Study Outline For:
Partnership Taxation

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Printable Copy of the Code

Printable Copy of the Regs

Code Sections


1.761-1(a) and 2
301.7701-1; 2; & 3

Entity Versus Aggregate Theory

   The rules for partnerships are found in Subchapter K (Sections 701 to 761) of the Internal Revenue Code. One of the principal objectives of these rules is to provide flexibility to partners in choosing a form to conduct business. The drafting of Subchapter K also represents the blending of two distinct views of partnerships which, in turn, have become a primary source of confusion and uncertainty. These views, the aggregate theory and entity theory, are intertwined throughout Subchapter K.

   Under the aggregate theory, the partnership is not viewed as a taxpaying entity. Instead, it is treated as a collection of partners, with all partners individually reporting their respective shares of income and deductions. The partnership essentially becomes a conduit for paying taxes and only files a tax return for informational purposes.

Example 1
Partnership AB with two equal partners computes its taxable income for the year in the amount of $50,000. As a tax conduit, $25,000 "flows through" to both partners individually to be taxed on their respective tax returns.

   The entity theory treats the partnership as a separate entity distinct and separate from its owners --just like a corporation. Under the entity theory, the partnership, like a corporation, has its own tax year, chooses its own accounting methods, and makes most of the income tax elections that bind the partnership and the partners. In addition, taxable transactions may be conducted between the partner and partnership.

Example 2
Partnership XYZ has an office building destroyed in a fire and receives sufficient insurance proceeds to create a casualty gain. The partnership, not the respective partners that would have to report the gain, must elect the involuntary conversion deferral under Section 1033

Defining The Partnership

   The statutory definition of the term partnership includes a syndicate, group, pool, joint venture, or other unincorporated organization that carries on any business, financial operation, or venture, and which is not a trust, estate, or corporation as defined by the Code. ===IRC Sec. 761

   In a practical sense, however, a partnership is a business venture or investment activity where two or more taxpayers, with the intention of producing a joint profit, enter into an agreement. Sometimes an occasion arises when two or more taxpayers join into a relationship that is not a partnership but the relationship is entered into with the intent of making a separate profit. Generally, these events are mere co-ownerships of property which do not constitute a partnership.

   Note that the distinguishing factor establishing a partnership is whether the co-owners (or partners) carry on a trade or business or conduct a financial operation and share in the joint profits. ===Regs. Sec. 1.761-1(a)

The following are considered partnership arrangements:
a. ====
An agreement between two corporations to manufacture goods and split the profits.
Two individuals who buy, develop, and subdivide real estate.
c. ====
Co-owners of rental property that offer substantial additional services for an added fee.

The following are not considered to be partnerships:
a. ====
A voluntary profit sharing arrangement between an employer and an employee.
A percentage of store profits paid to a creditor.
c. ====
A boxer and promoter of a prizefight which agree to share profits according to a contract agreement.

   Because the partnership focus is on a joint profit, a joint undertaking merely to share expenses is not a partnership. Thus, if two or more persons jointly construct a ditch to drain surface water from their properties, =they are not considered partners. Regs. Sec. 1.761-1(a)

Categories of Partnerships

   A general partnership is one where all the partners are general partners. Each general partner has personal liability for all the liabilities of the partnership. A general partner has the right to participate in management and also has the authority to bind the partnership in dealings with third parties.

   A limited partnership consists of one or more general partners and at least one or more limited partners. Limited partners have no right to participate in management and have no authority to bind the partnership to any liabilities. A limited partners personal liability is restricted to money or other property invested by the partner in the partnership, including additional contributions that may be required in the future under the partnership agreement.

Study Questions Make your selection by clicking the appropriate response letter.


Which of the following is an application of the aggregate theory of taxation?
A 60 percent partner sells a machine to a partnership in which she is a partner.

The partnership elects to amortize its organization costs.

The partner reports a capital gain of $10,000 from securities sold by the partnership.
The partners set up November 30 as a year-end date


Which of the following statements is true concerning the nature of partnerships?
In a general partnership, all the partners are personally liable for the debts of the partnership

In a limited partnership, the general partners are limited to the extent of their personal liability.

A limited partner may participate in management of the partnership.
A general partner has no right to bind the entire partnership to any liabilities.


Which of the following scenarios might be classified as a partnership arrangement for tax purposes?
An employer offers a salesman 20 percent of any profit that the company makes on a merchandise sale.

Two college kids split the profit from mowing lawns and performing landscaping activities during the summer.

Two individuals join together to purchase Exxon stock in the hopes that it will appreciate in value.
Three individuals join together to purchase a rental condominium near a university campus.

4.Which of the following is an example of the Entity Concept?
Treating foreign taxes as a deduction or credit.

Selecting an accounting method.

Selecting an inventory valuation method.
Determining whether certain items are expensed or capitalized.

