Study Unit 9: Contributions To A Partnership PDF

1 STUDY UNIT NINE CONTRIBUTIONS TO A PARTNERSHIP 9.1 Partnership Defined.................................................... 1 9.2 Filing Requirements........................................

1 STUDY UNIT NINE CONTRIBUTIONS TO A PARTNERSHIP 9.1 Partnership Defined.................................................... 1 9.2 Filing Requirements.................................................... 4 9.3 Contributions to a Partnership............................................ 6 9.4 Partnership Interest..................................................... 9 Partnerships are collaborative ventures governed by the partnership agreement. Ownership interest in a partnership is determined by contributions to the partnership and the operations of the partnership, including assumption of liability. Despite the flow-through nature of partnerships, filing requirements do exist, with the required tax year determined by several guidelines. 9.1 PARTNERSHIP DEFINED 1. A partnership is the relationship between two or more entities who join together to carry on a trade or business. An entity, when used in this context, may refer to an individual, a corporation, a trust, an estate, or another partnership. a. For federal tax purposes, the term “partnership” includes a syndicate, group, pool, or joint venture that is carrying on a trade or business and is not classified as a trust, an estate, a qualified joint venture, or a corporation. 1) Per-se corporations, such as insurance companies, cannot be classified as partnerships. 2) Tax-exempt organizations cannot be classified as partnerships. 3) A domestic limited liability company (LLC) with at least two members that does not file Form 8832 is classified as a partnership for federal income tax purposes. b. An agreement to share expenses does not constitute a partnership. c. Co-ownership of rental property is not a partnership unless services are provided to the tenants. d. A partnership is allowed to be excluded from treatment as a partnership if it is not in the active conduct of a business, for example, a partnership of individuals who pool their money for investment purposes. 1) All partners must elect for this treatment to apply. 2) Each member must separately include his or her share of the income and deductions. e. A single-member domestic LLC is treated as a disregarded entity but alternatively may elect treatment as a corporation for tax purposes. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 2 SU 9: Contributions to a Partnership Partnership Agreement 2. A partnership agreement includes the original agreement that determines the partner’s share of income, gains, losses, deductions, and credits. a. The agreement must be agreed to by all partners. b. The agreement must have substantial economic effect; otherwise, the allocation will be made based on the partner’s interest in the partnership. 1) There must be a reasonable possibility that the allocation will substantially affect the dollar amount of the partner’s share of ownership. 2) The partner to whom an allocation is made actually receives the economic benefit or burden corresponding to that allocation. Family Partnership 3. A family partnership is one consisting of a taxpayer and his or her spouse, ancestors, lineal descendants, or trusts for the primary benefit of any of them. Siblings are not treated as members of the taxpayer’s family for these purposes. Income or loss from a family partnership should be reported on Form 1065 rather than on Schedule C of Form 1040. a. For family members to be recognized as partners in a family partnership, one of the following requirements must be met: 1) If capital is a material income-producing factor, they acquired their capital interest in a bona fide transaction (even if by gift or purchase from another family member), actually own the partnership interest, and actually control the interest. 2) If capital is not a material income-producing factor, they joined together in good faith to conduct a business. They agreed that contributions of each entitle them to a share in the profits, and some capital or service has been (or is) provided by each partner. b. Services. A services partnership is one in which capital is not a material income- producing factor. 1) In a family partnership, a family member is treated as a services partner only to the extent (s)he provides services that are substantial or vital to the partnership. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 9: Contributions to a Partnership 3 c. Capital. A family member is treated as a partner in a partnership in which capital is a material income-producing factor. 1) However, the partnership agreement is disregarded to the extent a partner receives less than reasonable compensation for services. EXAMPLE 9-1 Family Partnership -- Gift to Child R gives Son a gift of $250,000. Son contributes it in exchange for a 50% interest in a newly formed partnership with R. R&R Partnership continues what was R’s sole proprietorship. The reasonable value of R’s services the following tax year is $75,000. Of R&R’s gross income of $125,000, $75,000 must be allocated to R for his services. Son’s distributive share attributable to his capital interest is no more than $25,000 [($125,000 – $75,000) × 50%]. 