Partnership Operations - Gleim Publications

1 STUDY UNIT TEN PARTNERSHIP OPERATIONS 10.1 Partnership Operations and Partner’s Taxable Income.......................... 2 10.2 Distribution of Partnership As...

1 STUDY UNIT TEN PARTNERSHIP OPERATIONS 10.1 Partnership Operations and Partner’s Taxable Income.......................... 2 10.2 Distribution of Partnership Assets.......................................... 12 10.3 Partners Dealing with Their Own Partnership................................. 14 A partnership is a business organization other than a corporation, a trust, or an estate, co-owned by two or more persons and operated for a profit. The partnership, as an untaxed, flow-through entity, reports taxable income or loss and separately stated items. 1) When computing his or her personal income tax liability, an individual partner must consider his or her distributive share of the partnership’s taxable income or loss and every other separately stated item for the partnership, regardless of whether any distributions were made from the partnership to the partner. Nonseparately and separately stated partnership items are currently taxed to the partners, but distributions are generally received tax-free. You should identify the different loss limitation rules. 1) Partnership inventory and unrealized receivables are very important because they can trigger ordinary income to one partner when another partner receives a distribution (even of money). 2) Similarly, precontribution gain must be identified as it can trigger and recharacterize otherwise unrecognized capital gain. 3) Partnership liability fluctuations also have special significance because they vary the partners’ bases in their partnership interests and affect treatment of distributions. 4) Be prepared to identify a payment to a partner as a guaranteed payment, as a distributive share, or in a nonpartner capacity, and the effect of the classification, e.g., a deduction to the partnership passed through ratably to all partners. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 2 SU 10: Partnership Operations 10.1 PARTNERSHIP OPERATIONS AND PARTNER’S TAXABLE INCOME Partnership-Incurred Liabilities 1. A partner’s share of partnership liabilities affects the partner’s basis in his or her partnership interest and can result in increased gain being recognized by the partner. Any increase in a partner’s share of liabilities increases the partner’s basis. The opposite is true for a decrease in partnership liabilities. Recourse Liabilities a. A liability is a recourse liability if the creditor has a claim against the partnership or any partner for payment if the partnership defaults. EXAMPLE 10-1 Recourse Liability ABC Partnership, a general partnership, purchased a building for $100,000 with a $90,000 mortgage from XYZ Bank secured by the building. Later, the building is destroyed and becomes worthless. Because ABC is a general partnership, ABC’s general partners are liable for the debts of the partnership in the event the partnership is unable to pay. If ABC defaults on the mortgage, XYZ can take legal action against the partners of ABC to pay the $90,000 debt. Thus, the loan is recourse to the partners of ABC (i.e., the partners bear the economic risk). 1) Partners generally share recourse liabilities based on their ratio for sharing losses. a) However, regulations allocate a recourse liability to the partner(s) who would be liable for it if, at the time, all partnership debts were due, all partnership assets (including cash) had zero value, and a hypothetical liquidation occurred. 2) A limited partner cannot share in recourse debt in excess of any of his or her obligations to make additional contributions to the partnership and any additional amount(s) that (s)he would actually lose if the partnership could not pay its debt. Nonrecourse Liabilities b. The creditor has no claim against the partnership or any partners. At most, the creditor has a claim against a particular secured item of partnership property. 1) Generally, partners share in nonrecourse liabilities based on their ratio for sharing profits. EXAMPLE 10-2 Nonrecourse Liabilities ABC, LLP, purchased a building for $100,000 with a $90,000 mortgage from XYZ Bank. The loan was secured by the building itself and no partner made a personal guarantee on the loan. In the event that ABC defaults and is unable to pay the loan, XYZ’s only option is to foreclose and sell the property. If the property’s value has decreased and the sale proceeds are insufficient to recover the balance of the loan, XYZ has no other legal remedy. This is because ABC’s partners have limited liability by being partners in an LLP and are not generally liable for the debts of the partnership. Thus, the loan is nonrecourse to the partners of ABC (i.e., the lender bears the economic risk, not the partners). Partnership Cancellation of Debt c. In general, if the taxpayer has cancellation of debt income because debt is canceled, forgiven, or discharged for less than the amount the taxpayer must pay, the amount of the canceled debt is taxable and the taxpayer must report the canceled debt on the tax return for the year the cancellation occurs. