Study Outline For:
Partnership Taxation
Module: Overview of Subchapter K

 

Partnership Operations  - Study Guide

Partnership Taxable Income
Except for electing large partnerships mentioned earlier, partnership taxable income is calculated much the same way as the taxable income of individuals with a few differences mandated by the Code. First, taxable income is divided into:
  1. separately stated items, and
  2. partnership ordinary income or loss.
The Code specifies a list of deductions that are available to individuals but that cannot be claimed by a partnership. These forbidden deductions include the following:
  1. Personal exemptions
  2. Additional itemized deductions for individuals
  3. Taxes paid to a foreign country or to a U.S. possession
  4. Charitable contributions
  5. Oil and gas depletion
  6. Net operating loss (NOL) carryback or carryover

Separately stated items

Each partners distributive share of the partnership's income must be reported. Code Section 702 establishes a list of items that must be separately stated at the partnership level so that their character can remain intact as the income and losses are passed through and reported at the partner level. Section 702(a) lists the following items that must be stated:

    1. Net short-term capital gains and losses.
    2. Net long-term capital gains and losses.
    3. Section 1231 gains and losses,
    4. Charitable contributions.
    5. Dividends eligible for a dividends-received deduction.
    6. Taxes paid to a foreign country or to a U.S. possession.
    7. Any other items provided by the Regulations.

Specially Allocated Items

As a general rule, a flow-through item must be separately stated if the income tax liability of any partner that would result from treating the item separately is different from the liability that would result if that item is included with partnership ordinary income. Items that the Regulations suggest should be separately stated in addition to what is in the Code include the following:

    1. gambling gains and losses;
    2. nonbusiness expenses;
    3. medical and dental expenses-,
    4. alimony payments-,
    5. intangible drilling and developmental costs-, and
    6. special allocations of partnership income. === Regs. Sec. 1.702-1(a)(7)


Partnership Ordinary Income or Loss

Section 702(a)(8) requires reporting as a separate category all of the partnership's taxable income or loss that is not otherwise required to be stated separately under Section 702(a). This is the amount that is reflected on the last line of page one on the Form 1065 as the ordinary income or (loss) of the partnership and is also the amount that is to be apportioned to the partners on their respective K-1s. Because the income or loss figure is found on the bottom line of page 1, Form 1065, it is often referred to as bottom line income or loss.

Included in this bottom line income or loss are such items as gross profits from sales and administrative and operating expenses. These represent the actual income and expenses of operating the business that are not subject to special limitations. In addition, other categories of income, such as depreciation recapture (Section 1245), are included as partnership ordinary income because they represent ordinary income that is not subject to any preferential treatment.

NOTE
It should be noted that the bottom line income or loss is sometimes incorrectly referred to as partnership taxable income. Although it is never totaled for reporting purposes, partnership taxable income is the sum of the separately stated items plus the bottom line income. Therefore, partnership taxable income is often substantially greater than partnership ordinary income.

Example

A partnership has net income per books of $63,000 computed as follows:

Net sales
$122,000
Sec. 1245 recapture
18,000
Long-term capital gain
15,000
Charitable contributions
10,000
Administrative expenses
82,000
 
----------
BOOK INCOME
$ 63,000
 
The partnership bottom line ordinary income is $58,000 ($122,000 + $18,000 - $82,000). The long-term capital gain and the charitable contributions are separately stated items. Also note that partnership taxable income is $63,000 (the sum of the bottom line income plus separately stated items.)

Study Questions Make your selection by clicking the appropriate response letter.

1.

Which of the following is not used to calculate ordinary income (loss) on Form 1065?

Guaranteed Payments to Partners

Ordinary income from other partnerships.

 
Payments to Keogh or IRA plans for partners.
 
Cost of goods sold.

2.

Items that may be subject to special tax treatment and that are reported separately on Schedule K of the partnership return include all of the following, except:
 
Dividends.

Capital gains and losses.

Charitable contributions.
 
Bad debts.

3.

Which of the following is not a separately stated item at the partnership level?
 
Section 1231 gains and losses.

Section 1245 recapture.