2) The recipient of gifted interest may not receive income greater than the proportionate share of the donor. 3) This rule applies to all, not just some, family members. d. Spouses filing a joint return may elect out of partnership treatment by choosing to be a qualified joint venture. 1) The only members of the joint venture must be the spouses, and both must materially participate and make the election. 2) Each spouse will be treated as a sole proprietor, allowing both to receive Social Security benefits. 3) All items of income, gain, loss, deduction, and credit attributable to the business must be divided between the spouses in accordance with each spouse’s respective interest in the joint venture. Constructive Ownership -- Partnership Interest 4. An individual is treated as owning the interest owned by his or her spouse, brothers and sisters, children, grandchildren, and parents. a. An interest directly or indirectly owned by or for a corporation, partnership, estate, or trust is considered to be owned proportionately by or for its shareholders, partners, or beneficiaries. b. Study Unit 14, Subunit 6, and item 12. in Study Unit 16, Subunit 1, have additional coverage of related party and constructive ownership. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 4 SU 9: Contributions to a Partnership 9.2 FILING REQUIREMENTS Tax Year 1. The partnership’s tax year is determined with respect to the partners’ tax years. a. Unless an exception applies, the partnership must use a required tax year. 1) The required tax year is the first of 2), 3), or 4) below that applies. Majority Interest 2) Majority interest tax year is the tax year of partners owning more than 50% of partnership capital and profits if they have the same tax year as determined on the first day of the partnership’s tax year. Principal Partner 3) Principal partners’ tax year is the same tax year of all principal partners, i.e., partners owning 5% or more in capital or profits, if they all have the same tax year. Least Aggregate Deferral 4) Least aggregate deferral tax year is determined by multiplying each partner’s ownership percentage by the number of months of income deferral for each possible partnership tax year and then selecting the tax year that produces the smallest total tax deferral. a) The deferral period begins with the possible partnership tax year-end date and extends to the partner’s tax year-end date. EXAMPLE 9-2 Least Aggregate Deferral Tax Year A and B each have a 50% interest in a partnership that started business on July 1. A uses a calendar year, while B has a fiscal year ending September 30. Because ownership is split 50/50 and different year endings are used, the least aggregate deferral year must be used. The two calculations are as follows: Months of 12/31 Interest in Deferral for Interest × Year End Year End Partnership 12/31 Year End Deferral A 12/31 50% 0 0 B 9/30 50% 9 4.5 Total deferral 4.5 Months of 9/30 Interest in Deferral for Interest × Year End Year End Partnership 9/30 Year End Deferral A 12/31 50% 3 1.5 B 9/30 50% 0 0 Total deferral 1.5 A September 30 year end is the least aggregate deferral year end for the partnership. b. Any time there is a change in partners or a partner changes his or her tax year, the partnership may be required to change its tax year. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 9: Contributions to a Partnership 5 2. A year other than one required may be adopted for a business purpose with IRS approval. Income deferral is not a business purpose. Natural Business Year a. Accounting for a natural business year, e.g., in a seasonal line of business, can be an acceptable business purpose. 1) It is any 12-month period for which at least 25% of annual gross receipts were received during the last 2 months of each of the preceding 3 years. Fiscal Year b. Under Sec. 444, a partnership may elect a tax year that is neither the required year nor a natural business year. The year elected may result in no more than 3 months of deferral (between the end of a tax year elected and the end of the required tax year). 1) Under Sec. 444, the partnership may make the election only if the partnership is not a member of a tiered structure and it did not previously make a Sec. 444 election other than to change to a shorter deferral period. Existing Tax Year c. If one or more than one qualifying tax year is also the partnership’s existing tax year, the partnership must maintain its existing tax year. Return Due Date 3. Partnership returns are due by the 15th day of the 3rd month following the close of the partnership’s tax year. a. An application for an extension of a partnership tax return is filed on Form 7004. The extension is for 6 months after the original due date of the return. Domestic Partnership 4. Every domestic partnership must file Form 1065, unless it neither receives income nor incurs any expenses treated as deductions or credits for federal income tax purposes. 