A partner’s distributive share of income or loss is generally determined by the partnership agreement. Such agreement can have different ratios for income or loss, and may agree to allocate other items (e.g., credits and deductions) in varying ratios.
In this post, partnerships agreements—where income or loss is usually determined, are outlined. The partnership agreements also determines: special allocation, contribution in property, distributable shares of income, guaranteed payment, and more. Read on…
Special allocations must have substantial economic effect. Economic effect is measured by an analysis of the allocation on the partners’ capital accounts. The special allocation (a) must be reflected in the partners’ capital accounts, (b) liquidation distributions must be based upon the positive capital account balances of partners, and (c) there must be a deficit payback agreement wherein partners agree to restore any deficit capital account balances.
An allocation’s economic effect will not be substantial if the net change recorded in the partners’ capital accounts does not differ substantially from what would have been recorded without the special allocation, and the total tax liability of all partners is less.
If no allocation is provided, or if the allocation of an item does not have substantial economic effect, the partners’ distributive shares of that item shall be determined by the ratio in which the partners generally divide the income or loss of the partnership.
Contribution in Property
If property is contributed by a partner to a partnership, related items of income, deduction, gain, or loss must be allocated among partners in a manner that reflects the difference between the property’s tax basis and its fair market value at the time of contribution.
Example: Putra contributes property with a tax basis of $1,000 and a fair market value of $10,000 to the LieDharmaPutra Partnership. If the partnership subsequently sells the property for $12,000, the first $9,000 of gain must be allocated to Putra, with the remaining $2,000 of gain allocated among partners according to their ratio for sharing gains.
If property contributed to a partnership is distributed within seven years to a partner other than the partner who contributed such property, the contributing partner must recognize the pre-contribution gain or loss to the extent that the precontribution gain or loss would be recognized if the partnership had sold the property for its fair market value at the time of distribution.
The above recognition rule will not generally apply if other property of a like-kind to the contributed property is distributed to the contributing partner no later than the earlier of” (a) the 180th day after the date on which the originally contributed property was distributed to another partner, or (b) the due date (without extension) for the contributing partner’s return for the tax year in which the original distribution of property occurred.
Changes In Ownership of Partnership Interest
If there was any change in the ownership of partnership interests during the year, distributive shares of partnership interest, taxes, and payments for services or for the use of property must be allocated among partners by assigning an appropriate share of each item to each day of the partnership’s taxable year.
Example: Putra becomes a 40% partner in calendar-year ‘Partnership Lie&Dharma’ on December 1. Previously, Lie and Dharma each had a 50% interest. ‘Partnership Lie&Dharma’ uses the cash method of accounting and on December 31 pays $10,000 of interest expense that relates to its entire calendar year. Putra’s distributive share of the interest expense will be ($10,000 / 365 days) x 31 days x 40% = $340.
Distributable Shares of Income and Guaranteed Payment
Distributable shares of income and guaranteed payments are reported by partners for their taxable year during which the end of the partnership fiscal year occurs. All items, including guaranteed payments, are deemed to pass through on the last day of the partnership’s tax year.
Guaranteed payments are payments to a partner determined without regard to income of the partnership. Guaranteed payments are deductible by the partnership and reported as income by the partners.
Example: Putra (on a calendar-year) has a 20% interest in a partnership that has a fiscal year ending May 31. Putra received a guaranteed payment for services rendered of $1,000 a month from 6/1 to 12/31/2011 and $1,500 a month from 1/1/2012 to 5/31/2012. After deducting the guaranteed payment, the partnership had ordinary income of $50,000 for its fiscal year ended 5/31/2012. Putra must include $24,500 in income on Putra’s calendar-year 2012 return ($50,000 x 20%) + ($1,000 x 7) + ($1,500 x 5).
Are Partners Considered To be Employees?
Partners are generally not considered to be employees for purposes of employee fringe benefits (e.g., cost of $50,000 of group-term life insurance, exclusion of premiums or benefits under an employer accident or health plan, etc.).
A partner’s fringe benefits are deductible by the partnership as guaranteed payments and must be included in a partner’s gross income.
Family partnerships are subject to special rules because of their potential use for tax avoidance. If the business is primarily service oriented (capital is not a material income-producing factor), a family member will be considered a partner only if the family member shares in the management or performs needed services.
Capital is not a material income-producing factor if substantially all of the gross income of the business consists of fees, commissions, or other compensation for personal services (e.g., accountants, architects, lawyers).
A family member is generally considered a partner if the family member actually owns a capital interest in a business in which capital is a material income-producing factor.
Where a capital interest in a partnership in which capital is a material income-producing factor is treated as created by gift, the distributive shares of partnership income of the donor and donee are determined by first making a reasonable allowance for services rendered to the partnership, and then allocating the remainder according to the relative capital interests of the donor and donee.