Tax-exempt interest.
 
Charitable contributions.

4.

Which of the following is normally a separately stated item at the partnership level?
 
Partners' salaries

Net operating loss

Section 179 expense
 
Depreciation

Allocating Partnership Taxable Income

Code Section 701 states that the persons carrying on business as partners, and not the partnership, are responsible for the income taxes in their separate capacities. In order to compute the tax in separate capacities, partnership level characterization must first be performed. This requires that:

  1. segregated items of partnership income, gains, losses or expenses, and the character of each be determined; and = IRC Sec. 702(a)(l)-(7)
  2. bottom line partnership taxable income be determined. ==IRC Sec. 702(a)(8)

After the partnership's separately stated items as well as partnership ordinary income or loss are determined, the totals of these categories must be allocated among the partners. Each partner must report and pay taxes on his distributive share. The partners distributive share is normally determined by the terms of the partnership agreement or, if the partnership agreement is silent, by the partner's overall interest in the partnership as determined by taking into account all facts and circumstances.

A partners distributive share is actually the portion of partnership taxable and nontaxable income that the partner has agreed to report for tax purposes. It should not be confused with the amount actually distributed to a partner. Actual distributions in a given year may be more or less than the distributive share reported by the partner.


Partnership agreement

The partnership agreement generally determines how a partner shares in the income and losses of the partnership. The interest may be as a single percentage or it may indicate profit and loss interests as separate percentages. Thus, a partnership agreement may state that a partner has a 10 percent interest in both partnership profits and losses or a partner has a 10 percent interest in partnership profits but a 30 percent interest in partnership losses.

If profit and loss percentages are stated separately, the partnership's taxable income for the year is first totaled to determine whether a net profit or net loss has been earned. Then the appropriate percentage (either profit or loss) is applied to each class of income for the year.


Retroactive allocations

If an individual becomes a partner in a partnership in the middle of the year and the partnership incurs a loss for the year, the partnership agreement can not allocate a share of the full year's loss to the new partner. Instead, the new partners distributive share of the partnership income is allocated either by making an interim closing of the books or taking into account the varying interest rule of the partners during the year. IRC Sec. 706(d)(1)

Interim closing of the books

Under an interim closing of the books, actual gains and losses are calculated as if multiple sets of books are being kept for each period of the year in which an ownership change occurs. Under the interim closing of the books method, a partnership may use a semimonthly convention which holds purchases of a partnership interest made during the first 15 days to be treated as happening on the first day of the month. Partners entering after the 15th day of the month are treated as entering on the 16th day of the month.
IR 84-129, 12/13/84

Varying interest rule

If a partner's ownership interest changes during the partnership tax year, the income or loss allocation takes into account the varying interest of the partners. This varying interest rule is applied for changes occurring to a partner's interest as a result of buying an additional interest in the partnership, selling part (but not all) of a partnership interest, giving or being given a partnership interest, or the admission of a new partner. The partners ownership interest is generally applied to the income earned on a daily basis.
Example
Z owns 30 percent of the XYZ Partnership from January 1 to June 30. On July 1, Z buys an additional 10 percent interest in the partnership. For the calendar year, XYZ Partnership has ordinary income of $80,000, which is earned evenly throughout the year. Z's share of income for the year is $28,033 ($11,901 + $16,132) calculated as follows:
         
Pre July 1 $80,000= X 181/365

X= 30% =

$11,901
Post June 30 $80,000= X 184/365 X =40% =
$16,132
       
$28,033

Special allocations
Special allocations are unique to partnerships and allow tremendous flexibility in sharing of specific items of income and loss among the partners. The IRS will respect a special allocation if it meets one of three requirements:
  1. The allocation must have substantial economic effect;
  2. The allocation is in accordance with the partner's interest in the partnership; or
  3. The allocation can be deemed to be in accordance with the partner's interest in the partnership.

If none of these conditions are met, the IRS will reallocate the partner's income and losses according to the partners interest in the partnership as determined by the Service.

