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ACCT 7201 Practical Guide to Partnerships and LLCs Test 1 (Chapters 1-5) Part 1 Basic Partnership Operations Chapter

er 1 What Is a Partnership? 101 Introduction For legal purposes a business activity may be conducted in various forms. A jointly held activity can be conducted as a tenancy in common, a general partnership, a limited partnership, a limited liability company, a limited liability partnership, a limited liability limited partnership, a professional corporation, a C corporation, or a publicly traded partnership. Partnership association between two or more persons who join to carry on a trade or business for profit. Each person contributes money, property, labor, or skill, and expects to share in the profits/losses. o General partnership every partner has unlimited liability for the debts of the partnership o Limited partnership At least one partners liability for the debts of the partnership is limited to that partners investment in the partnership Limited liability = limited partner (no management participation) Unlimited liability = general partner (able to participate in the management of the partnership) o Limited liability partnership (LLP) general partnership in which all general partners are protected at a minimum from personal liability for negligent acts committed by other partners or by employees not under his/her direct control Restricted to professional partnerships such as law firms and accounting firms o Limited liability limited partnership (LLLP) limited partnership that elects to become an LLP as well, thus affording the general partners the same protection from liability as an LLP o Limited liability company (LLC) entity whose owners can all participate in the management of the business, but who also are all given protection from the liabilities of the LLC (except to the extent of their investment) Not legally a partnership, but often treated as such for tax purposes Entity can legally be a partnership but does not have to be taxed as such. o Legal treatment determined by state/local laws o Federal income tax treatment determined under federal income tax laws o Certain categories of entities only exist for income tax purposes (S corporations) o Many types of legal entities do not have a separate, specifically defined counterpart for income tax purposes Three general sets of regulatory rules that classify entities as a partnership for tax purposes versus something other than a partnership (corporation, trust, or sole proprietorship) o check-the-box classification rules Allows taxpayers to choose whether to treat partnerships and other unincorporated entities which are not partnerships (LLCs) as either corporations or partnerships for federal income tax purposes o anti-abuse rules Allow the IRS to recharacterize something the taxpayer is treating as a partnership as something other than a partnership o Rules which allow investment joint ventures to choose whether to be partnerships or tenancies-in-common Allows simple partnerships that resemble jointly owned investments to elect to treat themselves not as partnerships, but as tenants-in-common for tax purposes

In addition, there is substantive case law distinguishing a partnership from other business arrangements, such as debtor-creditor or employee-employer relationships.

102 Classification of Partnerships Check-the-box regulations allow entities to choose their tax treatment by checking a certain box on Form 8832, Entity Classification Election o One exception: a business activity incorporated under the law of any state, federal, or foreign jurisdiction must be treated as a corporation for federal income tax purposes If shareholders of that corporation prefer a tax treatment similar to a partnership, they should make an S election o Default classification of unincorporated entities is usually to be treated as a partnerships, a jointly owned, unincorporated, profit-motivated domestic business entity (LLC or LLP) may elect to be a corporation for tax purposes Partnerships are required to file a Form 1065, U.S. Return of Partnership Income, each year by the 15th day of he fourth month after the close of the taxable year (April 15tH for calendar year) o Allowed an automatic 6 month extension of the time allowed for filing o Application must be made on Form 7004 filed by the unextended due date, does not have to contain a reason for the requested extension A single member unincorporated entity is treated as a disregarded entity unless it elects to be a corporation. o Cannot be treated as a partnership o Example A single member LLC owned by an individual will be treated as a sole proprietorship unless the individual elects to be treated as a corporation. Its business income and expenses will be reported on the individuals Schedule C, Form 1040, and its rental income/loss will be reported on the individuals Schedule E, Form 1040. o A corporation which owns a single member LLC would report its results as if it were a branch if it didnt elect to treat the LLC as a separate corporate subsidiary. o For entities in existence prior to January 1, 1997, their previously claimed classification will generally be respected for periods prior to that date if it was reasonable under the prior rules. Is the entity a trust? o Yes Trust o No Is the entity subject to special rules? Yes Apply special rules No Is the entity an eligible entity? No Corporation Yes Is the entity organized under domestic law? o Yes Does the entity have two or more owners? No Entity is disregarded unless it elects to be a corporation Yes Partnership unless it elects to be a corporation o No Does any member have unlimited liability? No Does the entity have only one owner? No Corporation unless it elects to be a partnership Yes Corporation unless it elects to be disregarded Yes Does the entity have only one owner? No Partnership unless it elects to be a corporation Yes Entity is disregarded unless it elects to be a corporation

103 Advantages and Disadvantages of Operating as a Partnership Flow-through taxation o Primary advantage of operating as a partnership for tax purposes is that although the partnership must file a tax return, a partnership is not taxable; the income from the partnership flows through to the partners and is recognized by them in the same character as it was recognized by the partnership. o Two positive effects: The income of the partnership is only taxed once at the partner level, unlike the double taxation that corporate shareholders suffer If the partnership has a loss the partner will be able to deduct their share of the loss, whereas a shareholder in a regular C corporation cant deduct their share of an S corporation loss Property distributions o Advantage to partnership can be less expensive to get assets rather than a corporation. o Distributions of property from a partnership are tax-free to both the partnership and the partner (non-cash). o Dividend income to corporation. Tax-free formation o Less expensive from tax perspective to form a partnership rather than corporation (unless you meet Sec. 351). o Contributions of property are tax-free unless the net liabilities the partner is relieved of due to the contribution exceed the partners basis in their partnership interest. Special allocations o Partnership has advantage of being able to specially allocate items of income or deduction to different partners. o All of the depreciation on a building can be allocated to just one partner for example. o Special allocations are commonly used to make investment in a partnership more attractive to high-tax bracket partners. Unlimited liability o Partnerships have disadvantage of note shielding the general partners from the liabilities of the partnership. o This is why so many businesses are now operated as LLCs (generally taxed as partnerships, but their owners are shielded from the liabilities of the entity). Self-employment income o Disadvantage of partnership is that nay trade or business income of the partnership is taxed to the general partners as self-employment income. Guaranteed payments for services provided by limited partners is also treated as self-employment income. Advantages of partnership: easy to form, liabilities of partnership increase partners basis. Disadvantages of partnership: difficult to transfer ownership, difficult to raise capital, deduction of losses are limited by basis, at-risk amounts, and passive activity loss rules, fringe benefit exclusion is not allowed.

