Chapter 10A. Partnership Formation C11-Chp-10-1A-Ptshp-Form-2011 Edited January 4, 2011 This file covers pages 1 through 20 Howard Godfrey, Ph.D., CPA.

Chapter 10A.Partnership Formation

C11-Chp-10-1A-Ptshp-Form-2011Edited January 4, 2011

This file covers pages 1 through 20

Howard Godfrey, Ph.D., CPAProfessor of Accounting

Copyright 2011

The student should be able to:

1. Differentiate between general and limited partnerships.

2. Explain the tax results of a contribution of property or services in exchange for a partnership interest.

3. Determine the permitted tax years for a partnership.

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Highlights of Recent Tax Law Changes

For organization expenditures incurred after 10-22-04, a partnership may deduct the first $5,000 of these expenditures in the tax year it begins business.

The partnership must reduce the $5,000 by the amount by which cumulative organizational expenditures exceed $50,000 although the $5,000 cannot be reduced below zero. Any remaining organizational expenditures can be amortized over a 180-month period beginning in the month it begins business.

Under the 2004 Jobs Act, for tax years beginning after 2004, a partnership must report each partner’s share of qualified production activities income on the partner’s Schedule K-l. The deduction applies at the partner level.

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Highlights of Recent Tax Law Changes

Proposed regulations were issued in May 1996 to amend the Sec. 7701 (and related regulations) classification scheme for business entities.

Check-the-box regulations permit:

partnerships to be taxed as C or S corps.

These regulations were finalized in December 1996 effective for tax year 1997.

1. Differentiate general and limited partnerships.

Definition of a PartnershipFor tax purposes, the term partnership includes a syndicate, group, pool, joint venture, or other unincorporated organization, which carries on a business or financial operation or venture. If two people (or business entities) work together to carry on any business or financial operation with the intention of making a profit and sharing that profit as co-owners, a partnership exists for federal income tax purposes. A partner is any individual, trust, estate, or corp. that is a member of a partnership.A. General and Limited Partnerships. Each state has laws governing the rights and restrictions of partnerships. They are usually patterned after the UPA or the Uniform Limited Partnership Act.

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Definition of a Partnership

1. General Partnership. Two or more partners join together and do not specifically provide that one or more of the partners are a limited partner.

2. Limited Partnership. There are two classes of partners. There must be one general partner who has the same rights and liabilities as a general partner in a general partnership. A limited partner is limited in liability only to the amount invested in the limited partnership plus any additional amount he has committed to contribute. He has no rights to actively manage the partnership.

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3. Limited Liability Companies (LLCs). Businesses may be taxed as a partnership while having limited liability protection for owners. State law provides the limited liability. Check-the-box regs permit each LLC to choose whether to be taxed as a partnership or as a corp.

4. Limited Liability Partnerships (LLPs). Many states recognize LLP as a business form. The primary difference between a general partnership and an LLP is that a partner is not liable for damages resulting from failures in the work of other partners or of people supervised by other partners. LLPs can be taxed under the check-the-box regs as a partnership or as a corp.

5. Electing Large Partnerships. Partnerships that qualify as “large partnerships” may elect to be taxed under a simplified reporting arrangement. To qualify as a large partnership, the partnership must not be a service partnership and must not be engaged in commodity trading. Partnership must have at least 100 partners.

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Overview of Taxation of Partnership Income

A. Partnership Profits and Losses. A partnership is not a taxpaying entity and income earned by a partnership is not subject to two layers of federal income taxes.

Each partner reports his share of the partnership's income, gain, loss, deduction and credit items as part of his regular tax return.

The partnership files a Form 1065 [U.S. Partnership Return of Income], an information return, which provides the IRS with information about the partnership's income and its allocation to the partners.

2. Explain the tax results of a contribution of property or services in exchange for a partnership interest.

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Partnership Contributions

Section 721(a) provides that no gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.

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Effect of Debt on Gain Section 752(b) provides that any decrease in a partner's share of the liabilities of a partnership, or any decrease in a partner's individual liabilities by reason of the assumption by the partnership of the individual liabilities, shall be considered as a distribution of money to the partner by the partnership. Sec. 731 provides that a partner does not recognize gain on a distribution unless cash distributed exceeds basis in the partnership interest. Under Sec. 733, a partner’s basis is reduced by distributions.