5. Schedules K-1 are filed with the return and furnished to the partners on or before the due date (including extensions) for the partnership return. A Schedule K-1 contains the partner’s distributive share of partnership income and separately stated items to be reported on the partner’s tax return. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 6 SU 9: Contributions to a Partnership 9.3 CONTRIBUTIONS TO A PARTNERSHIP Contribution of Property 1. Generally, no gain or loss is recognized on the contribution of property in exchange for a partnership interest. The contribution may occur at the formation of the partnership or after it has been in existence for some time. a. Gain or loss is recognized when the following situations occur: 1) The contributed property is distributed to a different partner within 7 years of the contribution date. The contributing partner’s recognized gain is the lesser of the precontribution gain or the gain that would result if the property were sold at FMV. 2) When a partner contributes property to a partnership and immediately receives a distribution, the transaction is essentially a sale. Gain realized is recognized to the extent the contributed property is deemed purchased by the other partners. EXAMPLE 9-3 Recognized Gain -- Purchase by Other Partner P and Q contributed land with FMVs of $250,000 and $500,000, respectively, each in exchange for a 50% interest in PQ Partnership. PQ mortgaged the land for $550,000 and distributed $250,000 of the proceeds to Q. Q recognizes any gain realized on 50% of the land she contributed. Fifty percent of the adjusted basis (AB) in the land is included in Q’s basis in her partnership interest. 3) A partner who contributed property receives a distribution of a different property (other than money) within 7 years of his or her contribution. The contributing partner recognizes gain on the lesser of a) FMV of the distributed property over the partner’s basis in his or her partnership interest or b) The difference between the FMV and the AB of the contributed property on the contribution date. EXAMPLE 9-4 Recognized Gain -- Partnership Distribution C is a partner in CD Partnership. CD Partnership holds three assets: property #1, property #2, and property #3. C contributed property #1, with an AB of $5,000 and a FMV of $10,000, to the partnership in the current year. The other two properties were acquired by the partnership. C’s basis in his partnership interest is $2,000. In Year 5, C receives property #3 (FMV $8,000) in a distribution from the partnership. C’s gain is the lesser of (1) $6,000 ($8,000 FMV property distributed – $2,000 AB in partnership interest) or (2) $5,000 ($10,000 FMV property #1 at contribution date – $5,000 AB property #1 at contribution date). C recognizes $5,000 of gain on the distribution. 4) A partner acts in an individual capacity in a transaction with the partnership. b. The basis of contributed property is the same in the hands of the partnership as it was in the hands of the partner. The holding period is carried over as well. Contributions of Services 2. The value of a capital interest in a partnership that is transferred to a partner in exchange for services is taxable as ordinary income. a. The income recognized is added to the basis of the partnership interest. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 9: Contributions to a Partnership 7 Partnership Basis when Service is the Contributing Factor vs. Cash or Property Contribution Figure 9-1 Visual Memory Aid: For candidates who are visual learners, the figure above and the description below can aid in recalling how partnership basis is determined for services contributed to the partnership. The basis to a service partner for a partnership interest is the amount of income recognized. If the service partner is an existing partner, the amount recognized is added to the old basis. In the illustration, the service basis partner is using a mop and hammer and holding a pie piece. His “piece,” or share, of partnership interest is equal to the income he receives while performing his service. A cash- or property-contributing partner calculates his or her basis by the value of the cash or the adjusted basis of the property at the time of the donation. The property-contributing partner “carries” the keys of the contribution to remind you that there is a “carryover” of basis. The image above is © Dugger Corcoran Illustrations, LLC. Reprinted with permission. