Taxation Essentials of LLCs and Partnerships. Larry Tunnell

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Chapter 1 Overview: Basic Tax Structure of Partnerships and LLCs

       Learning objectives

What is a partnership for federal income tax purposes?

For tax purposes, a partnership exists when two or more taxpayers join together, without incorporating, to carry on business or investment activities for their mutual (or “joint”) benefit. Partnerships can be used to conduct active businesses or to carry on investment activities. Moreover, the partnership can be structured in such a way that some partners participate actively in partnership operations while others play the role of passive investors, content to share in the profits (or losses) derived from partnership operations while playing no active role in day-to-day management activities. The primary strength of the partnership as a vehicle for conducting business is its flexibility. Partners can, for example, agree to share differently in the risks and rewards associated with partnership business activity. Yet, the partnership can still provide limited exposure to business risks for certain of its partners (for example, limited partners), providing the best of both worlds: (a) highly flexible arrangements for sharing in the risks and rewards of business activities and (b) limited liability for members. Moreover, unlike corporations, partnership income is subject only to one layer of tax-imposed at the partner level. For these reasons, partnerships are the preferred form of organization for a wide variety of business activities.

Partnerships versus other entities

      Legal protection

      There are several types of partnerships, each with different levels of liability protection for their partners. The first, and most basic, type of partnership is the general partnership. In a general partnership, all partners participate in management of the partnership, and all partners have the legal authority to enter into binding legal relationships on behalf of the partnership. Therefore, for example, if a law firm were organized as a general partnership, each of its partners would have the authority to enter into attorney- client relationships on behalf of the firm. Each of the firm's clients, even if they deal with only one attorney, is represented by the partnership, rather than by an individual attorney. The downside to this arrangement is that claims against the firm, even if due to the actions of only one partner, can be enforced against any and all partners of that firm, to the extent that the partnership's assets are insufficient to satisfy the claim.

Example 1-1

      In 1990, Leventhal & Horwath, then the eighth largest accounting firm in the United States, filed for bankruptcy protection under pressure from several lawsuits stemming from the failure of many of its audit clients. Like all accounting firms at the time, the firm was organized as a general partnership. The firm eventually dissolved, but its partners remained responsible for damage assessments awarded to claimants against the firm. Most of these partners had not been personally involved in the engagements targeted by the various lawsuits. Nonetheless, in addition to losing their jobs, each of the partners was left with personal responsibility for tens of thousands of dollars of partnership liabilities stemming from the lawsuits that drove the firm out of business. According to published reports, these liabilities generally exceeded the personal assets of most of the partners, meaning that many partners faced the prospect of personal bankruptcy following dissolution of the firm.

      Due to concerns about partner liability, it can be very difficult to attract investment capital to businesses organized as general partnerships. Moreover, there are many activities in which it is neither necessary nor desirable for all partners to be involved in management of the partnership or its affairs. For example, partnerships are often used to raise capital to purchase real estate (office buildings, apartment complexes, and the like), or to drill oil or gas wells. These activities require large amounts of money, but do not necessarily require the input of each partner in deciding which properties to acquire or where to drill for oil and gas. Organization of the operating or drilling companies as corporations would alleviate concerns over liability and participation in management but would raise new concerns over double taxation and lack of flexibility. Limited partnerships are designed to accommodate the business needs of these activities while still allowing them to be conducted in partnership form.

In a limited partnership, the power to bind the partnership contractually, and to make all management decisions, is vested in the hands of the general partners. Other partners, referred to as limited partners, make capital investments in the partnership but are not allowed to participate in management and cannot enter into binding contracts on behalf of the partnership. Reflecting their restricted ability to influence partnership affairs, these partners are shielded from responsibility for partnership obligations. Full liability for partnership debts rests with the general partners, who control the partnership's actions. Therefore, limited partners are in much the same position as shareholders in a corporation. They invest money in the partnership's business without expressing any voice in how the business is conducted. СКАЧАТЬ