In general, partnerships are organizations of two or more persons to carry on business activities for profit. For tax purposes, partnerships also include a syndicate, joint venture, or other unincorporated business through which any business or financial operation is conducted. Partnerships do not pay any income tax, but instead act as a conduit to pass through tax items to the partners.
In the United State, partnerships file an informational return (Form 1065), and partners report their share of partnership ordinary income or loss and other items on their individual returns. The nature or character (e.g., taxable, nontaxable) of income or deductions is not changed by the pass-through nature of the partnership.
In this post, I am going to overview business partnerships particularly in the U.S. Jurisdiction. Even if you are not in within the U.S. jurisdiction, you may still be able to learn treatment of business partnerships, and enrich your knowledge.
In the U.S., eligible business entities (a business entity other than an entity automatically classified as a corporation) may choose how they will be classified for federal tax purposes by filing Form 8832. A business entity with at least two members can choose to be classified as either an association taxable as a corporation or as a partnership. A business entity with a single member can choose to be classified as either an association taxable as a corporation or disregarded as an entity separate from its owner.
An eligible business entity that does not file Form 8832 will be classified under default rules. Under default rules, an eligible business entity will be classified as a partnership if it has two or more members, or disregarded as an entity separate from its owner if it has a single owner. Once an entity makes an election, a different election cannot be made for sixty months unless there is more than a 50% ownership change and the IRS consents.
General partnerships exist when two or more partners join together and do not specifically provide that one or more partners is a limited partner. Since each general partner has unlimited liability, creditors can reach the personal assets of a general partner to satisfy partnership debts, including a malpractice judgment against the partnership even though the partner was not personally involved in the malpractice.
Limited partnerships have two classes of partners, with at least one general partner (who has the same rights and responsibilities as a partner in a general partnership) and at least one limited partner.
A limited partner generally cannot participate in the active management of the partnership, and in the event of losses, generally can lose no more than his or her own capital contribution. A limited partnership is often the preferred entity of choice for real estate ventures requiring significant capital contributions.
Limited liability partnerships differ from general partnerships in that with an LLP, a partner is not liable for damages resulting from the negligence, malpractice, or fraud committed by other partners. However, each partner is personally liable for his or her own negligence, malpractice, or fraud. LLPs are often used by service providers such as architects, accountants, attorneys, and physicians.
Limited liability companies that do not elect to be treated as an association taxable as a corporation are subject to the rules applicable to partnerships (a single-member LLC would be disregarded as an entity separate from its owner). An LLC combines the nontax advantage of limited liability for each and every owner of the entity, with the tax advantage of pass-through treatment, and the flexibility of partnership taxation. The LLC structure is generally available to both nonprofessional service providers as well as capital-intensive companies.
Electing large partnerships are partnerships that have elected to be taxed under a simplified reporting system that does not require as much separate reporting to partners as does a regular partnership.
For example, charitable contributions are deductible by the partnership (subject to a 10% of taxable income limitation), and the Sec. 179 expense election is deducted in computing partnership ordinary income and not separately passed through to partners. To qualify, the partnership must not be a service partnership nor engaged in commodity trading, must have at least 100 partners, and must file an election to be taxed as an electing large partnership. A partnership will cease to be an electing large partnership if it has fewer than 100 partners for a taxable year.
Publicly traded partnerships are partnerships whose interests are traded on an established securities exchange or in a secondary market and are generally taxed as C corporations.
As a general rule, no gain or loss is recognized by a partner when there is a contribution of property to the partnership in exchange for an interest in the partnership. There are three situations where gain must be recognized:
Situation-1. A partner must recognize gain when property is contributed which is subject to a liability, and the resulting decrease in the partner’s individual liability exceeds the partner’s partnership basis. In this situation:
- The excess of liability over adjusted basis is generally treated as a capital gain from the sale or exchange of a partnership interest.
- The gain will be treated as ordinary income to the extent the property transferred was subject to depreciation recapture under Sec. 1245 or 1250.
Example: A partner acquires a 20% interest in a partnership by contributing property worth $10,000 but with an adjusted basis of $4,000. There is a mortgage of $6,000 that is assumed by the partnership. The partner must recognize a gain of $800, and has a zero basis for the partnership interest, calculated as follows:
Adjusted basis of contributed property = $ 4,000
Less: portion of mortgage allocated to other partners (80% x $6,000) = (4,800)
Partner’s basis (not reduced below 0) = $ 0
Situation-2. Gain will be recognized on a contribution of property to a partnership in exchange for an interest therein if the partnership would be an investment company if incorporated.
Situation-3. Partner must recognize compensation income when an interest in partnership capital is received in exchange for services rendered.