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Formation of a PartnershipA. Contribution of Property.

1. Nonrecognition of Gain or Loss. Formation of a partnership is governed by Sec. 721. When property is exchanged for a partnership interest, no gain or loss will be recognized by the partner or partnership.

The partnership's basis in the property is the partner's basis increased by any gain recognized by the partner under Sec. 721(b).

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2. Recognition of Gain or Loss. Exceptions to the general nonrecognition rule occur when

liabilities are contributed in excess of the property's basis such that the partner would have a negative basis for his partnership interest (including his allocation of general partnership liabilities) immediately after the contribution, or

where the partnership would be considered an investment company if incorporated (Sec. 721(b)).

Gain will also be recognized where there is a contribution of property followed by a distribution in an arrangement that may be considered a sale rather than a contribution.

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Formation of a PartnershipA. Contribution of Property.3. Effects of Liabilities. Each partner's basis is increased by his share of the partnership's liabilities as if he had contributed cash to the partnership in the amount of his share of the partnership liabilities. A partner whose personal liabilities are assumed by the partnership is treated as though cash had been distributed to him in the amount of the assumed liability.

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4. Partner's Basis in Partnership Interest. A partner's

beginning basis in partnership interest equals the sum of

money contributed plus basis of other property

contributed.

Gain recognized because of the assumption of a partner's

liability (that is treated as a deemed cash distribution) is

not used to increase basis.

This is commonly called the outside basis.

5. Holding Period for Partnership Interest. Holding period

for a partnership interest includes the transferor's holding

period for the contributed property if that property is a

capital asset or a Sec. 1231 asset in the transferor's hands.

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Formation of a PartnershipA. Contribution of Property.6. Partnership's Basis in Property. The partnership's basis in contributed assets is the same as its basis in the hands of the contributing partner increased by any gain recognized under the investment company rules of Sec. 721(b), (but not the liability assumption rules). Some properties contributed to a partnership after March 31, 1984 retain their character for subsequent partnership dispositions. This is commonly called inside basis.

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Formation of a PartnershipA. Contribution of Property.6. Partnership's Basis in Property.

Unrealized Receivables. An unrealized receivable is any

right to payment for goods or services that has not been

included in income because of the method of accounting

being used. If an unrealized receivable is contributed to a

partnership, ordinary income or loss is recognized when a

subsequent disposition occurs.

Inventory. If property is inventory in the hands of a

contributing partner, it remains inventory to the

partnership for a 5-year period. After 5 years, the

character of the property may be changed if the property is

a capital asset or Sec. 1231 asset in partnership's hands.

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6. Partnership's Basis in Property.

Capital Loss Property. A loss recognized by a partnership on disposition of contributed capital loss property within five years of the contribution date is a capital loss. The amount of loss so characterized is limited to the amount of loss that would have been recognized had the asset been sold on the date of contribution.

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7. Partnership's Holding Period. Partnership's holding period for its contributed assets includes the holding period of the contributing partner.

8. Section 1245 and 1250 Recapture Rules. Depreciation is not recaptured on contribution of Sec. 1245 or Sec. 1250 property to a partnership unless gain is recognized.

Adjusted basis and recapture potential carry over to the partnership.

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9. Contribution of Property after Formation. Anytime property is contributed in exchange for a partnership interest, the rules outlined above apply. They apply whether the contribution occurs during the formation of the partnership or at a later point in time.

Most contributions of property in exchange for a partnership interest are tax-free even if they occur years after the partnership was formed.

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Contribution of Services. A partner who receives a partnership interest in exchange for services has been compensated and recognizes ordinary income. Generally no income is realized on the receipt of a restricted interest in a partnership, until the restriction lapses or the interest can be freely transferred. Much of the uncertainty in this area of tax law was resolved when Rev. Proc 93-27 was issued which provides that the IRS generally will not tax a profits interest received for services. Such a profits interest will be taxed upon receipt only in three specified instances in which a FMV is readily ascertainable.

