types of income, deduction, etc., during a single tax year. 4. Two conflicting concepts govern partnerships; the entity and the aggregate concepts.

a. Under the entity concept, partnerships are treated as independent entities, separate and apart from the aggregate of its partners. Treats partners and partnerships as separate units and gives the partnership its own tax character. b. Under the aggregate or conduit concept, a partnership is a common pool to which each partner contributes capital or services in the pursuit of profit. Treats partnerships as a channel through which income, credits, deductions, and other items flow to the partners. Under this concept, the partnership is regarded as a collection of taxpayers c. Combined Concepts. Rules governing the formation, operation, and liquidation of a partnership contain a blend of both the entity and aggregate concepts. Forms of Doing Business Federal Tax Consequences 5. Partnerships and S corporations provide tax advantages over regular C corporations.

a. Partnerships and S corporations are flow-through or pass-through entities because owners are taxed on their

proportionate share of the entitys taxable income; thus avoiding double taxation because they are not separate taxable entities. Forms of Doing Business Federal Tax Consequences b. Administrative and filing requirements are usually simple for a partnership, and it offers certain planning opportunities not available to C or S corporations. For example: Forms of Doing Business Federal Tax Consequences (1) Both C and S corporations have rigorous allocation and distribution requirements. (2) Gains on appreciated assets are recognized at entity level for both C and S corporations upon liquidation. Partnership liquidation is generally tax-free. What is a Partnership? 6. A partnership is defined under common law as a contractual relationship between two or more persons who join together to carry on a trade or business, each contributing money, property, labor, or skill, and with the expectation of sharing in the profits and losses. a. For tax purposes a partnership includes syndicates, groups, pools, joint ventures, or other unincorporated organizations. b. Types of entities that may be treated as partnerships for tax purposes are: general partnerships, limited liability partnerships, limited partnerships, limited liability companies, and recently developed limited liability limited partnerships. In a general partnership, all partners have joint and several liability for debts of the partnership. A limited partnership has one general partner and one or more limited partner(s). Only general partners are liable to creditors. Liability for partnership debts effects the partners ability to deduct losses and effects the taxation of distributions in excess of basis. The limited liability partnership ("LLP") is a form of general partnership, created under state general partnership laws, in which partners are statutorily relieved of all or part of their personal liability for malpractice committed by the other partner(s). Several states, including Colorado, have extended the liability protection afforded LLP partners to non-malpractice torts and contractual liabilities. In other states, the LLP only provides insulation against negligence co-partners' negligence. All limited liability partnership ("LLP") statutes provide that LLP partners will be personally liable for their own negligence or malfeasance. A limited liability limited partnership ("LLLP") is a limited partnership, formed under the applicable state limited partnership statute, which specially registers and thereby provides liability protection to the general partners. Texas, Colorado, and Delaware expressly recognize limited liability limited partnerships. It effectively gives the same protection as an LLC. Limited Liability Companies provide the flexibility of partnership structure along with the liability protection of a corporation. Owners are referred to as members. All states recognize the LLC structure and allow it for all types of business and investment activities. There are three sets of rules governing classification as a partnership for federal tax purposes: Check the box rules

Anti-abuse rules 761(a) election for investments activities

7. The check-the-box Regulations allow most unincorporated business entities to select their Federal tax status. a. Unincorporated entity with two or more owners can generally choose to be taxed as either a partnership or a C corporation.

Exceptions to check the box rules: a. Trusts cannot elect to be taxed as partnerships. b. Newly formed publicly traded (sold on a stock exchange and more than 100 partners) partnerships must be taxed as corporations. Reg. Sec. 1.701-2(2) provides anti-abuse rules. IRS can deny partnership status if: Principal purpose of the partnership is to substantially reduce the partners aggregate federal income tax liability, and The reduction occurs in a manner inconsistent with the intent of Subchapter K Tenancy in Common distinguished: Co-ownership of property does not create a partnership per se. If the venture is an actively conducted business, it must report as a partnership. If a lower level of activity, can choose whether to file as partnership or not (ie, investments or rental property) Election under IRC 761 to be excluded from Subchapter K Organization must be formed: 1. For investment only, not active conduct of business 2. For joint production, extraction, or use of property but not for purpose of selling services or the property produced or extracted, or 3. By dealers or securities for underwriting, distributing, or selling a particular issue of securities

Investment partnerships: Compute their income without computing partnership taxable income Own property as co-owners, can buy or sell divided interests No active business - ie, providing services like maid service

Partnership Taxation 8. As previously stated, a partnership is not a taxable entity. Rather, the tax items flow through to the partners at the end of the entitys tax year and therefore partnerships pay no Federal income taxes.

