A partnership is not a separate taxable entity. However, the tax impact of partnership activities must be allocated to the partners and reported by them on their individual tax returns. This process is referred to as the flowthrough of tax items. Because the partnership is a conduit for tax purposes, certain elements of revenue and expense maintain their identity on the individual partner’s tax return. For example, a partner’s share of partnership investment income also will be classified as investment income on the individual return. It is important that certain items maintain their identity on the individual return because they are subject to special limitations and rules. Therefore, accounting for partnership income requires that certain items of revenue and expense be separately reported on the partnership informational tax return.
This post tries to describe how a partner’s tax basis in a partnership is different from the book basis, be able to calculate the tax basis, and explain the concept of double taxation, it also discuss how it may be minimized. Enjoy!
Tax Basis of a Partner’s Interest
Because the partnership is not viewed for tax purposes as a separate distinct entity but, rather, as consisting of separate distinct individuals, the individual partner’s interest in the partnership must be measured for tax purposes. This individual interest is referred to as “the partner’s tax basis“. The tax basis is primarily used to measure the tax gain or loss resulting from a partner’s sale of his/her interest in the partnership. In the most simple of cases, the partner’s tax basis is equal to cash contributed plus his/her personal tax basis in other property transferred to the partnership. This personal tax basis would represent the tax basis of the asset before transfer to the partnership.
To illustrate, assume a partner contributes $10,000 cash and equipment with a fair value of $70,000. The original cost of the equipment less depreciation taken for tax purposes resulted in a personal tax basis of $50,000. The tax and GAAP (book) basis of the partner’s interest is calculated as follows:
Tax GAAP (Book)
Cash contributed . . . . . . . . . . . . . . . . $10,000 $10,000
Equipment . . . . . . . . . . . . . . . . . . . . . $50,000 $70,000
Basis for partner’s interest . . . . . . . . $60,000 $80,000
Note: The partner’s tax basis in assets prior to transfer is not changed subsequent to transfer. In other words, the individual partner receives no increase (step-up) or decrease (step-down) in basis.
The calculation of a partner’s tax basis becomes more complex when personal liabilities are transferred to and assumed by the partnership. A partner’s tax basis is decreased by the value of the liabilities assumed by other partners. When the other partners assume a portion of the debt, it is as though that amount of debt has been forgiven. Forgiveness of debt represents income to a taxpayer. This income is eventually recognized upon the sale of a partnership interest because the tax basis has been reduced by this amount; therefore, the gain on the sale is increased by this amount.
Alternatively, a partner’s tax basis is increased by the value of other partners’ liabilities assumed by them. The allocation among partners of liabilities transferred to a partnership is based on the partners’ respective profit and loss ratios.
To illustrate, assume Partners A and B contribute assets with personal tax bases of $80,000 and $110,000, respectively. Liabilities associated with these assets are $30,000 and $60,000, respectively for A and B. Profits and losses are allocated 40% to Partner A and 60% to Partner B.
The tax basis of the partners is determined as follows:
Partner A Partner B
Tax basis of assets contributed . . . . . . . . . . . . . $ 80,000 $110,000
Tax basis of other partner’s liabilities assumed
(40% of $60,000 for A and 60% of $30,000 for B) $ 24,000 $18,000
Tax basis of liabilities assumed by other partners
(60% of $30,000 for A and 40% of $60,000 for B) ($18,000) ($24,000)
Tax basis of partner’s interest . . . . . . . . . . . . . . .($86,000) ($104,000)
It is important to note that the sum of the tax bases of partners’ interests ($86,000 plus $104,000 in the above example) must always equal the sum of the tax basis of assets contributed by the partners ($80,000 plus $110,000 in the above example).
The initial tax basis of a partner subsequently changes due to the ongoing activities of the partnership. The basis will be increased by the following:
. Additional contributions of individual assets.
. The partner’s share (based on profit and loss ratios) of increases in partnership liabilities resulting from:
- Assuming partners’ personal liabilities.
- Direct liabilities of the partnership.
. The partner’s share of partnership income measured on a tax basis.
. The partner’s share of separately identified items of income not included in tax income (loss).
A partner’s basis will be decreased by the following:
- Distributions of partnership assets.
- The portion of the partner’s additional personal liabilities assumed by the other partners.
- The partner’s share of partnership losses measured on a tax basis.
- The partner’s share of separately identified items of loss not included in taxable income (loss).