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On June 1, 2010, in recognition of her services to the company, Beth received a 10% interest in the capital and profits of Rock Co., a partnership. Rock's net assets at that date had a basis of $70,000 and a fair market value of $100,000.

In Beth's 2010 income tax return, what amount must Beth include as income from transfer of profits interest?a.$ 7,000 ordinary income.b.$ 7,000 capital gainc.$10,000 ordinary income.d.$10,000 capital gain.

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On June 1, 2010, in recognition of her services to the company, Beth received a 10% interest in the capital and profits of Rock Co., a partnership. Rock's net assets at that date had a basis of $70,000 and a fair market value of $100,000. In Beth's 2010 income tax return, what amount must Beth include as income from transfer of profits interest?c.$10,000 ordinary income.

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Contribution of Services.

1. Consequences to the Partnership. Payments made by the partnership in the form of a partnership interest are either deductible as an expense or capitalized. The timing of the partnership's deduction for the expense matches the timing for the partner to include the value of the partnership interest in income.

The expense deduction is allocated among the partners other than the service partner.

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Contribution of Services.

2. Partnership Gain or Loss. When an interest in a partnership is transferred for services rendered, gain or loss will be recognized by partnership on the difference between the FMV of the property deemed transferred by the partnership and its basis.

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Organizational and Syndication Expenditures. Costs of organizing a partnership are treated as capital expenditures. Partnership can elect to deduct the first $5,000 of these expenditures in the tax year it begins business. The first $5,000 must be reduced by the amount by which total organizational expenditures exceed $50,000 although the $5,000 cannot be reduced below zero. Any remaining organizational expenditures are amortized over a period of 180 months beginning the month the partnership starts business.Page 10-15 summarizes tax consequences of the formation of a partnership.

Existing Partnership debt. -$ Bob's Percent ownership 50% Bob's land: Had a FMV of: Had a basis of: 5,000$ Was subject to debt of: 9,000$

What is gain? Basis? (Twice)

Bob invests land in partnership - 1

Partnership assumed Bob's debt.

Bob invested land into partnership.Bob received general ptshp interest.

Bob is admitted to Local Partnership

1 Bob's land had a value of

2 Bob's land had a basis of 5,000$

3 Ptshp capital % received by Bob 50%

4 Ptshp capital % - other partners 50%

5 Partnership debt before investment

6 Partnership debt assumed by Bob

7 Bob's debt assumed by PTSHP

8 Bob's debt assumed by other Ptnrs

9 Excess of line 8 over lines 2 + 6

10 Bob's Gain-Positive Amt. on Line 9

Bob contributes land to partnership - 2

1 Bob's land had a value of

2 Bob's land had a basis of 5,000$

3 Ptshp capital % received by Bob 50%


5 Partnership debt before investment -

6 Partnership debt assumed by Bob -

7 Bob's debt assumed by PTSHP 9,000

8 Bob's debt assumed by other Ptnrs 4,500

9 Excess of line 8 over lines 2 + 6 -

10 Bob's Gain-Positive Amt. on Line 9 -$

Bob contributes land to partnership - 2A

Land basis before contribution

Add:

Partnership debt assumed by Bob

Less:

Bob's Debt assumed by other Ptnrs

Bob's Basis - Cannot be negative

Bob's Basis in partnership


Land basis before contribution 5,000

Add:Partnership debt assumed by Bob

Less: Bob's Debt assumed by other Ptnrs (4,500)

Bob's Basis - Cannot be negative $500

Bob's Basis in partnership

Bob contributes land to partnership - 3A

Bob's land basis (before cont.) 5,000

Add: gain - invesment co.(rare)

Do not add gain for excess debt XXX

Ptshp's basis in asset invested 5,000

Partnership basis in land received.


Existing Partnership debt. -$ Jan's Percent ownership 20% Jan's land: Had a FMV of: 10,000$ Had a basis of: 4,000$ Was subject to debt of: 2,000$


Jan invests land in partnership - 1

Partnership assumed Jan's debt.

Jan invested land into partnership.Jan received general ptshp interest.