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 10: Partnership Operations 3 Partners’ Capital Accounts 2. A capital account is maintained for each partner at the partnership level. a. A partner’s initial capital account balance is the fair market value (FMV) of the assets (net of liabilities) (s)he contributed to the partnership. b. It is separate from the partner’s adjusted basis (AB) in his or her partnership interest. c. The basis in partnership interest is assessed in order to track the tax position of the investment. EXAMPLE 10-3 Adjusted Basis of Contributed Property Taxpayer contributes property that has an adjusted basis of $400 and a fair market value of $1,000. Taxpayer’s partner contributes $1,000 cash. While each has increased their capital account by $1,000, the adjusted basis of Taxpayer’s partnership interest is only $400 and the adjusted basis of Taxpayer’s partner’s partnership interest is $1,000. Partner’s Taxable Income 3. A partner’s taxable income may be affected by his or her interest in a partnership in several ways. Examples include a. His or her distributive share of partnership income and separately stated items b. Sale of his or her partnership interest c. Dealings with the partnership (e.g., guaranteed payments) 4. A partner reports his or her distributive share of partnership items for the partnership’s tax year that ends with or within the partner’s tax year. Partnership Taxable Income 5. Partnership taxable income is determined in the same way as for individuals except that certain deductions are not allowed for a partnership, other items are required to be separately stated, and business interest expense is limited. Separately Stated Items 6. Each partnership item of income, gain, deduction, loss, or credit that may vary the tax liability of any partner must be separately stated. Items that must be separately stated include the following: a. Section 1231 gains and losses b. Net short- and long-term capital gain or loss from the sale or exchange of capital assets c. Guaranteed payments d. Interest and dividend income e. Royalties f. Tax-exempt income and related expenses g. Investment income and related expenses h. Rental activities, portfolio income, and related expenses i. Cancellation of debt j. Recovery items (e.g., prior taxes, bad debts) k. Charitable contributions l. Foreign income taxes paid or accrued m. Depletion on oil and gas wells n. Section 179 deductions o. Distributions p. Qualified items of income, gain, and loss for the qualified business income deduction Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 4 SU 10: Partnership Operations Ordinary Income 7. This is all taxable items of income, gain, loss, or deduction that are not separately stated. a. Ordinary income is different from taxable income, which is the sum of all taxable items, including the separately stated items and the partnership ordinary income or loss. 1) Ordinary income includes such items as gross profit, administrative expenses, and employee salaries. 2) Exception: Guaranteed payments are subtracted as expenses for computing ordinary business income but are separately stated as income to the recipient partner. Deductions 8. Certain deductions, e.g., charitable contributions, are disallowed in computing partnership taxable income. These are items that must be separately stated by the partnership. a. Each partner may be entitled to a deduction for his or her distributive share of these items in computing his or her personal tax liability. Contributions to Employee Retirement Accounts 9. Contributions made by a partnership for its employees under a qualified SEP, SIMPLE IRA, pension, profit sharing plan, annuity plan, or another deferred compensation plan may be deducted subject to limitations. a. Contributions to an employee’s IRA are included in the employee’s salaries and wages. Partner’s Distributive Share 10. Each partner is taxed on his or her share of partnership income whether or not it is distributed. a. A partner’s distributive share of any partnership item is allocated by the partnership agreement as long as the allocation has substantial economic effect, which means the allocation is not for tax avoidance. 1) For example, allocation of tax-exempt income to one partner and taxable interest (equal in amount) to another partner in a lower tax bracket has no substantial economic effect; i.e., it is motivated by tax avoidance. b. If the partnership agreement does not allocate a partnership item, the item must be allocated to partners according to their interests in the partnership. Precontribution Gain or Loss c. To the extent of gain not recognized on contribution of property to the partnership, gain or loss subsequently recognized on the sale or exchange of an asset by the partnership must be allocated to the contributing partner. 