Distinguishing Between Partnerships and Corporations

   When two or more taxpayers embark on a business venture they must decide on a business form for their activity. The choice most often is between a corporation or partnership form of operation. Although there are specific advantages to each, certain tax considerations may influence the choice of entity. Under the existing tax rate structure, partnerships seem to have a decided advantage over the corporate form of operation due to the double tax regime applied against corporations.

   The rules for determining entity classification are complex. Congress has provided us with two distinct sets of regulations to assist in making this determination:

  • Check-the-Box and
  • Publicly Traded Partnership (PTP) rules.

Check-the-Box Regulation

The IRS issued final regulations in December 1996, which simplify the entity classification system of the former "Association" rules.    Effective January 1, 1997, the "check-the-box" rules generally permit unincorporated organizations to elect to be treated as associations (taxable as a corporation) or as partnerships without regard to the number of corporate characteristics that an entity maintains. Business entities that are organized as corporations under state law, certain foreign entities, and trusts are excluded from using this election. ======= Regs. Sec. 301.7701-1 through 3

    The check-the-box election is prepared on Form 8832 (Entity Classification Election). The election, however, is something of a misnomer. Business entities that do not elect a particular classification are labeled under "default" rules. Under these rules, noncorporate organizations with more than one member are treated as partnerships, and single-member entities are disregarded for federal tax purposes. Thus, most entities will achieve their desired classification without the necessity of filing an election.===== Regs. Sec. 301.7701-3(b)(1)

Business Entities

   The key to the check-the-box rules is the concept of a "business entity" which is defined as any entity recognized for federal tax purposes that is not already classified as a trust or corporation. The regulations specify that an unclassified business entity with two or more members must be classified either as a corporation or a partnership. A business entity with only one owner must be classified as a corporation or be disregarded as an entity and taxed similar to sole proprietorships. These are referred to as "disregarded entities." ===== Regs. Sec. 301.7701-2(a)

Business entities existing on December 31, 1996, will retain the classification claimed under prior law unless an election to change classification is made.

Electing Out of Subchapter K

   The check-the-box regime does not change the rules regarding the election not to be taxed as a partnership. Consequently, an entity treated as a partnership under the check-the-box rules, whether by election or default, will still be permitted to "elect out" of Subchapter K-provided it meets the requirements for that election (see next Section). Thus, an entity with two or more members can avoid corporate treatment under, "check-the-box." and at the same time, "elect out" of Subchapter K and allow its members to report any taxable income as if it were earned directly by them.

Publicly Traded Partnerships (PTPs)

   A Publicly Traded Partnership is a Master Limited Partnership (MLP) whose units are registered with the Securities and Exchange Commission and then sold on a public stock exchange. The appeal of the MLP primarily stems from the tax savings that could be generated by operating a business in the partnership form with one level of tax as opposed to a corporation with two levels of tax.

   In 1987, Congress enacted legislation to curb the benefit of MLPS. For those MLPs already in existence on December 31, 1987, Congress allowed up to 10 years before the transition to corporate status.

   An important by-product of this legislation was the effect of the passive loss rules on PTPS. Prior to the 1987 Act, an interest in a PTP was treated the same as the interest in any other passive activity. By definition, a limited partnership interest was treated as a passive activity. Thus, losses could only be used to offset gains from other passive activities. In most cases, however, investors purchased PTPs as passive income generators (PIGs). The effect would be essentially to convert portfolio income into passive income.

Example 1 ==
Investor T has $100,000 to invest in either corporate bonds yielding 10 percent ($10,000 of portfolio income) or a PTP generating $10,000 of income per year. If T already owns a passive activity that generates passive losses of $10,000, the passive income generated by the investment in the PTP is netted against the passive loss and results in $0 net taxable income. If, on the other hand, T invests in the corporate bonds, taxable income is $10,000 and a suspended passive loss of $10,000 carries forward.

   Congress eliminated the partnership advantages by directing that PTPs pay tax as corporations. For those PTPs surviving as partnerships, Congress also placed severe restrictions, The 1987 legislation mandated that any losses and credits attributable to an interest in a PTP are not allowed to offset the partner's other income, or even other passive income. Instead, the losses are suspended and carried forward and applied against net income from that partnership in the succeeding year. Upon a complete disposition of the partner's entire interest in the PTP, any remaining suspended losses are allowed as a deduction against other income. Income from a PTP is treated as portfolio income.

Example 2 ==
Master Limited Partnership XYZ generates a $10,000 loss in year 1 and $3,000 of income in year 2. No deduction is allowed in year 1. Instead, $10,000 is suspended until year 2, where $3,000 of that loss is utilized to offset the income for the year. The remaining $7,000 is carried forward until it fully offsets any future earnings from XYZ alone or until the interest in XYZ is entirely disposed.
Study Questions Make your selection by clicking the appropriate response letter.