Jan is admitted to Local Partnership

1 Jan's land had a value of 10,000$

2 Jan's land had a basis of 4,000$

3 Ptshp capital % received by Jan 20%



6 Partnership debt assumed by Jan

7 Jan's debt assumed by PTSHP

8 Jan's debt assumed by other Ptnrs


10 Jan's Gain-Positive Amt. on Line 9

Jan contributes land to a partnership - 2

1 Jan's land had a value of 10,000$

2 Jan's land had a basis of 4,000$

3 Ptshp capital % received by Jan 20%



6 Partnership debt assumed by Jan -

7 Jan's debt assumed by PTSHP 2,000

8 Jan's debt assumed by other Ptnrs 1,600

9 Excess of line 8 over lines 2 + 6 -

10 Jan's Gain-Positive Amt. on Line 9 -$

Jan contributes land to a partnership - 2A


Add:Partnership debt assumed by Jan

Less: Jan's Debt assumed by other Ptnrs (1,600)

Jan's Basis - Cannot be negative 2,400$

Jan's Basis in partnership

Jan contributes land to a partnership - 3A

Jan's land basis (before cont.) 4,000

Add: gain - investment co.(rare)




Jan contributes land to partnership - 4

Existing Partnership debt. -$ Jon's Percent ownership 20% Jon's land: Had a FMV of: 10,000$ Had a basis of: 4,000$ Was subject to debt of: 6,000$


Jon invests land in partnership - 1

Partnership assumed Jon's debt.

Jon invested land into partnership.Jon received general ptshp interest.

Jon is admitted to Local Partnership

1 Jon's land had a value of 10,000$

2 Jon's land had a basis of 4,000$

3 Ptshp capital % received by Jon 20%



6 Partnership debt assumed by Jon

7 Jon's debt assumed by PTSHP

8 Jon's debt assumed by other Ptnrs


10 Jon's Gain-Positive Amt. on Line 9

Jon contributes land to a partnership - 2

1 Jon's land had a value of 10,000$

2 Jon's land had a basis of 4,000$

3 Ptshp capital % received by Jon 20%



6 Partnership debt assumed by Jon -

7 Jon's debt assumed by PTSHP 6,000

8 Jon's debt assumed by other Ptnrs 4,800

9 Excess of line 8 over lines 2 + 6 800

10 Jon's Gain-Positive Amt. on Line 9 800$

Jon contributes land to a partnership - 2A

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Add:Partnership debt assumed by Jon

Less: Jon's Debt assumed by other Ptnrs (4,800)

Jon's Basis - Cannot be negative -$

Jon's Basis in partnership

Jon contributes land to a partnership - 3A

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Jon's land basis (before cont.) 4,000

Add: gain - investment co.(rare)




Jon contributes land to partnership - 4

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Peggy Pink contributed land to a new partnership in return for a 50% interest in capital & profits. The land had a FMV of $10,000, a basis of $5,000, and was subject to a $9,000 debt which was assumed by the partnership.

What was Pink’s gain recognized?

What was Pink's basis in the partnership as a result of this contribution?

a. $5,500 b. $1,500 c. $500 d. $0

1 Pink's property had a value of

2 Pink's property had a basis of

3 Ptshp capital % received by Pink

4 Ptshp capital % - other partners


6 Partnership debt assumed by Pink

7 Pink's debt assumed by PTSHP

8 Pink's debt assumed by other Ptnrs


10 Pink's Gain-Positive Amt. on Line 9

Pink contributes asset to a partnership

1 Pink's property had a value of $10,000

2 Pink's property had a basis of $5,000

3 Ptshp capital % received by Pink 50%



6 Partnership debt assumed by Pink

7 Pink's debt assumed by PTSHP $9,000

8 Pink's debt assumed by other Ptnrs $4,500


10 Pink's Gain-Positive Amt. on Line 9 $0

Pink contributes asset to a partnership

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Land basis before contribution $5,000

Add:Partnership debt assumed by Jon

Less: Jon's Debt assumed by other Ptnrs (4,500)