1) Postcontribution gain or loss is allocated among partners as distributive shares, i.e., as any other gain or loss. EXAMPLE 10-4 Postcontribution Gain or Loss Tony and Mary form a partnership as equal partners. Tony contributes cash of $100,000, and Mary contributes an asset with a basis of $80,000 and a FMV of $100,000. Two years later, the partnership sells the asset for $110,000. The $30,000 gain ($110,000 selling price – $80,000 basis) is allocated, $25,000 to Mary [$20,000 precontribution gain + (50% partnership interest × $10,000 postcontribution gain)] and $5,000 to Tony (50% partnership interest × $10,000 postcontribution gain). Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 10: Partnership Operations 5 d. A partner generally must recognize gain on the distribution of property (other than money) if the partner contributed appreciated property to the partnership during the 7-year period before the distribution. 1) The gain recognized is the lesser of the following amounts: a) The excess of i) The fair market value of the property received in the distribution, over ii) The adjusted basis of the partner’s interest in the partnership immediately before the distribution, reduced (but not below zero) by any money received in the distribution. b) The “net precontribution gain” of the partner. This is the net gain the partner would recognize if all the property contributed by the partner within 7 years of the distribution and held by the partnership immediately before the distribution were distributed to another partner other than a partner who owns more than 50% of the partnership. 2) The character of the gain is determined by reference to the character of the net precontribution gain. This gain is in addition to any gain the partner must recognize if the money distributed is more than his or her basis in the partnership. 3) Subunit 10.2 has further discussion regarding property distributions. Character e. The character of distributive shares of partnership items is generally determined at the partnership level. 1) Any capital loss (FMV < AB) inherent at contribution is capital loss to the extent of any loss realized when the partnership disposes of the property. This applies for 5 years after contribution. 2) Partnership gain or loss on inventory and unrealized receivables is ordinary income. This treatment of the inventory (but not the receivables) disappears 5 years after contribution. f. If the size of a partner’s interest in the partnership varies (e.g., by sale, purchase, exchange, liquidation) during a partnership tax year, the distributive shares of partnership items must be apportioned on a daily basis. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 6 SU 10: Partnership Operations Elections by Partnership or Partner 11. A few of the elections available to partnerships are made at the partnership level: a. Partnerships make all elections available (except for those listed in b. below), such as 1) Methods of accounting 2) Computing depreciation 3) Inventory methods 4) Installment method election 5) Expensing intangible drilling and development costs These elections apply equally amongst all partners; however, no election made by a partnership has any force or effect with respect to any partner’s nonpartnership interests. b. Partners make the following elections on the individual income tax return: 1) Deduction or credit of foreign income taxes paid a) The amount is limited to the partner’s distributive share from the partnership. 2) Treatment of mining and exploration expenditures 3) Basis reduction following discharge of indebtedness Adjustments to Basis 12. The basis of a partner’s interest in a partnership is adjusted each year for subsequent contributions of capital, partnership taxable income (loss), separately stated items, variations in the partner’s share of partnership liabilities, and distributions from the partnership to the partner. Initial basis + Subsequent contributions of capital +/– Distributive share of partnership ordinary business income (loss) + Separately stated taxable and nontaxable income – Separately stated deductible and nondeductible expenditures + Increase in allocable share of partnership liabilities – Decrease in allocable share of partnership liabilities – Current-year excess business interest expense – Share of the adjusted basis of charitable property contributions and foreign taxes paid or accrued – Distributions from partnership = Adjusted basis in partnership interest EXAMPLE 10-5 Year-End Adjusted Basis The taxpayer’s ownership and basis in the partnership are 50% and $15,000, respectively, at the beginning of the year. The partnership has ordinary income of $8,000, made charitable contributions of $3,000, and made a $5,000 distribution to the taxpayer. The taxpayer’s basis at the end of the year is $12,500 [$15,000 beginning basis + ($8,000 ordinary income × 50% ownership) – ($3,000 charitable contribution × 50% ownership) – $5,000 distribution]. a. Basis is adjusted for variations in a partner’s allocable share of partnership liabilities during the year, e.g., by payments on principal. 