Example
Newly formed Partnership XY purchases an apartment complex. According to the partnership agreement, all of the depreciation deductions on the apartments are apportioned to partner X. If one of the aforementioned special allocation requirements is met, the apportionment is observed. If none of the requirements are met, the Service will allocate the depreciation to both partners X and Y according to their partnership interest.

The rules for special allocations will be discussed thoroughly in the Module on Allocations


Study Questions Make your selection by clicking the appropriate response letter.

1.

In order for a partnership to make a special allocation of income or expenses, one of the following conditions must be satisfied, except:
 
The allocation must have substantial economic effect.

The allocation is in accordance with the partner's interest in the partnership.

The allocation is deemed to be in accordance with the partner's interest in the partnership
 
The allocation is tax neutral.

2.

Partner's distributive share of income or loss can best be described as follows:
 
Amounts actually distributed to the partner.

A partner's share of taxable and nontaxable income.

A partner's share of taxable income plus amounts actually distributed to the partner.
 
A partner's share of taxable and nontaxable income plus amounts actually distributed to the partner.

3.

Z is a 30 percent partner who works for the partnership. The partnership's records show.

  • Gross profit $300,000
  • Guaranteed salary to Z 30,000
  • Operating expenses 214,000

Z received the salary and withdrew an additional $12,000 during the year. Z's basis in the partnership was $27,000 at the beginning of the year. Z must report on his tax return.

 
$42,000

$46,800

$55,800
 
$58,000

4.

D owns 10 percent of the ABC Partnership from January 1, 1999 through June 30, 1999. On July 1, 1999, D buys an additional 10 percent of the partnership. The ABC Partnership ordinary income for 1999 is $100,000 and it is earned evenly throughout the year. If 1999 is not a leap year, D's distributive share of the ordinary income using the varying interest rule is:
 
$15,190

$15,041

$15,000
 
$14,958
Partnership Loss Determination

The amount of partnership losses that a partner can deduct (including capital losses) is limited by Section 704(d) to the basis of the partners interest at the end of the partnership year. A partner's share of partnership losses in excess of basis is disallowed in the current year and must be carried forward to be deducted in future years when the partners basis increases.


Applying the limitation

The Regulations detail how the limitation is applied to different types of partnership losses:

  • First, the partnership's basis must be adjusted to reflect contributions, distributions, and any income items for the year.
  • To the extent that the partners distributive share of the loss items exceeds the year-end adjusted basis, the losses will be disallowed.
  • The disallowed balances of each category of loss are prorated and then carried forward as distributive shares in subsequent years until fully absorbed. Regs. Sec. 1.704(d)(2)
Example

At the beginning of the year Partner X's basis is $4,500. During the year, X contributes $2,500 and has the following share of income and loss items:

  1. Ordinary income of $2,000,
  2. Section 1231 loss of $7,000, and
  3. Short-term capital loss of $3,000.

X's year-end adjusted basis is $9,000 ($4,500 Beginning + $2,500 contributed + $2,000 income). The loss items of $10,000 ($7,000 + $3,000) exceed the year-end adjusted basis by $1,000. Therefore, only $9,000 of the loss is deductible and must be prorated $6,300 to Section 1231 losses ($9,000 - $7,000/$10,000) and $2,700 to the short-term capital losses ($9,000 * $3,000/$10.000)

The character of any excess losses is preserved when the losses are carried forward. In addition, any losses carried forward from the prior year must be aggregated with the current year losses before the limitation of Section 704(d) is applied. Thus, in the previous example, X would have carried forward a Section 1231 loss of $700 and a short-term capital loss of $300 to be aggregated with the separately stated gains and losses of the next year. Regs. Sec. 1.704-1(d)(4)


Effect of suspended losses

The Regulations provide that any disallowed or suspended losses may be deducted in a subsequent year to the extent of the partner's adjusted basis at the end of the subsequent year. There is no time restriction on the carryforward period. As a result, an excess loss may be allowable in any subsequent year that a partner makes a capital contribution, accumulates income or increases the partnership interest.