Jon's Basis - Cannot be negative 500$

Pink's Basis in partnership

Pink contributes land to a partnership

3. Determine the permitted tax years for a partnership.

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Partnership ElectionsA. Partnership Taxable Year. Selection of a partnership tax year determines the timing of when each partner takes his share of income, expense, gain, loss, deduction and credit items into his return. Partnership must use the same tax year as one or more majority partners (i.e., those partners who have an aggregate interest in partnership profits and capital in excess of 50%). If such a rule does not apply, then the tax year of all of its principal partners (i.e., a partner who owns a 5% or more interest in capital or profits) must be used or the tax year which provides the "least aggregate deferral" is used. An alternative tax year based on an acceptable business purpose (e.g., natural business year) may be used.

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Partnership ElectionsA. Partnership Taxable Year.

Revenue Act of 1987 provided an election under Sec. 444 which permits a partnership, that does not either

(1) establish a business purpose for its tax year,

(2) adopt or change to a tax year that conforms to the taxable year of its principal partners, or

(3) did not obtain IRS approval for its tax year,

to elect under Sec. 444 to retain either the tax year used in 1986 or a tax year-end which results in a deferral period of the lesser of the current deferral period or three months.

1 2 3 4 5 6 7 8 9 10 11 12 1 2 3

1 2 3 4 5 6 7 8 9 10 11 12

Owner's Tax Year 2010

Apr.

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Tax Years - Flow-Through Entities

4

Calendar Year 2010

Entity Tax year

1 2 3 4 5 6 7 8 9 10 11 12 1 2 3

1 2 3 4 5 6 7 8 9 10 11 12

Owner's Tax Year 2010

Apr.

15

Tax Years - Flow-Through Entities

4

Calendar Year 2010

Entity Tax year

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B. Other Partnership Elections. In general, all elections that can affect the computation of taxable income from the partnership must be made by the partnership. Three elections are specifically reserved for the partners. These are treatment of discharge of indebtedness, deduction and recapture of certain mining exploration expenditures, and the choice between deducting or crediting foreign income taxes.

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The following slides contain a case for class discussion (involving transfer of assets to a partnership in exchange for a partnership interest).

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Partner 1 contributes land to form partnership.

Partner 2 contributes cash to form partnership.Basis FMV

Partner 1Land from Partner 1 $160,000

Land from Partner 1 $200,000

Partner 1's ownership 25%

Partner 2 Cash invested by Partner 2 $600,000

Partner 2's ownership 75%

Total Assets $800,000

No debt on the land.

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Case 1. Organize Partnership

721(a) Ptnr 1 - recognized gain of:

722 Ptnr 1 - basis in ptshp interest:

722 Ptnr 2 - basis in ptshp interest:

721(a) Ptshp - recognized gain of:

723 Ptshp - basis in land of:

1223(1) Ptnr -1's Holding period starts?

1223(2) Ptshp holding period for land starts?

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Case 1. Organize Partnership

721(a) Ptnr 1 - recognized gain of: $0

722 Ptnr 1 - basis in ptshp interest: $160,000

722 Ptnr 2 - basis in ptshp interest: $600,000

721(a) Ptshp - recognized gain of: $0

723 Ptshp - basis in land of: $160,000

1223(1) Ptnr -1's Holding period starts?

1223(2) Ptshp holding period for land starts?

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Case 2.

Organize corporation, not a partnership.

Stockholder 1351 S/H-1 - recognized gain:

358 S/H-1 - basis in stock:

Corporation1032 Corp - recognized gain:

362 Corp - basis in land:

1223(1) S/H-1 holding period for stock starts?

1223(2) Corp's holding period for land starts?

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Case 2.

Organize corporation, not a partnership.

Stockholder 1351 S/H-1 - recognized gain: $0

358 S/H-1 - basis in stock: $160,000

Corporation1032 Corp - recognized gain: $0

362 Corp - basis in land: $160,000

1223(1) S/H-1 holding period for stock starts?

1223(2) Corp's holding period for land starts?

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The

End –

Part A

Chapter 10A. Partnership Formation C11-Chp-10-1A-Ptshp-Form-2011 Edited January 4, 2011 This file covers pages 1 through 20 Howard Godfrey, Ph.D., CPA.

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