Digging Deeper s1

Chapter 11 Digging Deeper

Contents:

CONCEPTUAL BASIS FOR PARTNERSHIP TAXATION

1. The unique tax treatment of partners and partnerships can be traced to two legal concepts that evolved long ago: the aggregate (or conduit) concept and the entity concept. These concepts have been used in both civil and common law and have influenced practically every partnership tax rule.

Aggregate (or Conduit) Concept. The aggregate (or conduit) concept treats the partnership as a channel through which income, credits, and deductions flow to the partners. Under this concept, the partnership is regarded as a collection of taxpayers joined in an agency relationship with one another. The imposition of the income tax on individual partners reflects the influence of this doctrine. The aggregate concept has also influenced the tax treatment of other pass-through entities, such as S corporations (Chapter 12) and trusts and estates.

Entity Concept. The entity concept treats partners and partnerships as separate units and gives the partnership its own tax “personality” by (1) requiring a partnership to file an information tax return and (2) treating partners as separate and distinct from the partnership in certain transactions between a partner and the entity. A partner’s recognition of capital gain or loss on the sale of the partnership interest illustrates this doctrine.

Combined Concepts. Some rules governing the formation, operation, and liquidation of a partnership contain a blend of both the entity and aggregate concepts.

SERVICE CONTRIBUTIONS

2. When a partner receives an interest in the partnership that includes only an interest in the entity’s future profits, the partner typically does not recognize any gross income when the interest is received. Because the amount of the future profits cannot be determined with reasonable accuracy and the partner holds no liquidation rights, the interest is valued at zero at that time. Rev.Proc. 93-27, 1993-2 C.B. 343 includes more details about this situation, and it discusses some exceptions to the rules.

INITIAL COSTS, ACCOUNTING METHODS, AND TAX YEAR OF A PARTNERSHIP

3. Acquisition Costs of Depreciable Assets. Expenditures may be incurred in changing the legal title in which certain assets are held from that of the contributing partner to the partnership name. These costs include legal fees incurred to transfer assets or transfer taxes imposed by some states. Such costs are depreciable assets in the hands of the partnership. However, since the partnership “steps into the shoes” of contributing partners for determining depreciation on preexisting contributed assets, acquisition costs are treated as a new asset, placed in service on the date the cost is incurred (e.g., when the asset is transferred to the entity).

Syndication Costs. Syndication costs are capitalized, but no amortization election is available.1 Syndication costs typically include the following expenditures incurred for promoting and marketing partnership interests.

· Brokerage fees.

· Registration fees.

· Legal fees paid to the underwriter, placement agent, and issuer (general partner or the partnership) for security advice or advice on the adequacy of tax disclosures in the prospectus or placement memo for securities law purposes.

· Accounting fees related to offering materials.

· Printing costs of prospectus, placement memos, and other selling materials.

Method of Accounting. Like a sole proprietorship, a newly formed partnership may adopt either the cash or accrual method of accounting or a hybrid of these two methods.

However, a few special limitations on cash basis accounting apply to partnerships. The cash method of accounting may not be adopted by a partnership that:

· has one or more C corporation partners or

· is a tax shelter.

A partnership with a C corporation partner still can use the cash basis treatment if:

· the partnership meets the $5 million gross receipts test described below,

· the C corporation partner(s) is a qualified personal service corporation, such as an incorporated attorney, or

· the partnership is engaged in the business of farming.

A partnership meets the $5 million gross receipts test if it has not received average annual gross receipts of more than $5 million. ‘‘Average annual gross receipts’’ is the average of gross receipts for the three tax years ending with the tax period prior to the tax year in question. For new partnerships, the period of existence is used. Gross receipts are annualized for short tax periods. A partnership must change to the accrual method the first year after the year in which its average annual gross receipts exceed $5 million. It then must use the accrual method thereafter.

A tax shelter is a partnership whose interests have been sold in a registered offering or a partnership in which 35 percent of the losses are allocated to limited partners.

Example: Jason and Julia are both attorneys. Several years ago, each of them formed a professional personal service corporation to operate their separate law practices. This year, the two attorneys decide to form the JJ Partnership, which consists of the two professional corporations. JJ’s gross receipts are $6 million. JJ may adopt the cash method of accounting, since it is a partnership consisting of qualified personal service corporations. Because JJ has no C corporate partners that are not personal service corporations, the cash method is available even though JJ’s average annual gross receipts are greater than $5 million. JJ also may adopt the accrual method of accounting or a hybrid of the cash and accrual methods.

Tax Year of the Partnership. Partnership taxable income (and any separately stated items) flows through to each partner at the end of the partnership’s tax year. A partner’s taxable income, then, includes the distributive share of partnership income for any partnership tax

year that ends within the partner’s tax year.

When all partners use the calendar year, it would be beneficial in present value terms for a profitable partnership to adopt a fiscal year ending with January 31. Why? When the adopted year ends on January 31, the reporting of income from the partnership and payment of related taxes can be deferred for up to 11 months. For instance, income earned by the partnership in September 2013 is not taxable to the partners until January 31, 2014. It is reported in the partner’s tax return for the year ended December 31, 2014, which is not due until April 15, 2015. Even though each partner may be required to make quarterly estimated tax payments, some deferral still is possible.

