Updates in Partnership Taxation

Transcription

1 Updates in Partnership Taxation Presented by: Nicholas Livers Hyden, Miron & Foster, PLLC 200 Louisiana Little Rock, Arkansas (501) Partnership Basis. Partnership basis is a concept separate and distinct from a partner s capital account. A partnership will keep track of a partner s basis in his or her partnership interest, will keep track of the partnership s basis in the partnership property, and will keep track of the partner s capital account. Capital accounts are established for each partner and are intended to measure each partner s economic investment in the partnership. Capital accounts are used to keep track of contributions, distributions and allocations. Basis, on the other hand, is used to determine the post tax dollars each partner has invested so that the gain or loss on the disposition of the partnership interest or of partnership property may be properly calculated. At times, a partner s basis and capital account may be the same. At other times, the two may be different. For example, if a partner contributes $100, to a partnership, that partner s outside basis in the partnership interest will be $100,000.00, and the partner s capital account will be $100, The two numbers will be the same. However, if a partner contributes appreciated property in which he has a basis of $60, and a fair market value of $100,000.00, the partner s outside basis in the partnership will be $60, while that partner s capital account will be $100, The two numbers are used for different purposes, and it is important to make annual adjustments and keep track of both numbers. It is very important to keep track of a partner s basis in the partnership interest, or the outside basis, because the partner s outside basis is used to determine the taxability of any distributions made to the partner and is used to determine the taxability of any disposition of the partnership interest by the partner. The outside basis of the partner will fluctuate every year, so it is very important to keep accurate records and make annual adjustments to the partner s outside basis in the partnership interest. a. Initial Basis in the Partnership Interest. The initial outside basis of a partner in a partnership interest is governed by the rules of 722. Section 722 provides, The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under 721(b) to the contributing partner at such time.

2 The initial basis of a partner in a partnership interest is generally easy to determine. If the partner contributes money, the outside basis is equal to the amount of money contributed. If the partner contributes property, the outside basis is equal to the basis in the property contributed. Thus, at the time of contribution, a partner will need to know his or her outside basis in the property contributed. Finally, the basis is increased if the partner recognizes any gain under 721(b) upon the contribution. This rule is an exception to the general rule of Section 721(a) that provides no gain or loss is recognized to the partnership or any partners upon the contribution of property to a partnership in exchange for a partnership interest. In most cases, no gain is recognized on contribution of property to a partnership. The exception is that gain is recognized upon a contribution of property if the partnership would be considered an investment company under 351 if the partnership were incorporated. It is important to note that pursuant to 752, a partner s share of any liabilities of the partnership will be considered a contribution of money by such partner to the partnership. Because a partner s share of liabilities of the partnership is treated as a contribution of money, the partner s share of liabilities will be added to the partner s outside basis in the partnership interest under 722. The Regulations under 752 lay out a complex set of rules to determine a partner s share of partnership liabilities, so one should consult the regulations when liabilities are an issue. Upon the formation of the partnership, it is important to determine and record the partner s initial outside basis in the partnership interest. The outside basis is the measuring stick that will be used in the future to determine the taxability of distributions to the partner and the taxability of dispositions of the partnership interest. Example 1: Partner A contributes $100,000 and Partner B contributes real estate valued at $100,000 to the Partnership. Partner B had a basis in the real estate of $75, Upon the formation of the Partnership, each Partner s outside basis and capital account are as follows: Outside Basis Capital Account Partner A: $100, $100, Partner B: $75, $100, As example 1 demonstrates, it is possible for the outside basis to be different than the capital account. The reason is the basis and capital account serves different purposes. The outside basis measures the investment of post tax dollars that the partner in the partnership interest. It will be used to determine the extent to which future distributions or future dispositions of the interest will be taxable. Partner A contributed $100, of post tax dollars. If the partnership increases in value and Partner A sells his interest for $125,000.00, he will recognize $100, gain. Whereas, Partner B has invested $75, of post tax money. He has an economic investment of $100,000.00, which is