Upon a sale or exchange of a partnership interest, if any suspended losses exist, the selling partner is not entitled to take the previously disallowed losses, and the selling partner's basis remains at zero for gain computation purposes. Although the Code or Regulations do not specifically indicate, it seems apparent that the excess carryforwards should not be transferable to the purchasing partner. This is because the gain recognized is computed from a zero basis and not a negative basis that would have occurred if the disallowed loss had been recognizable.


Tax planning strategy

If partnership losses are projected for a given year, careful tax planning can ensure the deductibility of a partner's entire distributive share of such loss. Current year partnership losses can be deducted in a given year if a calendar year partner makes an additional capital contribution by December 31. Likewise, if the partnership incurs additional debt before year-end, it would operate to increase the partners basis and allow a deduction for the potential suspended loss. Note, however, that other provisions may cause a limitation in the deduction (e.g., at-risk and passive loss limitations). These provisions are discussed in Module G.


Study Questions Make your selection by clicking the appropriate response letter.

1. G and H are partners in the calendar year GH Partnership and share equally in its profits and losses. G had a basis of $5,000 in the partnership, before his distributive share of a $14,000 ordinary loss reported by GH for 1998. In 1999, the partnership reports a $6,000 ordinary gain on Form 1065, What income or loss should G properly report on his 1999 individual return? Assume that there are no other transactions that affect G's basis in the partnership for 1998 and 1999.
 
$0.

$1,000 income.

$3,000 income.
 
$4,000 income.

2.

D is a partner in the DL Partnership. At the start of the current year, D's interest basis in the partnership is $10,000. No distributions or contributions have been made during the year. The partnership has a taxable loss for the year of $28,000 and a long-term capital loss of $12,000. D has a 50 percent interest in profits and losses. Ignoring any passive loss limitations on his own income tax return for the current year, D may offset.
 
$14,000 of the ordinary loss against his ordinary income, and $6,000 of the long-term capital loss against his long-term capital gains.

$10,000 of the ordinary loss against his ordinary income

$4,000 of the ordinary loss against his ordinary income, and $6,000 of the capital loss against his long-term capital gains.
 
$7,000 of the ordinary loss against his ordinary income, and $3,000 of the capital loss against his long-term capital gains.

3.

G and H do business as the GH Partnership, sharing profits and losses equally. All parties use the calendar year for tax purposes. On January 1 of last year, G's basis in the partnership was $25,000 and G made no withdrawals from the partnership during the year. The partnership sustained an operating loss of $90,000 last year and earned a profit of $30,000 in the current year. Ignoring any passive loss limitations, G's personal income tax return for last year should include:
 
An ordinary loss of $25,000.

An ordinary loss of $25,000 and a capital loss of $20,000.

An ordinary loss of $40,000.
 
An ordinary loss of $45,000

Provisions Outside of Subchapter K
Certain provisions outside of Subchapter K affect the amount of loss that an individual partner can deduct in any given year. Two major provisions are the at risk limitations and passive loss rules which are next. 


At risk limitations 

Although a partner may have sufficient basis to claim a loss, at risk limitations may restrict a partner from deducting losses where there is no financial risk of loss. IRC Sec. 465(a) 

A partner's at-risk amount generally includes his adjusted basis in the partnership taking into account only those liabilities for which the partner has personal liability. This is in contrast to a partner's outside basis computation which may include the partner's share of all partnership liabilities without regard to any personal liability on the obligations, Thus, a partners outside basis may include both recourse and nonrecourse liabilities, while the same partner's at risk basis would only include recourse liabilities. 

With respect to liabilities, neither general nor limited partners are considered to be at risk with respect to liabilities for which the partner is protected against loss through nonrecourse financing, guarantees, or similar arrangements. 

Ordinarily, nonrecourse liabilities are not included in the at-risk basis. However, after 1986, qualified nonrecourse financing is included in a partner's at-risk amount. Qualified nonrecourse financing generally means any loan from a qualified lender that is secured by real property and borrowed for the purpose of owning the real property.

Limited partners are not at-risk for any liabilities of the partnership except to the extent of their capital contributions. Consequently, additional partnership liabilities will not increase their amount at risk. There may be instances where, pursuant to the partnership agreement, the limited partner is obligated to make additional capital contributions to the partnership. Such amounts are included in the partner's basis but generally are not included in the at-risk amount until actually contributed. 

