Taxation Essentials of LLCs and Partnerships. Larry Tunnell

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СКАЧАТЬ on the capital gains. Therefore, the combined tax cost of changing the LLC's federal tax status from a corporation to a partnership will be $38,800 ($21,000 corporate tax, plus $8,900 tax to Q, plus $8,900 tax to R).

      The election to change tax status should clearly not be made without full consideration of the potential costs and consequences.

Practical insight: Typically, a practitioner and a taxpayer would not be inclined to incur the federal income tax cost associated with the liquidation of a corporation so that the business form could be switched to a partnership form unless some other significant non-tax business purpose existed.

Overview of the basic framework of partnership taxation

      The partnership tax framework allows partners and partnerships wide latitude in structuring their companies and in dealing with one another. Formation of a partnership, like formation of a corporation, is generally a tax-free transaction. Indeed, the rules governing partnership formation are even more lenient than those governing corporate formation, in that there is no requirement that contributing partners have “control” of the partnership in order for the transaction to be tax-free. Also, like corporate formations, the partners' bases in assets contributed to the partnership carry over to the partnership (that is, the partnership takes a “carryover” basis in contributed properties), and the partners' initial bases in their partnership interest is generally equal to the basis of cash and other property contributed to the partnership in exchange for that interest. (However, a partner's basis in his partnership interest is also increased by his share of partnership liabilities, unlike the shareholder or corporation treatment of liabilities.)

      A major difference between partnerships and corporations, of course, is that the taxable income of the partnership is taxable to the partners, rather than to the partnership itself. Therefore, the reporting process by which the partnership's taxable income is reported to the IRS, and to its partners, is rather complex. Moreover, the process of accounting for partnership income is more complex in that the partners must account for their shares of partnership income or loss each year, whether or not any distributions of that income are received or additional contributions are made by the partners.

      Another major difference between partnerships and corporations is the treatment of distributions to partners. Because the partners are taxed directly on their shares of partnership income, distributions of that income are generally tax-free. Most distributions are treated as decreases in the basis of their partnership interests rather than as taxable income. To ensure that the distribution to a partner of his or her share of partnership income does not inadvertently trigger recognition of taxable gain, partners are required to adjust their bases in their partnership interests to reflect their shares of the partnership's income or loss each year. The result of these basis adjustments is that a partner will generally have sufficient basis to absorb a subsequent distribution of his or her share of partnership profit without triggering gain recognition.

       Example 1-11

Arthur contributed property with a tax basis of $100,000 and a fair market value of $500,000 to the newly formed AY Partnership this year in exchange for a 50% interest therein. For its first year, the partnership reported taxable income of $600,000, of which Arthur's share was $300,000. The partnership distributed half its income to the partners and reinvested the other half in its operations. Therefore, Arthur received a distribution of $150,000. Absent an adjustment to his basis in his partnership interest to reflect his $300,000 share of the partnership's income, the distribution to Arthur of $150,000 of his share of partnership profits would trigger recognition of a $50,000 taxable gain. (His initial tax basis in the partnership interest was only $100,000, which would not be sufficient to absorb a $150,000 distribution).

      However, because Arthur's tax basis in his partnership interest is increased by his $300,000 share of partnership income (to $400,000), the $150,000 distribution will be tax-free. His remaining tax basis in the partnership interest will be $250,000 ($400,000 - $150,000). Looked at another way, his basis in the partnership interest was increased by the $150,000 share of partnership profits which he did not withdraw from the partnership. By not withdrawing this portion of his share of profits, he essentially contributed those profits back to the partnership. His basis in the partnership interest is increased accordingly.

      Note that one result of the preceding framework is that the partners' aggregate bases in their partnership interests (outside basis) generally equal the partnership's aggregate bases in its assets (inside basis). This equality is important because it prevents taxpayers from using partnerships to manipulate the tax consequences associated with the sale or other disposition of property. Because the partners' outside bases in their partnership interests generally equal the partnership's aggregate inside basis in its assets, the same amount of gain or loss is recognized when a partner sells his or her interest in a partnership as would have been recognized if he or she had sold the asset(s) contributed to the partnership in exchange for that interest. Likewise, the partnership will recognize the same amount of gain or loss from the sale of its assets as the partners who contributed those assets would have recognized had they sold them directly, rather than through the partnership.

       Example 1-12

Jamie contributed property with a tax basis of $28,000 and a fair-market value of $50,000 to the JQL partnership in exchange for a one-third interest therein. She will recognize no gain or loss on exchange of the property for the partnership interest. Her basis in her partnership interest is $28,000, and the partnership takes a $28,000 basis in the property contributed by Jamie. Assuming that Jamie subsequently decides to sell her interest in the partnership for its $50,000 value, she will recognize a taxable gain of $22,000. This is the same amount of gain she would have recognized had she sold the property rather than contributing it to the partnership. Likewise, if the partnership sells the property contributed by Jamie for its $50,000 fair market value, it will also recognize a $22,000 gain. Therefore, transfer of the property to the partnership does not change the tax consequences associated with a later sale of the property or of the partnership interest received in exchange for the property.

Partnership operations

      Measuring and reporting partnership income

      Although partnership income is taxed at the partner level, it must be measured and reported by the partnership. The partnership files an annual tax return, Form 1065, with the IRS. Attached to the return is a Schedule K-1 for each partner in the partnership, reporting that partner's share of each item of partnership income or loss. Two copies of each Schedule K-1 are filed—one with the IRS and one with the partner. The K-1 identifies the partner, his or her social security number (or other identification number), and his or her address, along with such partner's share of partnership items of income, loss, gain, deduction and other information (for example, alternative minimum tax preferences, and the like). The partners then include their shares of each item of partnership taxable income, as reported to them on Schedule K-1, on their individual tax returns. They pay tax on their shares of partnership taxable income whether or not those shares are distributed to them during the year.

      The computation of partnership taxable income is complicated by the need to ensure that all items of partnership income are treated the same on the partners' returns as if those items had been earned or incurred by the partners directly rather than through the partnership. For example, for individuals, the deduction for net capital losses is limited to $3,000 per year. This limitation applies both to net capital losses incurred directly and those incurred by partnerships and allocated to the individual partners.

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