1. . .

Which of the following statements are true in classifying an entity under the check-the-box regulations?
Business entities classified as corporations under state law are not eligible for check-the-box.

Disregarded entities can be taxed as corporations.

A two-owner entity can elect to be taxed as a trust under check-the-box.
Business entities formed before 1997 must make a new classification election.

2. . .

Which of the following is not a reason for the initial growth in master limited partnerships?  
Avoidance of the double tax on corporate earnings.

Limited investor liability.

Transferability on public exchanges.
A passive income generator to offset passive losses.

3. . .

If the IRS reclassifies a partnership as a corporation, which of the following will apply?
The partnership must file a corporate tax return (Form 1120) and pay the corporate tax.

The partnership must file a partnership return (Form 1065) and pay the corporate tax.

The partners must pay the corporate tax on the income.
The partners must reorganize as a corporation under applicable state law.

4. . .

A Publicly Traded Partnership generates $8,000 of losses in year 1, $2,000 of income in year 2, and is disposed of in year 3. Determine the appropriate tax treatment if the entity is treated as a partnership.
The $8,000 loss is treated as a portfolio loss on the partners tax return.

The $8,000 is not deductible until the partnership is completely disposed of in year 3.

The $2,000 is passive income to be offset against passive losses from other activities.
The $6,000 of unused losses will be allowed as a deduction against other income in year 3.

  Exclusion from the Partnership Provisions

   The Code allows certain co-owners of property to elect to be excluded from the burden of filing a partnership tax return. As a general rule, this provision only applies to partnerships used for investment purposes or the joint production or extraction of minerals.

   If qualified, the partnership may elect to be partially or completely excluded from the provisions of Subchapter K. The election only applies to the provisions of Subchapter K. Consequently, an excluded partnership will still treated as a partnership for those Code sections that make reference to the entity outside of Subchapter K. ====== Regs. Sec. 1.761-2(a)

Example 1
Individuals A and B own a building that they lease commercially. The building burns during the taxable year. If A and B operate as a partnership, the partnership must elect to defer the profits under the involuntary conversion rules if a casualty gain occurs. Thus, both A and B are bound by the same decision. If A and B elect to be excluded from Subchapter K as co-owners, they can choose individually whether to apply the deferral rules or pay the tax on their respective individual returns.

Making the Election

   The election to be excluded from the partnership provisions is made by attaching a statement to the Form 1065 for the first taxable year in which the election is made. The election must be made on a timely filed return. The Form 1065 only needs to show the name and address of the organization.

The attachment must indicate that:
The organization qualifies for the election; 
b. ====
All members of the organization elect to be excluded from the partnership provisions;
c. ====
The address where a copy of the organization's operating agreement is available; and
The names and addresses of all members of the organization
Regs. Sec. 1.761-2(b)(2)(i).

Revoking the election

   Once made, the election is irrevocable without the written permission of the IRS, Application for permission to revoke must be submitted to the Commissioner of the IRS no later than 30 days after the beginning of the first taxable year to which the revocation is to apply.

   It should be noted that the election in reality is nominally irrevocable. An organization may voluntarily break the election at any time by engaging in activities that no longer entitle the organization to be treated as a qualifying joint venture or partnership. ===Regs, Sec. 1.761-2(b)(3)(i)

Deemed election

   If a partnership fails to follow this procedure, it will be deemed to have made this election if all the surrounding facts suggest that this was the original intention of the parties to be excluded from the partnership rules. Whether an organization has been deemed to have made the election is a factual determination to be made by the IRS at the time of audit. In order to avoid a discretionary disallowance, the election should be formally made whenever possible.
                                                                                                                            Regs. Sec. 1.761-2(b)(2)(ii)

Study Questions Make your selection by clicking the appropriate response letter.

1. . .

In what manner can two individuals revoke the election to be excluded from the partnership provisions?
File an election to resume tax treatment within the provisions of Subchapter K.

File an application to revoke the election to be taxed outside of Subchapter K within 30 days of the year-end.

No information is required - just begin filing a partnership tax return.
Engage in an activity that no longer qualifies for the election.

2. . .

Which of the following partnerships cannot elect to be excluded from the partnership provisions of Subchapter K?
Two individuals who join together to buy 100 shares of IBM stock.

Two individuals who join together to produce and extract oil.

Two CPAs who join together to start a tax return preparation service.
Two CPAs who join together to invest in potentially profitable land that may appreciate in the future.

3. . .

Concerning the election to be excluded from partnership taxation, which of the following statements is not true?
A deemed election may be made based upon all the surrounding facts and circumstances.

The election must be made by attaching a statement to a Form 1065.

Once made, the election is irrevocable without the permission of the IRS.
The election exempts the partners from partnership treatment under the Internal Revenue Code.

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