Deductions disallowed due to at-risk limitations carry over to subsequent years and are deductible whenever sufficient at-risk amounts are established. There is no limit to the number of years to which a taxpayer may carry over such disallowed deductions. 


Passive loss limitations 

Code Section 469 provides that income as well as losses are classified into three separate categories: 

    1. active income, 
    2. portfolio income; and 
    3. passive income. 
Partnership income is generally classified as either active or passive income depending on the involvement of the partners. A partner who actively participates in the administration and operations of the partnership is deemed to have active income. Otherwise, a partner is viewed to have passive income or losses. By definition, a limited partner is deemed to be passive in nature. IRC Sec. 469(h)(2) 

Partners who are designated as passive owners are limited in the amount of losses and credits that they can deduct. Passive losses as well as tax credits generated by the partnership are deductible only to the extent of a partner's other passive income and cannot be used to offset ordinary income. In addition, any portfolio income (dividends and interest) must be segregated and cannot be used to absorb the passive losses of the partnership. IRC Sec. 469(e)(1) 

Disallowed passive losses and credits are suspended and carried forward until a disposition of the partnership interest occurs. When a taxable disposition is made, all suspended losses (but not credits) are deducted in the following order: 

    1. Against any gain from the partnership disposition; 
    2. Against any net income from other passive activities; 
    3. Against any other income or gain. IRC Sec. 469(g)(1)
Generally, with a limited exception, any suspended credits are disregarded at the time of disposition. IRC Sec. 469(o)(9) 

Code Section 469 also provides a special rule for certain real estate partnerships. By definition, rental real estate activities are considered to be passive in nature. However, if a general partner owns at least 10 percent of the partnership and actively participates in the real estate business, then that partner may deduct up to $25,000 against other nonpassive income. The benefit of this $25,000 deduction will be phased-out when the partner's Adjusted Gross Income (AGI) exceeds $100,000. The phase-out rate is $1 for every $2 the partner earns in excess of $100,000. Consequently, no deduction is allowed when a partners AGI reaches $150,000. IRC Sec. 469(i)
 
Example 
B has AGI of $120,000 and is a 25 percent partner in the AB general partnership that reflects a rental real estate loss of $18,000 on his K-1 (not reflected in AGI). If B actively participates in the rental business, a deduction of $15,000 ($25,000 - $10,000 phase-out) is allowed against the $120,000 AGI. The remaining $3,000 is suspended. 

Section 465 was enacted to prevent investors from deducting losses in excess of amounts for which they were financially at risk. Partners must be certain their deductible losses are not limited by either Sec. 704(d) or Sec. 465. It is quite possible that partners will be limited by Sec. 465 even though they have sufficient basis to deduct the loss under Sec. 704(d). 


Study Questions Make your selection by clicking the appropriate response letter.

1.
Which of the following is not a requirement for the $25,000 rental real estate deduction provided in Section 469 to apply to a real estate partnership? 
 
The partner must have active participation in rental real estate activities.
 
The partner must own at least 10 percent of the value of the partnership. 
 
The partner must be a general partner. 
 
The $25,000 benefit must begin a phase-out when a partner's AGI exceeds $150,000. 

 
2.
The ABC Partnership has a general partner A who actively participates in the business. Partner A has a $30,000 distributive share of ordinary losses for 1998. At the end of 1998 the basis limitation of Section 704(d) is $40,000 before the loss is taken into account. The at-risk basis is $15,000. What is the Section 704(d) basis on December 31, 1998 after the loss is taken into account? 
 
$10,000 
$15,000 
$25,000 
 
$40,000 

 
3.
D buys a 10 percent capital and profits interest in a partnership in 1998. D is a limited partner and does not participate in the partnership business. D has no passive investment income. D's distributive share of the partnership's loss for 1998 is $40,000. D's Section 704(d) basis in the partnership is $32,000 and D's at-risk basis is $16,000. How much of the loss can D deduct?
 
$40,000 
$32,000 
$16,000 
 
None

Copyright © 2003 Bizzer.com