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 8 SU 9: Contributions to a Partnership Liabilities 3. When a partner contributes property subject to a liability or the partnership assumes a liability of the contributing partner, the partner is treated as receiving a distribution of money from the partnership in the amount of the liability. a. A distribution reduces the partner’s basis in the partnership interest. EXAMPLE 9-5 Basis in Partnership -- Contribution of Property John contributed an office building with an AB of $500,000 for a share in the partnership. The office building currently has a mortgage with a balance of $200,000. John’s basis in the partnership is $300,000 ($500,000 AB – $200,000 mortgage). Recognized Gain b. To the extent liabilities assumed by the partnership exceed the partner’s aggregate AB in all property contributed, the partner recognizes gain (and basis in the partnership interest is zero). 1) Note that a partner still bears responsibility for his or her share of the liabilities assumed by the partnership. EXAMPLE 9-6 Gain -- Liability Assumed by the Partnership In 2023, Albert acquired a 20% interest in a partnership by contributing a parcel of land and $10,000 in cash. At the time of Albert’s contribution, the land had a fair market value of $50,000, had an AB to Albert of $20,000, and was subject to a mortgage of $70,000. Albert’s relinquished liability creates a gain. When Albert became a 20% partner, he was relieved of 80% of the mortgage debt. Thus, 80% of his $70,000 mortgage, or $56,000, is a benefit to Albert because the other partners are assuming part of the mortgage obligation. Therefore, Albert has a recognized gain of $26,000 ($56,000 benefit – $10,000 cash – $20,000 AB of property). Cash contributed $ 10,000 + AB of property contributed 20,000 + Any gain recognized on contributed property or services 26,000 + Share of partnership liabilities 14,000 – Partner’s liability assumed by partnership (70,000) = Basis in partnership interest $ 0 Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 9: Contributions to a Partnership 9 9.4 PARTNERSHIP INTEREST 1. The original basis of a partner’s interest acquired in exchange for contributions of property is the sum of a. The money contributed, b. The adjusted basis (AB) of property contributed, and c. The amount of any recognized gain by the partner under Sec. 721(b) on the contribution (partnership treated as an investment company). 2. The assumption of liabilities by the partner is treated as a contribution of money to the partnership and increases basis. 3. The amount of liabilities assumed by the partnership is treated as a distribution to the contributing partner and reduces basis. 4. A partner’s basis in a cash-basis partnership includes liabilities only to the extent that the liability a. Creates or increases the partnership’s basis in its assets b. Gives rise to a current deduction c. Gives rise to a nondeductible, noncapital expense of the partnership 5. Accrued but unpaid expenses and accounts payable are not included in the basis of a partner’s interest in a cash-basis partnership. 6. A partner includes a liability only to the extent that the partner bears the economic risk of loss. Partner’s Basis 7. A partner’s basis in contributed items is exchanged for basis in the partnership interest received, adjusted for gain recognized and liabilities. EXAMPLE 9-7 Basis in Partnership Interest Using the information from Example 9-6 on the previous page, basis is calculated as follows: Cash contributed $ 10,000 + AB of property contributed 20,000 + Any gain recognized on contributed property or services 26,000 + Share of partnership liabilities 14,000 – Partner’s liability assumed by partnership (70,000) = Basis in partnership interest $ 0 Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 10 SU 9: Contributions to a Partnership Partnership’s Gain 8. The partnership realizes neither gain nor loss when it receives contributions of money or property in exchange for a partnership interest. Partnership’s Basis 9. The partnership’s basis in contributed property is equal to the contributing partner’s AB in the property immediately before contribution, increased by any gain recognized by the partner. It is not adjusted for liabilities. Holding Periods 10. The holding period (HP) of the partner’s interest includes the HP of contributed capital and Sec. 1231 assets. If the interest was received in exchange for ordinary income property or services, the HP starts the day following the exchange. a. The partnership’s HP in contributed property includes the partner’s HP, even if the partner recognized gain. Partner Purchased Interest 11. The basis in a partnership interest purchased from a partner is its cost, which is the sum of the purchase price and the partner’s share of partnership liabilities. a. The partnership may elect to adjust the basis in its assets by the difference between the transferee’s basis in his or her partnership interest and his or her proportionate share of the partnership’s AB in its assets. This is referred to as a Sec. 754 election. 1) Section 743 provides that this adjustment to basis will apply only for the transferee partner. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].