 a. Many partnership tax items retain their identity as they flow through to the partners. This treatment requires such items to be separately stated because the items might affect any two partners tax liabilities in different ways. b. Non-separately stated items include ordinary income and expenses related to the partnerships trade or business activities. Partnership Reporting 9. Partnerships file an information tax return, Form 1065.

a. Schedule K accumulates all items that must be separately reported to the partners. The amounts on Schedule K are allocated to each partner and reported on Schedule K1. b. Partnerships prepare either Schedule M1 or Schedule M3 to reconcile book and tax net income. Schedule M3 is required if the partnership has $10 million or more in assets at the end of the year. c. Schedule L generally shows an accounting-basis balance sheet, and Schedule M2 reconciles partners beginning and ending capital accounts. Partners Ownership Interest in a Partnership 10. Partners ownership interest consists of a capital interest and a profits interest. a. Capital interest is a partners capital sharing ratio, which is the partners percentage ownership of the partnerships capital. It determines the percentage of the net asset value a partner would receive on immediate liquidation of the partnership. b. Profits (loss) interest is the partners percentage allocation of current partnership operating results. Partnerships can change the profit and loss allocations at any time simply by amending the partnership agreement. c. Profits and capital interests do not have to be equal, and the profits interest may not be the same over time. In fact, a profits interest may vary for different types of income, deduction, etc., during a single tax year. d. Partnership agreements may provide for special allocations of tax items to specified partners, or it may allocate items in different proportions (consider can this be done in an S Corporation or a C corporation?) e. Partners have a basis in their partnership interest. When income flows through to a partner, the partners basis increases and when losses flow through, the basis is reduced. Without basis adjustments, partnership income would be subject to double taxation. Example: JJ partnership Starts with $10,000 in capital, then reports $20,000 in income. If the partners sell their interests for more than $30,000, they will report gain, if they sell their interests for less than $30,000, they will report loss. Partnership Law in the Internal Revenue Code Partnership tax law is generally found in: Subtitle A Chapter 1

Subchapter K Code Sections 701 through 777 Lets Practice finding these code sections in RIA checkpoint

761 Terms defined. (a) Partnership. For purposes of this subtitle, the term partnership includes a syndicate, group, pool, joint venture, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a corporation or a trust or estate. Joint venturer as partner Co-owners of condemned land were partners although each received fractional interest in real estate from liquidated corp.; they continued business using same assets, filed partnership returns and reported condemnation proceeds as receipts from partnership condemnation sale. Roy P. Varner et al. (1973) TC Memo 1973-27 , PH TCM 73,027 . Joint venturer as partner Partnership status not imposed: There was no joint venture, losses weren't shared, money received by one was payment for services, not share of profits. Status of parties under local law not controlling. Kahn Est. et al. v Comm. (1974, CA2) 34 AFTR2d 74-5278 , Joint venturer as partner Venture agreement granting 1/3 undivided interest didn't create partnership where co- venturers weren't obligated to share sales proceeds. Agreement was a devise to obtain capital gains treatment and was disregarded. Weldon Hudson (1990) TC Memo 1990-570 , PH TCM 90,570 . Joint venturer as partner Cattle raisers were partners and their property partnership property. They filed partnership returns and split business profits and losses. Property was listed on books and in tax returns as partnership asset. George Helmer (1975) TC Memo 1975-160 , PH TCM 75,160 . Joint venturer as partner Partner status imposed. Taxpayer and brother had pattern of operating business ventures as partners and were found guilty of conspiracy to sell drugs as joint venture. Daniel T. Galluzzo et al. (1981) TC Memo 1981-733 , PH TCM 81,733 . Joint venturer as partner

 Taxpayer was mere independent contractor and was paid for services rendered. No partnership was created as taxpayer didn't have ownership interest in property, was paid bonus (which suggested additional compensation for services rendered), and no business formalities that would create partnership were observed. Lyle Mayhew (1992) TC Memo 1992-68 , TC Memo 92,068 . Employment Relationship Distinguished If one party is compensated by profit-sharing, another partnership element must exist (ie, sharing of losses, capital contributions, or mutual control) R.W. Ewing v. Commr. 17 TCM 626 Employment Relationship Distinguished R.O. Wheeler v. Commr. 37 TCM 883, TC Memo 1978-208 One partner provided capital, the other services. Court held that a partnership still existed. If partner is only providing services, must have substantial management authority and contribute skill, expertise, or credibility. Creditor Debtor Relationship Distinguished Stanchfield v. Commr., 24 TCM 1681, TC Memo 1965-305 Stanchfield loaned money to construction firm. In return, he was to receive half the profits, but there was no agreement as to losses. He ended up losing $111,000. The IRS contended these were nonbusiness bad debts (capital losses). Court held that he was really a partner with ordinary losses.