1) Partner capital accounts are not adjusted for partnership liability variations. b. Basis is not reduced below zero. c. Basis is reduced without regard to losses suspended under passive activity loss rules and at-risk rules or losses creating an NOL under the excess loss rules. d. No adjustment to basis is made for guaranteed payments received. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 10: Partnership Operations 7 Loss Limits 13. A partnership ordinary loss is a negative balance of taxable income. Basis Limit a. A partner’s distributive share of a partnership ordinary loss is allowable as a deduction to the partner only to the extent of the partner’s AB in his or her interest in the partnership at the end of the year. Excess loss is deductible in a subsequent year in which AB is greater than zero. At-Risk Rules b. Each partner may deduct only a partnership ordinary loss to the extent (s)he is at risk with respect to the partnership. 1) The at-risk limits also apply at the partnership level with respect to each partnership activity. 2) The amount of a partnership loss currently deductible (up to an amount for which the partnership bears economic risk of loss with respect to each partnership activity) is allocated to partners as a deductible distributive share. a) Only partnership liabilities for which a partner is personally liable can be considered in a partner’s at-risk limit. c. Passive activity losses are deductible in the current tax year only to the extent of gains from passive activities (in the aggregate). 1) Partnership ordinary loss is generally passive to a partner unless the partner materially participates in the partnership activity. Excess Business Loss d. When total losses from all trades or businesses exceed all gross income and gains from all sources, only $289,000 of the net loss is deductible on an individual return ($578,000 in the case of MFJ). 1) Any nondeductible loss is treated as a net operating loss. Gift of a Partnership Interest 14. Generally, no gain is recognized upon the gift. However, if partnership liabilities allocable to the gifted interest exceed the AB of the partnership interest, the donor must recognize gain. No loss is recognized on the gift. a. The donee’s basis in the interest is the donor’s basis after adjustment for the donor’s distributive share of partnership items up to the date of the gift. b. For purposes of computing a loss on a subsequent sale of the interest by the donee, the FMV of the interest immediately prior to the gift is used if the FMV of the gifted partnership interest is lower than the basis at the time of the gift. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 8 SU 10: Partnership Operations Inheritance 15. The tax year of a partnership closes with respect to a partner whose entire interest in the partnership terminates, whether by death, liquidation, or otherwise. a. The successor has a FMV basis in the interest. b. The partnership tax year does not close with respect to the other partners. EXAMPLE 10-6 Effect of Partnership Liabilities Ivan acquired a 20% interest in a partnership by contributing property that had an adjusted basis to him of $8,000 and a $4,000 mortgage. The partnership assumed payment of the mortgage. The basis of Ivan’s interest is calculated as follows: Adjusted basis of contributed property $8,000 Minus: Part of mortgage assumed by other partners (80% × $4,000) 3,200 Basis of Ivan’s partnership interest $4,800 EXAMPLE 10-7 Effect of Partnership Liabilities If, in Example 10-6, the contributed property had a $12,000 mortgage, the basis of Ivan’s partnership interest would be zero. The $1,600 difference between the mortgage assumed by the other partners, $9,600 (80% × $12,000), and his basis of $8,000 would be treated as capital gain from the sale or exchange of a partnership interest. However, this gain would not increase the basis of his partnership interest. EXAMPLE 10-8 Adjusted Basis of Partner’s Interest Enzo contributes to his partnership property that has an adjusted basis of $400 and a fair market value of $1,000. His partner contributes $1,000 cash. While each partner has increased his capital account by $1,000, which will be reflected in the partnership’s books, the adjusted basis of Enzo’s interest is only $400 and the adjusted basis of his partner’s interest is $1,000. EXAMPLE 10-9 Adjusted Basis of Partner’s Interest Juan and Teresa form a cash-basis general partnership with cash contributions of $20,000 each. Under the partnership agreement, they share all partnership profits and losses equally. The partnership borrows $60,000 and purchases depreciable business equipment. This debt is included in the partners’ basis in the partnership because incurring it creates an additional $60,000 of basis in the partnership’s depreciable property. If neither partner has an economic risk of loss in the liability, it is a nonrecourse liability. Each partner’s basis would include his or her share of the liability: $30,000. If Teresa is required to pay the creditor if the partnership defaults, she has an economic risk of loss in the liability. Her basis in the partnership would be $80,000 ($20,000 + $60,000), while Juan’s basis would be $20,000. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 10: Partnership Operations 9 EXAMPLE 10-10 Sale, Exchange, or Other Transfer Kumar became a limited partner in the ABC Partnership by contributing $10,000 in cash on the formation of the partnership. The adjusted basis of his partnership interest at the end of the current year is $20,000, which includes his $15,000 share of partnership liabilities. The partnership has no unrealized receivables or inventory items. Kumar sells his interest in the partnership for $10,000 in cash. He had been paid his share of the partnership income for the tax year. Kumar realizes $25,000 from the sale of his partnership interest ($10,000 cash payment + $15,000 liability relief). He reports $5,000 ($25,000 realized gain – $20,000 basis) as a capital gain. EXAMPLE 10-11 Sale, Exchange, or Other Transfer -- Partner Withdrawal The facts are the same as in Example 10-10, except Kumar withdraws from the partnership when the adjusted basis of his interest in the partnership is zero. He is considered to have received a distribution of $15,000, his liability relief. He reports a capital gain of $15,000. Reporting Requirements of a Partnership 16. A partnership, as a conduit, is not subject to federal income tax. But it must report information that includes partnership items of income, loss, deduction, and credit to the IRS. a. A partnership is required to file an initial return for the first year in which it receives income or incurs expenditures treated as deductions for federal income tax purposes. b. Form 1065 is used for the partnership’s information return. c. Signature by any partner is evidence that the partner was authorized to sign the return. Only one partner is required to sign the return. d. Any partnership item that may vary tax liability of any partner is separately stated on Schedule K. e. A Schedule K-1 is prepared for each partner and contains the partner’s distributive share of partnership income and separately stated items to be reported on the partner’s tax return. f. There are penalties for not filing correct information returns and/or not furnishing correct payee statements. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 10 SU 10: Partnership Operations Large Businesses with Gross Receipts of More Than $5 Million and Government Entities (Average annual gross receipts for the most recent 3 taxable years) IRC 6721 & IRC 6722 Time returns Due 01-01-2023 Due 01-01-2024 filed/furnished thru 12-31-2023 thru 12-31-2024 Not more than 30 days late $50 per return/ $60 per return/ (by March 30 if the due date is February 28) $588,500 maximum $630,500 maximum $110 per return/ $120 per return/ 31 days late – August 1 $1,766,000 maximum $1,891,500 maximum $290 per return/ $310 per return/ After August 1 or Not At All $3,532,500 maximum $3,783,000 maximum $580 per return/ $630 per return/ Intentional Disregard No limitation No limitation Small Businesses with Gross Receipts $5 Million or Less (Average annual gross receipts for the most recent 3 taxable years) IRC 6721 & IRC 6722 Due 01-01-2023 Due 01-01-2024 Time returns thru 12-31-2023 thru 12-31-2024 filed/furnished (inflation adjusted) (inflation adjusted) Not more than 30 days late $50 per return/ $60 per return/ (by March 30 if the due date is February 28) $206,000 maximum $220,500 maximum $110 per return/ $120 per return/ 31 days late – August 1 $588,500 maximum $630,500 maximum $290 per return/ $310 per return/ After August 1 or Not At All $1,177,500 maximum $1,261,000 maximum $580 per return/ $630 per return/ Intentional Disregard No limitation No limitation g. A partnership return is due (postmark date) on or before the 15th day of the 3rd month following the close of the partnership’s tax year. h. Inadequate filing. Penalty is imposed in the amount of the number of persons who were partners at any time during the year, multiplied by $235 (for 2023 returns filed in 2024) for each of up to 12 months (including a portion of one) that the return was late or incomplete. Partnership Representative 17. The IRC provides for designation of a partnership representative who has sole authority to commit the partnership to tax and litigation matters. a. All partnerships must designate a partnership representative who 1) May be a partner in the partnership, 2) Must have a substantial presence in the U.S., and 3) Has sole authority to act on behalf of the partnership for purposes of the new rules. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 10: Partnership Operations 11 b. The partnership representative’s exclusive authority also includes acting on the partnership’s behalf in all matters involving examination of the partnership’s tax return, conducting administrative practice before the IRS, and conducting matters of litigation regarding disputed tax adjustments. 