Example: X received a 10% capital interest in the ABC Partnership in exchange for services rendered. On the date X was admitted to the partnership, ABC’s net assets had a basis of $30,000 and a FMV of $50,000. X must recognize compensation income of $5,000.
Property contributed to the partnership has the same basis as it had in the contributing partner’s hands (a transferred basis). The basis for the partner’s partnership interest is increased by the adjusted basis of property contributed. No gain or loss is generally recognized by the partnership upon the contribution.
The partnership’s holding period for contributed property includes the period of time the property was held by the partner. A partner’s holding period for a partnership interest includes the holding period of property contributed, if the contributed property was a capital asset or Sec. 1231 asset in the contributing partner’s hands.
Although not a separate taxpaying entity, the partnership must make most elections as to the tax treatment of partnership items. For example, the partnership must select a taxable year and various accounting methods which can differ from the methods used by its partners. Partnership elections include an overall method of accounting, inventory method, the method used to compute depreciation, and the election to expense depreciable assets under Sec. 179.
Income and Loss In Partnership
Since a partnership is not a separate taxpaying entity, but instead acts as a conduit to pass-through items of income and deduction to individual partners, the partnership’s reporting of income and deductions requires a two-step approach.
Step-1. All items having special tax characteristics (i.e., subject to partial or full exclusion, % or dollar limitation, etc.) must be segregated and taken into account separately by each partner so that any special tax characteristics are preserved. These special items are listed separately on Schedule K of the partnership return and include: (a) Capital gains and losses; (b) Sec. 1231 gains and losses; (c) Charitable contributions; (d) Foreign income taxes; (e) Sec. 179 expense deduction for recovery property; (f) Interest, dividend, and royalty income; (g) Interest expense on investment indebtedness; (h) Net income (loss) from rental real estate activity; (i) Net income (loss) from other rental activity.
Step-2. All remaining items (since they have no special tax characteristics) are ordinary in nature and are netted in the computation of partnership ordinary income or loss from trade or business activities. Frequently encountered ordinary income and deductions include: (a) Sales less cost of goods sold; (b) Business expenses such as wages, rents, bad debts, and repairs; (c) Guaranteed payments to partners; (d) Depreciation; (e) Amortization (over sixty months or more) of partnership organization expenses; (f) Sec. 1245, 1250, etc., recapture; (g) See Form 1065 outline at beginning of chapter for more detail.
The character of any gain or loss recognized on the disposition of property is generally determined by the nature of the property in the hands of the partnership. However, for contributed property, the character may be based on the nature of the property to the contributing partner before contribution:
- If a partner contributes unrealized receivables, the partnership will recognize ordinary income or loss on the subsequent disposition of the unrealized receivables.
- If the property contributed was inventory property to the contributing partner, any gain or loss recognized by the partnership on the disposition of the property within five years will be treated as ordinary income or loss.
- If the contributed property was a capital asset, any loss later recognized by the partnership on the disposition of the property within five years will be treated as a capital loss to the extent of the contributing partner’s unrecognized capital loss at the time of contribution. This rule applies to losses only, not to gains.
Three sets of rules may limit the amount of partnership loss that a partner can deduct:
Rule-1. A partner’s distributive share of partnership ordinary loss and special loss items is deductible by the partner only to the extent of the partner’s basis for the partnership interest at the end of the taxable year [Sec. 704(d)]. According to this rule:
- The pass-through of loss is considered to be the last event during the partnership’s taxable year; all positive basis adjustments are made prior to determining the amount of deductible loss.
- Unused losses are carried forward and can be deducted when the partner obtains additional basis for the partnership interest.
Example: A partner who materially participates in the partnership’s business has a distributive share of partnership capital gain of $200 and partnership ordinary loss of $3,000, but the partner’s basis in the partnership is only $2,400 before consideration of these items. The partner can deduct $2,600 of the ordinary loss ($2,400 of beginning basis + $200 net capital gain). The remaining $400 of ordinary loss must be carried forward.
Rule-2. The deductibility of partnership losses is also limited to the amount of the partner’s at-risk basis [Sec. 465]. According to this rule:
- A partner’s at-risk basis is generally the same as the partner’s regular partnership basis with the exception that liabilities are included in at-risk basis only if the partner is personally liable for such amounts.
- Non-recourse liabilities are generally excluded from at-risk basis.
- Qualified non-recourse real estate financing is included in at-risk basis.
Rule-3. The deductibility of partnership losses may also be subject to the passive activity loss limitations [Sec. 469]. Passive activity losses are deductible only to the extent of the partner’s income from other passive activities. According to this rule:
- Passive activities include (a) any partnership trade or business in which the partner does not materially participate, and (b) any rental activity.
- A limited partnership interest generally fails the material participation test.
- To qualify for the $25,000 exception for active participation in a rental real estate activity, a partner (together with spouse) must own at least 10% of the value of the partnership interests.