11.1 Partnership Formation and Operations

Partnerships offer unique tax advantages for business owners. From tax-free formation to flexible income allocation, they provide a versatile structure for multiple stakeholders. This section explores the intricacies of partnership taxation, including formation rules, operational considerations, and income treatment.

Understanding partnership taxation is crucial for effective business planning. We'll dive into how partnerships report income, maintain capital accounts, and handle special allocations. We'll also compare partnerships to other entity types, highlighting key differences in tax treatment and flexibility.

Tax implications of partnerships

Formation and contribution rules

• Partnership formation generally tax-free under IRC Section 721
  • Partners contribute property or services without immediate gain/loss recognition
  • Allows for smooth business startup without tax burden
• Partnership's tax basis in contributed property
  • Typically equals contributing partner's adjusted basis
  • Preserves built-in gain/loss for future recognition
• Partner's initial partnership interest basis
  • Sum of cash and adjusted basis of property contributed
  • Tracks investment for future gain/loss calculations
• Special rules for contributions of property with liabilities
  • May trigger gain recognition for contributing partner
  • Prevents abuse through debt-shifting strategies
• Guaranteed payments for partner services/capital
  • Treated as ordinary income to recipient partner
  • Deductible by partnership as business expense
  • Examples: monthly salary, interest on capital contributions

Partnership agreements and allocations

• Partnership agreement crucial for determining tax aspects
  • Governs profit/loss allocations among partners
  • Must have substantial economic effect to be respected
  • Example: 60/40 split of profits based on capital contributions
• Section 704(c) allocation rules
  • Governs built-in gain/loss on contributed property
  • Ensures pre-contribution gains/losses allocated to contributing partner
  • Example: Partner contributes building worth $1M with$600K basis, $400K gain allocated back to that partner on sale

Key elements of partnership operations

Tax reporting and flow-through

• Partnerships file annual information return (Form 1065)
  • Reports income, deductions, credits, and other tax items
  • No entity-level taxes paid by partnership itself
• Income/losses flow through to partners
  • Reported on individual tax returns via Schedule K-1
  • Partners taxed regardless of actual distributions
• Partnership tax year determination
  • Generally based on partners' tax years
  • Special rules for selecting different tax year
  • Example: Calendar year if majority interest partners use calendar year

Capital accounts and allocations

• Capital accounts maintained for each partner
  • Reflects contributions, allocations, and distributions
  • Crucial for tracking economic arrangement among partners
• Special allocations must have substantial economic effect
  • Requires careful structuring and documentation
  • Example: Allocating depreciation deductions to partner providing building
• Partner basis tracking
  • Affects tax treatment of distributions and losses
  • Includes share of partnership liabilities
• Centralized Partnership Audit Regime (post-2017)
  • Potentially shifts certain tax liabilities to partnership level
  • Streamlines IRS audits of large partnerships

Tax treatment of partnership income

Character and limitations of income/losses

• Partnership income retains character as it flows through
  • Ordinary income, capital gains treated same at partner level
  • Example: Partnership sells stock for capital gain, reported as capital gain by partners
• Loss limitations for partners
  • Basis limitations (cannot deduct losses exceeding basis)
  • At-risk rules (limit losses to amount partner could actually lose)
  • Passive activity loss restrictions (limit losses from passive activities)
• Partner's share of liabilities included in interest basis
  • Increases ability to deduct losses and receive tax-free distributions
  • Example: Partner's $50K share of partnership debt increases loss deduction limit

Deductions and credits

• Qualified Business Income (QBI) deduction (Section 199A)
  • Applies at partner level
  • Complex calculations based on partnership activities/income
  • Example: 20% deduction on qualified business income for eligible partners
• Tax credits flow through to partners
  • Proportional to ownership interests
  • Subject to individual limitations and phase-outs
  • Examples: Research and development credit, energy credits
• Self-employment tax on partnership income
  • Applies to each general partner's distributive share
  • Special rules for limited partners (generally exempt)
• Certain deductions limited at both partnership and partner levels
  • Section 179 expense deduction
  • Example: $1M Section 179 limit at partnership level, further limited by partner's income

Partnerships vs other business entities

Comparison to corporations

• Partnerships avoid "double taxation" of C corporations
  • No entity-level tax, only partner-level tax on income
  • C corps taxed at corporate level and shareholder level on dividends
• More flexible than S corporations
  • S corps have ownership restrictions (100 shareholder limit, no foreign owners)
  • Partnerships allow varied ownership structures (individuals, corps, other partnerships)
• Greater flexibility in allocating tax items
  • Partnerships can specially allocate income/losses
  • S corps must allocate based on stock ownership percentages
• More flexibility in tax-free property contributions/distributions
  • Easier to contribute property to partnership without gain recognition
  • More options for tax-free property distributions to partners

Comparison to other entities

• Shared ownership vs sole proprietorships
  • Partnerships allow multiple owners, sole props have single owner
  • Partnerships require more complex tax reporting/compliance
• LLCs can elect partnership taxation
  • Combines liability protection with partnership tax benefits
  • Popular choice for many small businesses
• Tax basis adjustments available
  • Partnerships can adjust asset basis on interest transfers/distributions
  • Not available to S corps without special elections
  • Example: Step-up in basis when new partner buys interest, reducing future gains