1) A partner (other than the designated partnership representative) does not have the statutory right to notification of an audit or updates on its progress and does not have the right to participate in the audit or resulting litigation. 2) The partnership representative is designated annually on the partnership’s tax return, and the effective date is the date of filing the return. c. A partnership with 100 or fewer partners may opt out of having a partnership representative as long as all partners are “qualifying partners.” 1) Qualifying partners are individuals, estates of deceased partners, and corporations (both C and S corporations). 2) If the partnership elects to opt out, the IRS will proceed with an audit of each individual partner. d. Affirmative action of electing a partnership representative or opting out must occur on each year’s tax return. Consistent Treatment Rules e. The partner’s treatment of partnership items must be consistent with the treatment of that item by the partnership in all respects, including the amount, timing, and characterization of the item. Reporting for Qualified Business Income Deduction (QBID) 18. In regards to a partnership, the qualified business income (QBI) deduction is determined at the partner level. To allow partners to correctly figure the deduction on the partner’s Form 1040 return, the partnership must report QBI related items on the partner’s Schedule K-1. a. Identify each trade or business that is a specified service trade or business (SSTB). The SSTBs are subject to special limitations, not applicable to the qualified trades or businesses, and generally include a trade or business where the principal asset is the reputation or skill of one or more of its employees. b. The QBI (e.g., income, gain, deduction, and loss) from the trade or businesses. c. The W-2 wage totals paid to employees by each trade or business. 19. Each partner must report his or her share of items consistently with their treatment on the partnership return. 20. When a partner dies, his or her distributive share of self-employment income is figured through the end of the month in which the death occurs. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 12 SU 10: Partnership Operations 10.2 DISTRIBUTION OF PARTNERSHIP ASSETS A distribution is a transfer of value from the partnership to a partner in reference to his or her interest in the partnership. A distribution may be in the form of money, liability relief, or other property. A draw is a distribution. Current Distributions 1. A current (or operating) distribution reduces the partner’s basis in the partnership interest. a. A decrease in a partner’s allocable share of partnership liabilities is treated as a distribution of money. Money Distributions b. The partnership recognizes no gain on money distributions. 1) A partner recognizes gain only to the extent the distribution (FMV) exceeds the AB in the partnership interest immediately before the distribution. a) Gain recognized is capital gain. b) Basis in the interest is decreased, but not below zero. c) Loss is not recognized. Property Distributions c. Partnership. Generally, no gain or loss is recognized by the partnership when it distributes property, including money. 1) Precontribution gain or loss. If property is distributed to a noncontributing partner within 7 years of contribution, the partnership recognizes gain or loss realized to the extent of any unrealized gain or loss, respectively, that existed at the contribution date. a) Allocate this recognized gain (loss) to the contributing partner. b) The contributing partner’s basis in his or her partnership interest is increased. c) Basis in the property is also increased. d) The distributee has a transferred basis. 2) Disproportionate distributions of unrealized receivables or substantially appreciated inventory result in gain recognition. a) Inventory is considered substantially appreciated if its FMV exceeds 120% of the partnership’s adjusted basis. b) Gains from such distributions are taxed as ordinary income. d. Partner. The distributee partner generally recognizes gain only to the extent that money (including liability relief) exceeds his or her AB in his or her partnership interest. 1) However, property distributions made to a partner may cause a partner to recognize any remaining precontribution gain if the FMV of the distributed property exceeds the partner’s basis in his or her partnership interest prior to the distribution. The gain recognized is the lesser of a) The remaining precontribution gain or b) The excess of the FMV of the distributed property over the adjusted basis of the partnership interest immediately before the property distribution (but after any reduction for any money distributed at the same time). Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 10: Partnership Operations 13 e. The partner’s basis in the distributed property is the partnership’s AB in the property immediately before distribution, but it is limited to the distributee’s AB in his or her partnership interest minus any money received in the distribution. 1) When the above limit applies, allocate basis first to unrealized receivables and inventory, up to the partnership’s AB in them, and second to other (noncash) property. 2) If the available basis is too small, the decrease (Partnership basis in assets – Basis in partnership interest) is allocated to the assets. The decrease is allocated by the following steps: a) Assign each asset its partnership basis. b) Calculate the decrease amount. c) Allocate the decrease first to any assets that have declined in value. d) Allocate any remaining decrease to the assets based on relative adjusted basis at this point in the calculation. EXAMPLE 10-12 Allocation if Available Basis Is Inadequate Karen has a $6,000 basis in the BK Partnership immediately before receiving a current distribution (there is no remaining precontribution gain). The distribution consists of $5,000 cash, a computer with a FMV of $1,500 and a $4,000 basis to the partnership, and a desk with a FMV of $500 and a $1,500 basis to the partnership. Karen’s basis in the distributed property is determined as follows: Beginning basis in partnership interest $6,000 Less: Money received (5,000) Remaining basis to allocate $1,000 Computer Desk Step 1: Allocate partnership basis to each asset. Partnership basis in assets $ 4,000 $1,500 Step 2: Calculate decrease. Total partnership basis $5,500 Basis to allocate (1,000) Decrease amount $4,500 Step 3: Allocate decrease to assets Decline in FMV (2,500) (1,000) with a decline in FMV. Relative adjusted basis $ 1,500 $ 500 Step 4: Allocate remaining decrease of Remaining decrease (750)* (250)* $1,000 ($4,500 – $2,500 – $1,000) based on relative adjusted basis. Karen’s basis in distributed property $ 750 $ 250 * $750 = ($1,500 ÷ $2,000) × $1,000 $250 = ($500 ÷ $2,000) × $1,000 f. The partner’s holding period in the distributed property includes that of the partnership. g. The partner’s basis in his or her ownership interest in the partnership is reduced by the amount of money and the AB of property received in the distribution. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 14 SU 10: Partnership Operations 10.3 PARTNERS DEALING WITH THEIR OWN PARTNERSHIP The Code recognizes that a partner can engage in property, services, and loan transactions with the partnership in a capacity other than as a partner, i.e., as an independent, outside third party. The tax result, in general, is as if the transaction took place between two unrelated persons after arm’s- length negotiations. Customary Partner Services 1. When a partner performs services for the partnership that are customarily performed by a partner, the partner’s return is generally his or her share of profits of the partnership business. a. A partner’s allocable share of partnership items is the partner’s “compensation” for acting to perform the normal functions of a partner, e.g., driving the truck and keeping books of an ice cream vending partnership. 1) It is gross income, not as compensation, but as a distributive share of partnership income. 2) The value of the services is not deductible by the partnership. Guaranteed Payments 2. A guaranteed payment (GP) is a payment to a partner for services rendered or capital used that is determined without regard to the income of the partnership. It is used to distinguish payments that are a function of partnership income and payments connected with partners acting in a nonpartner capacity. a. Services. The services must be a customary function of a partner. They are normal activities of a partner in conducting partnership business. b. Fixed amount stated. If the partnership agreement provides for a GP in a fixed amount, e.g., annual salary amount, the GP amount is the stated amount. c. Use of capital. The payment may be stated to be interest on the partner’s capital account or to be rent on contributed property. d. Stated minimum amount. The partnership agreement may allocate a share of partnership income to the partner but guarantee payment of not less than a stated amount to the partner even if the allocable share is less. 1) If so, the GP amount is any excess of the guaranteed minimum amount over the distributive share allocable to the partner. e. For purposes of determining the partner’s gross income, the GP is treated as if made to a nonpartner. 1) The partner separately states the GP from any distributive share. 2) The payment is always ordinary income to the partner (compensation, interest, possibly rent). 3) The GP is reported in the recipient partner’s tax year that includes the end of the partnership tax year (in which the GP was made or deducted by the partnership). 4) Receipt of the GP does not directly affect the partner’s AB in his or her partnership interest. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 10: Partnership Operations 15 f. For purposes of determining deductibility by the partnership, a GP is treated as if made to a nonpartner. 1) The payment is deductible if it would have been deductible if made to a nonpartner. 2) If the GP exceeds the partnership’s ordinary income, the resulting ordinary loss is allocated among the partners (including the partner who receives the GP). EXAMPLE 10-13 Guaranteed Payment to a Partner Under a partnership agreement, Meena is to receive 30% of the partnership income, but not less than $13,000. The partnership has net income of $30,000. Meena’s share, without regard to the minimum guarantee, is $9,000 (30% × $30,000). The guaranteed payment that can be deducted by the partnership is $4,000 ($13,000 – $9,000). Meena’s income from the partnership is $13,000, and the remaining $17,000 of partnership income will be reported by the other partners in proportion to their shares under the partnership agreement. If the partnership net income had been $50,000, there would have been no guaranteed payment since Meena’s share, without regard to the guarantee, would have been greater than the guarantee. g. For all other purposes, the GP is treated as if made to a partner in his or her capacity as a partner. 1) A partner is not an employee of the partnership. 2) The GP is self-employment income to the receiving partner. EXAMPLE 10-14 Partner’s Ordinary Income Under the terms of a partnership agreement, Erica is entitled to a fixed annual payment of $10,000 without regard to the income of the partnership. Her distributive share of the partnership income is 10%. The partnership has $50,000 of ordinary income after deducting the guaranteed payment. She must include ordinary income of $15,000 [$10,000 guaranteed payment + $5,000 ($50,000 × 10%) distributive share] on her individual income tax return for her tax year in which the partnership’s tax year ends. EXAMPLE 10-15 Partner’s Ordinary Income Lamont is a calendar-year taxpayer who is a partner in a partnership. The partnership uses a fiscal year that ended January 31, 2023. Lamont received guaranteed payments from the partnership from February 1, 2022, until December 31, 2022. He must include these guaranteed payments in income for 2023 and report them on his 2023 income tax return. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 16 SU 10: Partnership Operations Nonpartner Capacity 3. Payments to a partner without regard to income of the partnership for property or for services not customarily performed by a partner are generally treated as if the transaction took place between two unrelated persons after arm’s-length negotiations. a. Loans. Interest paid to a partner on a (true) loan is all gross income to the partner and a deductible partnership item. b. Services. Payments to the partner for services rendered (of a nature not normally performed by a partner) to or for the partnership are gross income to the partner and generally an ordinary deductible expense of the partnership. c. Property. A partner acting as a nonpartner (independent third party, outsider) can sell (or exchange) property to (or with) the partnership and vice versa. Gain or loss on the transaction is recognized unless an exception applies. EXAMPLE 10-16 Sale to Partner Acting as a Nonpartner Partnership sells land to Partner. Partnership recognizes loss unless the sale is to a related party. The loss is a partnership item allocable to partners as distributive shares. Partner takes a cost basis in the property. d. Character and loss limit rules. 1) Applicability. These loss limits apply to any transaction between the partnership and either a) A partner who owns more than 50% of the partnership or b) Another partnership if more than 50% of the capital or profits interest of each is owned by the same persons. 2) Character. Any gain recognized is OI if the property is held as other than a capital asset by the acquiring partner or partnership. EXAMPLE 10-17 Sale of Capital Assets -- Change in Character Dora has held a capital asset for several years. The asset has a basis of $16,000 and a FMV of $24,000. She sells the asset to a partnership in which she is more than a 50% owner. The partnership will hold the property as a depreciable asset. Her gain of $8,000 ($24,000 – $16,000) will be ordinary income since she sold a capital asset to a more-than-50%-owned partnership that is not a capital asset to the partnership. If the partnership were to hold the asset as a capital asset, her gain would be capital gain. 3) Related party sales. a) The acquiring party has a cost basis, and a subsequent taxable disposition event results in no more gain recognition than any excess of realized gain over the loss previously disallowed. b) Expenditures are deductible when, and not before, the amount is includible in gross income by the payee, even if the payor is an accrual-method taxpayer. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].