Tax-Related Aspects of a Partnership

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!

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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)
                                                                  Basis                Basis

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:

[1]. Additional contributions of individual assets.

[2]. 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.

[3]. The partner’s share of partnership income measured on a tax basis.

[4]. 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.

Other Tax

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.