| Study
Outline For:
Partnership
Taxation
Module:
Overview
of Subchapter K | | |
|
| Code
Sections | Regulations |
| 761 |
1.761-1(a)
and 2 | | | |
| | |
| |
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. Under the entity theory, the partnership
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 |
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. |
| -b.
| 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. |
| -b.
| 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.
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|
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)
NOTE ==
|
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. |
===
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 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:
| a.
| 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 |
| d. | 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)
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Section
706(b)(1), as amended in 1988, establishes the guidelines for selecting a partnership's
taxable year. The thrust of this provision has two major effects. First, it intends
to make the taxable years of a partnership conform to the taxable years of a majority
of its partners. Second, it directs that all partnerships must adopt the required
taxable year after December 31, 1986. Generally,
a partnership must have the same taxable year as that of its majority partners.
A majority partner is defined as one or more partners having the same tax year
and whose combined interest in partnership capital and profits is greater than
50 percent. The majority interest is generally examined and established on the
first day of the partnership's taxable year. When
there are no majority partners, the partnership must adopt the same tax year as
that of its principal partners. A principal partner is one who owns at least 5
percent of partnership capital or profits. If the principal partners have different
tax years, the partnership must adopt a year that results in the least amount
of deferred income to the partners. ==Temp.
Reg. 1.706-lT(a) If
a partnership has both majority partners and a principal partner, the partnership
must adopt the tax year of the majority partners.
Example
1 |
A partnership is owned by 30
individuals on a calendar year owning a 2 percent interest each and by a corporation
on a fiscal year owning the remaining 40 percent, Although the corporation constitutes
the only principal partner, the individuals represent a majority. Thus, the partnership
must adopt the calendar year. | If
a partnership wants to adopt a year that differs from that of its majority or
principal partners, it must first establish a business purpose. The partnership
may establish a business purpose by meeting the provisions established in Rev.
Proc. 72-51 and Rev. Proc. 83-25. These procedures generally suggest that a partnership
may be able to adopt a fiscal year if the adoption results in the deferral of
income to the partners of three months or less. The
1986 Tax Act that modified the required tax year specifically states that the
three-months-or-less deferral of income does not by itself constitute a business
purpose. Thus, a calendar year partnership that wants to adopt a September, October,
or November year-end, must develop a business purpose that is independent of the
deferral of income issue. The election to change to a fiscal year is made by the
partnership and not by its partners.
Section
444 Election Under
the Revenue Act of 1987, Congress enacted Code Section 444 that gave partnerships
the right to elect a taxable year other than the required year specified under
Section 706(b), In order to prevent abuses due to deferral benefits, Section 444(c)
requires that partnerships make a required payment and the adoption of the deferral
period not exceed three months. New partnerships make the election by having the
general partner file Form 8716 by the earlier of: - The
15th day of the fifth month following the month that includes the first day of
the taxable year for which the election will be effective; or
- The
due date of the tax return resulting from the Section 444 election. ==Temp.
Reg. 1.444-3T(b)(1)
According
to the terms of the Section 444 election, the partnership must make required payments
on Form 720 that represent the amount of tax deferred by the use of the different
tax year. The required payment is computed under the rules of Section 7519 and
is taxed at a rate equal to the maximum individual tax rate plus 1 percent times
the deferred amount of income. This tax is phased-in over a four-year period.
Partnerships that have a deferral of $500 or less are exempt from this payment.
Even if no payment is necessary, Form 720 should still be filed showing a zero
amount due. Once
the election is made, it remains in effect until it is terminated.
Termination
can take place in one of four ways: -
The partnership reverts back to its required year.
-
The partnership liquidates.
- The
partnership willfully fails to file a return and make the required payments.
- The
partnership becomes a member of a tiered structure
|
If
the election is terminated, the partnership must file a short period tax return
and print on the top of the page 'Section 444 Election Terminated." The partnership
that made the election is no longer eligible to make another election for any
tax year Note
that only partnerships that would otherwise be required to use a calendar year
are subject to this tax and that Sections 444 and 7519 are not applicable to partnership
entities that are using a year other than a required year due to a request granted
under the business purpose test of Section 706(b).
Annualizing
Partnership Taxable Income
The
process of changing a taxpayers tax year will result in a taxable year of fewer
than 12 months. Section 443 provides that in computing the income tax for the
short period, the income period must be annualized. It makes no difference whether
the change is with or without the permission of the Commissioner.
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