Lesson 1. Aggregate vs. Entity Approach 1. Aggregate approach: the partnership as a separate entity is disregarded and each partner is viewed as directly owning an undivided interest in the partnership’s assets operations. If the tax law used only aggregate concepts, the partnerships and their partners would be treated: – Each partner would be taxed on share of partnership income and would be viewed as owning a direct interest in each partnership asset. – Contributions and distributions would be viewed as taxable transfers. . The portions of Subchapter K that reflect the aggregation approach: taxation of partnership income to the partners and the nonrecognition provisions for contributions to and distributions from partnerships. – Sec. 701: Partnership itself is not subject to tax. Partners are taxed on their share of income as if they earned it directly. – Sec. 702: Partners calculate their income tax based on different items and realize the items as if they are realized by the partnership. Transfer of partnership interests: gain or loss on the sale of exchange is recognized to the transferor and is considered capital gain or loss. 3. Entity approach: partnership is considered an entity separate from partners. If the tax law used only entity concepts, the partnerships and their partners would be treated: – The partnership itself would be subject to tax on partnership income. – Contributions and distributions would be taxed – Transfers of partnership interests would be taxed without regard to the character of basis of the entity’s assets. . The portions of Subchapter K that reflect the entity approach: transfer of partnership interests. – Sec. 703: partnership taxable income is determined at the partnership level (Income, deductions, gains, losses and credit). Partners then can calculate their taxable income based on partnership taxable income. Partnership adopts its own accounting method and it does not affect the partners’ non-partnership tax items. – Out-side basis is separated from in-side basis. 5.
Portions of Subchapter K that allow partners flexibility concerning their income tax treatment: – Partners’ distributive share of partnership income, gain, loss, deduction or credit: is determined in partnership agreement and partners can characterize payments to a retiring partner or a deceased partner. – Partner has flexibility to withdraw or transfer his interest – Partner can elect to adjust the bases of partnership assets in connection with certain distributions of assets and transfers. 6.
Outside of Subchapter K, however, determining which of the two theories should apply is much more uncertain. 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| 7. Intent of subchapter K: Subchapter K is intended to permit taxpayers to conduct joint business activities including investment, through a flexible economic arrangement without incurring an entity level tax. Implicit in the intent of subchapter K are the following requirements– (1) The partnership must be bona fide and each partnership transaction or series of related ransactions (individually or collectively, the transaction) must be entered into for a substantial business purpose. (2) The form of each partnership transaction must be respected under substance over form principles. (3) Except as otherwise provided in this paragraph (a)(3), the tax consequences under subchapter K to each partner of partnership operations and of transactions between the partner and the partnership must accurately reflect the partners‘ economic agreement and clearly reflect the partner’s income (collectively, proper reflection of income).