A partner’s tax basis may not be decreased below zero. If operating losses would decrease the basis below zero, they are carried forward by the partners and used to offset subsequent increases in basis.
Avoidance of Double Taxation
Major differences exist between partnerships and corporations in the area of taxation. These differences result from the fact that corporations, unlike partnerships, are viewed as separate and distinct taxable entities. The primary result of this difference is that a corporation is taxed when the income is earned (assuming an accrual tax basis), and the individual shareholders are taxed when the income is distributed as dividends. This characteristic is referred to as double taxation, and its significance depends on the extent to which dividends are distributed and on the tax rates to which the shareholders are subject.
The effect of double taxation may be minimized if employee-shareholders do not receive dividends but are rewarded in the form of salaries, which are deductible expenses. However, the Internal Revenue Service must be satisfied that the amount of such salaries is reasonable. A corporation also may attempt to avoid double taxation by accumulating earnings or by electing to be taxed as a partnership through a Subchapter S election.
Rather than distributing taxable dividends, the corporation may retain income so that the shareholders are not currently taxed on that income. However, if the shareholders sell their stock in the corporation and if the stock sells at a price that exceeds its tax basis, the gain on the sale would be taxed at the rate applied to capital gains. In effect, the accumulated earnings then become taxed.
It should be noted, however, that the retention of income may not be practical because of the accumulated earnings tax. This tax is a penalty imposed on a corporation that accumulates its earnings to avoid the income tax that would have been incurred by the shareholders if dividends had been distributed. The intent to avoid taxes may be established by demonstrating that the corporation has accumulated earnings in excess of the reasonable needs of the business. Reasonable needs of the business would include such items as plant expansion, asset replacement, debt retirement, stock retirement, customer-supplier loans, and working capital.
The disadvantage associated with double taxation may be eliminated if a corporation elects to be taxed as a Subchapter S-corporation. Under this election, the corporation is treated as a partnership for tax purposes. The corporate entity itself pays no tax, and the shareholders pay tax on their share of corporate income, whether or not it is distributed to them. This special treatment is based on the view that certain corporations, in substance, are the same as a partnership. This analogy is appropriate for nonpublic corporations, in which major shareholders act in the same capacity as partners in a partnership.
The corporation electing to be taxed as a Subchapter S corporation must meet certain requirements. For example: the corporation must have only one class of stock owned by 75 or fewer stockholders. Certain technical procedures also are employed with respect to the determination and classification of taxable income.
A limited liability company (LLC), if properly structured, will be treated as a partnership for federal tax purposes. Most LLCs are formed with the intent of being classified as a partnership for tax purposes and therefore must avoid having a majority of its attributes or characteristics suggest a corporate form of organization. The tax code will classify an entity as a corporation rather than a partnership if it has more corporate, versus noncorporate, characteristics or attributes. These characteristics are associates, an objective to carry on business and divide the gains, continuity of life, centralization of management, limited liability, and free transferability of interests. Most LLC agreements are structured to avoid the attributes of continuity of life and free transferability of interests in order to receive tax treatment as a partnership rather than a corporation.
Some of the more significant tax-related differences between a partnership and a corporation are summarized below:
Tax-Related Differences a Partnership Vs. a Corporation
Level(s) of Taxation
- Partnership – Not a separate taxable entity but, rather, a conduit through which taxable items are passed on to the owners (partners). The individual partners are taxed on their shares of partnership income, whether distributed or not, at the progressive tax rates applicable to individuals.
- Corporation – A separate, distinct taxable entity apart from the shareholder. Therefore, income is taxed once at the corporate level and again at the shareholder level when such income is distributed (i.e., double taxation).
Maintaining the Identity of Various Elements of Taxable Income
- Partnership – Elements making up a partnership’s income maintain their special tax status on the returns of the individual partners; e.g., if a partnership has tax exempt income, it retains its identity in the preparation of the individual partners’ tax returns as tax-exempt income.
- Corporation – Elements making up corporate income do not maintain their special status when distributed to shareholders in the form of a dividend; e.g., if corporate income includes some tax-exempt income, that income will be taxed to the shareholders when distributed in the form of a dividend.
Both partnership and Corporation – The tax advantages associated with certain fringe benefits are much greater for employee-shareholders than they would be if the employees were partners in a partnership. Such fringe benefits may involve profit-sharing plans, pension plans, medical reimbursement and insurance plans, group life insurance, and death benefits.