3 shown in his capital account, but he has not paid taxes on the appreciation of the property. His post tax money invested is $75, If he sells his interest for $125,000.00, then he will have $50, of taxable gain. If a partner acquired his or her interest as a transferee of an interest, whether by purchase, gift or inheritance, that partner s basis in the partnership interest will be determined under Section 742. Section 742 provides that the interest in a partnership acquired other than by contribution shall be determined under 1011 et. seq. Thus, if a partnership interest is acquired as an inheritance from a decedent, the outside basis of that partner will be equal to the fair market value of the interest at the date of death of the decedent. Section 1014(a). If the partner purchased the interest, then that partner s basis will be equal to the cost paid for the partnership interest. Section If a partner acquired an interest by gift, then Section 1015 provides that the initial basis of the interest in the hands of the donee will be equal to the donor s adjusted basis immediately prior to the transfer (though the donee s basis is limited to the fair market value of the interest at the time of the gift). b. Adjustment to Initial Basis. After the initial contribution to the partnership, the outside basis of a partner in the partnership interest will be subject to annual adjustments. The purpose of these adjustments are to make sure that the partner s adjusted basis in the partnership interest accurately reflects the partner s economic investment in the partnership so that the partner will realize gain or loss on the sale or disposition of the interest that accurately reflects the partner s economic gain or loss. The adjustment ensures that the income or loss from a partnership is only taxed once. Section 705(a)(1) provides that the adjusted basis of a partner s interest in a partnership is increased by the partner s distributive share of partnership taxable income as determined under 703(a), by the income of the partnership exempt from tax; and by the excess of the deductions for depletion over the basis of property subject to depletion. In addition, in the event that a partnership incurs a liability, then the partner s share of that liability will be treated as a contribution of money to the partnership by the partner, and the partner s outside basis will be increased. Section 705(a)(2) provides that the outside basis of a partnership interest is decreased (but not below zero) by distributions by the partnership and by the sum of the partner s distribute share of losses of the partnership and by expenditures of the partnership not deductible in computing the taxable income and not properly chargeable to the capital account. If there is a decrease in the partner s share of partnership liabilities, there is a deemed distribution of cash to such partner from the partnership, and therefore a corresponding decrease in the basis of the partner s outside basis (but not below zero). Section 752(b), 733(1). Example 2:

4 Partner A has an outside basis in her partnership interest of $100, Partner B has an adjusted basis in her partnership interest of $75, The partnership income for 2013 is $100,000. The partnership makes a distribution of $25, to each partner. At the end of 2013, the outside basis of each partner is calculated as follows: Partner A: $100, (Beginning Basis) $ 50, (Share of partnership income) ( 25,000.00) (Amount Distributed) $125, (Adjusted Basis at the end of 2013) Partner B: $75, (Beginning Basis) $50, (Share of Partnership income) (25,000.00) (Amount Distributed) $100, (Adjusted basis at end of 2013) c. Partnership Basis in Partnership Property. A partnership s basis in property contributed by a partner is equal to the contributing partner s adjusted basis at the time of the contribution plus the amount of any gain recognized by the partner upon the contribution pursuant to 721(b). Therefore, with the exception of contributions to partnerships that qualify as investment companies, a partnership has a carryover basis in the contributed property. 2. The Importance of Basis. A partner must determine the adjusted basis in the partnership interest whenever necessary for the determination of the partner s tax liability or the tax liability o another taxpayer. Certain events will trigger the necessity of a partner to determine the basis of his or her partnership interest. A sale or disposition of the partnership interest will require the partner to determine his or her basis in the interest. A distribution from the partnership will require the partner to determine his or her basis in the partnership interest. In many instances, when a partner holds the partnership interest throughout the entire taxable year, then the determination can be made at the end of the taxable year. Treas. Reg (a)(1). For example, when calculating a partner s outside basis in order to determine the extent to which a partner may deduct a partner s share of partnership losses, the partner s outside basis will be calculated at the end of the taxable year. In other instances, a partner s basis may need to be determined in the middle of a taxable year. For example, if all or a portion of a partner s interest is sold or transferred during a taxable year, the adjusted basis of the partner s interest should be determined as of the date of the sale, exchange or liquidation. Treas. Reg (a)(1). Such a determination would be necessary to calculate the gain or loss recognized in that share. If a partnership fails to keep track of the outside basis and fails to make annual adjustments to the outside basis, then the basis may be very difficult to determine when it is needed. Therefore, it is very important to adjust and record the outside basis of partners on an annual basis.

5 a. Distributions from a Partnership to a Partner. There are two types of possible distributions from a partnership to a partner. One type of distribution is a distribution of profits in an on-going partnership. The second is a distribution to a partner is full or partial liquidation of the partner s interest in the partnership. The taxability of both types of distributions are covered in Section 731. Section 731(a)(1) provides that upon the distribution from a partnership to a partner, gain is not recognized by such partner except to the extent that any money distributed exceeds the adjusted basis of such partner s interest in the partnership immediately before the distribution. If gain is recognized, it will be treated as gain arising from the sale or exchange of the partnership interest of the distribute partner. In the event of a distribution that is not a liquidating distribution, no gain is recognized by the partner unless the funds distributed exceeds the outside basis of the partner. This is consistent with the pass-through principle of partnership taxation. The partner paid tax on this money when it was reported as income by the partnership. The income passed through to the partner, and the partner paid tax on the income. The income allocated to the partner increased the outside basis of such partner in his partnership interest. Upon a distribution of this income to the partner, the partner has sufficient outside basis to avoid being taxed a second time upon the distribution of the money to the partner. Furthermore, as noted above, if a partner s share of partnership liabilities decreases, the decrease is considered a distribution of money to such partner. So if a partnership liability is discharged, or and a partner s share of the liabilities is decreased, the partner may have taxable income to the extent that the share of the liabilities of the partner exceeds the outside basis of the partner in the partnership interest. Example 3. Partner C is a partner in Partnership ABC. C was given a partnership interest in exchange or services provided by C. Because the partner contributed no money or property, the partner has no initial basis in the partnership interest. In 2013, the Partnership has $120, of income, $40, of which is allocated to C. In 2013, Partner C s outside basis will increase by $40, and Partner C must report $40, of income on C s tax return. The partnership distributes $40, to C. C has sufficient basis to cover this distribution to C, and C will not be taxable upon the distribution of the income to C. A loss is never recognized upon a distribution of money to a partner except in the case of a liquidating distribution. As noted above, a partner will recognize gain in a liquidating distribution to the extent that a distribution of money exceeds the partner s basis. Example 4:

6 Partner A and B are members of a partnership. In 2013 A and B s basis and capital accounts are as follows: Basis Capital Account Partner A: $100, $100, Partner B: $75, $100, Partner A and B constructed a building on real estate, and sold it. Upon selling the real estate they decided to liquidate the partnership. The real estate was sold in 2013 for $250, and they recognized $50, gain upon the sale. A s outside basis is increased to $125, and B s is increased to $100, Upon liquidation, A receives $125, and B receives $125, Upon the liquidating distribution, A will not recognize any gain, and B will recognize gain of $25, A partner will not recognize a loss upon a distribution unless there is a distribution in liquidation of the partner s interest. In such event, the partner will recognize a loss to the extent that the partner s outside basis exceeds the sum of money distributed plus the basis of any unrealized receivables and inventory distributed. Example 5: Partner A and B are members of a partnership. In 2013 A and B s basis and capital accounts are as follows: Basis Capital Account Partner A: $100, $100, Partner B: $100, $100, Partner A and B constructed a building on real estate, and held it for sale. Due to a dip in the real estate market, the real estate depreciated in value to $190, A agrees with B that B s interest will be liquidated. The partnership distributes $90,000 to B in complete liquidation of B s interest. B will recognize a loss of $10, upon the liquidation of B s interest. b. Disposition of Partnership Interest. Upon the disposition of a partnership interest, the same rules apply as to the disposition of other types of property. Upon the sale of a partnership interest, the selling partner will recognize gain or loss to the extent the purchase price paid exceeds or is lower than the partner s outside basis in the partnership interest. The gain or loss is calculated by taking the difference between the amount realized and the outside basis of the partnership interest. 3. Guaranteed Payments.

7 A guaranteed payment is a payment that is made by a partnership to a partner for services or for the use of capital. Typically, any payment made to a partner for services performed is not considered a salary, but will be classified as a guaranteed payment. For example, where a partnership paid a management fee of 5% of gross rentals to the general partner in a partnership was classified as a guaranteed payment to a partner and was not considered wages or salary paid. Rev. Rul So while payments to partners for services performed look a lot like a salary paid to an employee, the payment is not properly classified as a salary for tax purposes. Rather, the payment to the partner is properly classified as a guaranteed payment. Guaranteed payments are addressed in Section 707(c) of the Internal Revenue Code. This Section provides, to the extent determined without regard to the income of the partnership, payments to a partner for services or the use of capital shall be considered as made to one who is not a member of the partnership, but only for the purposes of section 61(a) (relating to gross income) and, subject to section 263, for purposes of section 162(a) (relating to trade or business expenses). Assume that a partnership consisting of Partner A, B and C set the salary of A, the general partner, at $100, for They will pay this to partner A over 12 months in exchange for A s services to be performed as the general partner. This amount is paid without regard to the income of the partnership. This amount is not classified as wages. Section 707(c) provides that this amount shall be a guaranteed payment. Once a payment is classified as a guaranteed payment, that classification will have implications on how the payment is reported by the partnership and the partner for tax purposes. The classification of a payment as a guaranteed payment produces tax results that are a blend of payment made to a partner and payments made to a nonpartner. Section 707(c) provides that the amount will be included in the partner s ordinary income under 61(a). Thus, like a salary paid to a non-partner, the amount is taxable to the partner as ordinary income. Likewise, the payment is deductible to the partnership. Under 162(a), the partnership will deduct the payment made to the partner, and such deduction may create a loss to be allocated among the partners. However, for other purposes, the guaranteed payment is treated as a distributive share of partnership income. As noted above, guaranteed payments are treated as ordinary income only for purposes of 61(a) and 162(a). for other purposes, guaranteed payments are considered a distributive share of the partnership income. I.R.C. 707(c), Treas. Reg (c). The regulations provide that a partner who receives a guaranteed payment is not regarded as an employee of the partnership for the purpose of withholding tax at source, deferred compensation plans, etc. Treas. Reg (c). The IRS seems to take the position that it is not possible for a guaranteed payment recipient to be an employee of the partnership. See Rev. Rul Section 1402(a) defines net earnings from self-employment to mean the gross income derived by an individual from any trade or business carried on by the individual, less deductions attributable to the trade or business, plus the individual s distributive

8 share of income or loss from any trade or business carried on by a partnership of which he or she is a member. Guaranteed payments for services, therefore, are subject to the self-employment tax. The partnership will not report this payment on a W-2 and will not withhold taxes from the payment. Rather, the partner receiving the guaranteed payment is the one responsible to pay the self-employment taxes.