Required Tax Years. To prevent excessive deferral of taxation of partnership income, Congress and the IRS have adopted a series of rules that prescribe the required tax year an entity must adopt if no alternative tax years (discussed below) are selected. Three rules are presented in the box below. The partnership must consider each rule in order. The partnership’s required tax year is the tax year determined under the first rule that applies.

The first two rules in the box are relatively self-explanatory. Under the least aggregate deferral rule, the partnership tests the year-ends that are used by the various partners to determine the weighted-average deferral of partnership income. The year-end that offers the least total deferral is the required tax year under this rule.

In Order, Partnership Must Use / Requirements
Majority partners’ tax year / More than 50% of capital and profits is owned by partners who have the same tax year.
Principal partners’ tax year / All partners who own 5% or more of capital or profits are principal partners.
All principal partners must have the same tax year.
Year with smallest amount of income deferred / ‘‘Least aggregate deferral rule’’ (see example below).

Example: Anne and BonnieCo are equal partners in the AB Partnership. Anne uses the calendar year, and Bonnie uses a fiscal year ending August 31. Neither Anne nor BonnieCo is a majority partner, as neither owns more than 50%. Although Anne and BonnieCo are both principal partners, they do not have the same tax year. Therefore, the general rules indicate that the partnership’s required tax year must be determined by the ‘‘least aggregate deferral rule.’’ The following computations support August 31 as AB’s tax year, since the 2.0 product using that year-end is less than the 4.0 product when December 31 is used.

Test for 12/31 Year-End
Partner / Year Ends / Profit Interest / Months of Deferral * / Product
Anne / 12/31 / 50% / ´ / –0– / = / 0.0
BonnieCo / 8/31 / 50% / ´ / 8 / = / 4.0
Aggregate number of deferral months / 4.0
Test for 8/31 Year-End
Partner / Year Ends / Profit Interest / Months of Deferral * / Product
Anne / 12/31 / 50% / ´ / 4 / = / 2.0
BonnieCo / 8/31 / 50% / ´ / –0– / = / 0.0
Aggregate number of deferral months / 2.0

*Months from entity’s test year end to owner’s year end.

Alternative Tax Years. If the required tax year is undesirable to the entity, three other alternative tax years may be available.

· Establish to the IRS’s satisfaction that a business purpose exists for a different tax year, typically a natural business year at the end of a peak season or shortly thereafter.2

· Elect under § 444 a tax year so that taxes on partnership income are deferred for not more than three months from the required tax year. Then, have the partnership maintain with the IRS a prepaid, non-interest-bearing deposit of estimated deferred taxes.3 This alternative may not be desirable because the deposit is based on the highest individual tax rate plus one percentage point, or 36 percent.

· Elect a 52- to 53-week tax year that ends with reference to the required tax year or to the tax year elected under the three-month deferral rule.

REPORTING OPERATING RESULTS

4. Penalties. Each partner’s share of partnership items should be reported on his or her individual tax return in the same manner as presented on the Form 1065. If a partner treats an item differently, the IRS must be notified of the inconsistent treatment.4 If a partner fails to notify the IRS, a negligence penalty may be added to the tax due.

To encourage the filing of a partnership return, a penalty of $195 per partner per month (or fraction thereof), but not to exceed 12 months, is imposed on the partnership for failure to file a complete and timely information return without reasonable cause.5 A “small partnership” with 10 or fewer individual and C corporation partners is excluded from these penalties.6 A husband and wife (or their estates) count as one partner in meeting this test.

PARTNERSHIP DISTRIBUTIONS

5. A distribution from the partnership to a partner may consist of cash or partnership property. All distributions, cash and property, fall into two distinct categories.

· Liquidating distributions.

· Nonliquidating distributions.

Whether a distribution is a liquidating or nonliquidating distribution depends solely on whether the partner remains a partner in the partnership after the distribution is made. A liquidating distribution occurs either (1) when a partnership itself liquidates and distributes all of its property to its partners or (2) when an ongoing partnership redeems the interest of one of its partners. This second type of liquidating distribution occurs, for example, when a partner retires from a partnership, or when a deceased partner’s interest is liquidated. The two types of liquidating distributions receive differing tax treatment.

A nonliquidating distribution is any distribution from a continuing partnership to a continuing partner—that is, any distribution that is not a liquidating distribution. Nonliquidating distributions are of two types: draws or partial liquidations. A draw is a distribution of a partner’s share of current or accumulated partnership profits that have been taxed to the partner in current or prior tax years of the partnership. A partial liquidation is a distribution that reduces the partner’s interest in partnership capital but does not liquidate the partner’s entire interest in the partnership. The distinction between the two types of nonliquidating distributions is largely semantic, since the basic tax treatment typically does not differ.

Example: Kay joins the calendar year KLM Partnership on January 1 by contributing $40,000 cash to the partnership in exchange for a one-third interest in partnership capital, profits, and losses. Her distributive share of partnership income for the year is $25,000.

If the partnership distributes $65,000 ($25,000 share of partnership profits + $40,000 initial capital contribution) to Kay on December 31, the distribution is a nonliquidating distribution as long as Kay continues to be a partner in the partnership. This is true even though Kay receives her share of profits plus her entire investment in the partnership. In this case, $25,000 is considered a draw, and the remaining $40,000 is a partial liquidation of Kay’s interest. If, instead, the partnership is liquidated or Kay ceases to be a partner in the ongoing partnership, the $65,000 distribution is a liquidating distribution.