104 Tax Issues Involving Classification of LLCs as Partnerships Federal income tax regulations require most jointly-owned unincorporated domestic business entities, such as LLCs, to be treated as partnerships unless they elect corporate status. In the case of an LLC, no member is legally a limited or general partner. All the members resemble limited partners from a limited liability standpoint, while all members who are managers resemble general partners from an operational standpoint. Classification of debt as recourse or nonrecourse becomes less clear when applied to non-partnership entities.

Passive loss limitation rules affected. An interest in an LLC certainly falls within the literal definition of a limited partnership interest. Commentators have argued that manager-members should not be treated as limited partners for the purposes of the material participation test since they are allowed to participate in management, unlike limited partners. In Gregg v. US the LLC member was treated as a general partner for passive loss purposes because he had the element of control required to be considered a general partner under the applicable state law. In Thompson v. US the LLC member was treated as a general partner because the Court maintained that a limited partnership interest for Code Sec. 469 purposes meant an interest in an entity that was in fact organized as a limited partnership under applicable state law and held by one who is in fact a limited partner. The Court also held that even if the taxpayer were considered to hold a partnership interest, the taxpayer might escape passive treatment under the regulations exception for general versus limited partners, which was distinguished not on the basis of limited liability characteristics, but on the basis of whether the taxpayer had the element of control required under state law. If the term general partner were deemed to mean a partner with personal liability for the organizations liabilities, then in an LLC there would be no one whom the partners may designate as the tax matters partner for purposes of partnership audits. LLC members who are treated as limited partners for purposes of Code cannot take into account their distributive shares that are not subject to Social Security tax for retirement. Proposed regulations o Code Sec 1402 provide that an individual will generally be treated as a limited partner unless he or she has personal liability for the debts of or claims against the partnership by reason of being a partner, has authority to contract on behalf of the partnership under the statute or law pursuant to which the partnership is organized, or participates in the partnerships trade or business for more than 500 hours during the taxable year. o If most activities of a partnership involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting, the individual will not be considered a limited partner. The retiring or deceased member of an LLC would have to be treated as a general partner for liquidation payments under Code Sec 736. In an LLC, the issue was whether recourse debt for which the LLC itself was personally liable could be treated as nonrecourse debt and therefore qualified nonrecourse debt if all the requirements were met.

105 Reclassification Code Sec 701 regulations provide that the intent of Subchapter K is to permit taxpayers to conduct business for joint economic profit through a flexible arrangement that accurately reflects the partners economic arrangement without incurring an entity level tax. The partnership must be bona fide and each transaction or series of related transactions must be entered into for a substantial business purpose. The form of each transaction must be respected under substance over form principles. Except as otherwise provided in the regulations, the consequences to each partner from operations and transactions between the partner and the partnership must accurately reflect the partners economic agreement and clearly reflect the partners income. The IRS can recast a transaction involving a purposed partnership as if it were not a partnership if the partnership is formed or availed of with a principal purpose of substantially reducing the present value or the partners aggregate federal tax liability, and the reduction occurs in a manner inconsistent with the intent of Subchapter K. If both met, IRS can disregard partnership in whole or part.

106 Distinguishing Partnerships from Other Relationships

If a financial venture amounts to an actively conducted business, then it must be accounted for as a partnership. If a lower level of activity is presented it can be treated as either a partnership or co-tenancy. Relevant factors include: the existence of a partnership agreement, filing partnership tax returns, how title to property is taken, and the owners ability to separately sell their shares of the property. Some rentals resemble passive investments and others are operated as active businesses. Absent a demonstrated intent to conduct activity as partners, a co-ownership arrangement, not a partnership, is deemed to exist when two persons who join together as co-owners and only perform services for maintenance. Joint ventures and other unincorporated organizations may be excluded from Subchapter K at the election of the partnership by all the members. A partnership qualifies as an investing partnership if: the owners can compute their income without the necessity of computing partnership taxable income, the owners own the property as co-owners, the venture consists of coowners who reserve the right to separately acquire or dispose of their interests in any property acquired, and the co-owners must not use the jointly held property to actively conduct business or irrevocably authorize a representative to purchase, sell, or exchange the invest property. Each participant can separately delegate such authority for a period of one year or less. Participants in a joint production, extraction, or property-use arrange must also be co-owners, must reserve the right to separately dispose of their interests, and must not jointly sell services or properties either produced or extracted. A partnership does not exist if a joint undertaking is made for the sole purpose of sharing expenses. When two or more persons actively conduct a trade or business with an intention to share profits, but one part lacks a proprietary interest, an employment relationship and not a partnership is likely to exist. Some courts have focused on the degree of managerial control vested with a person in determining whether he/she is a partner or an employee. Lessor-lessee relationships pose problems similar to that of creditor-debtor arrangements; if the lessor retains too much control over the operation of an active trade or business, a partnership is likely to arise.

Chapter 3 Receipt of a Partnership Interest for Services An interest in capital that vests in the service partner immediately is valued and treated as personal service income on the date of receipt. If interest received by the service partner does not vest immediately, service partner recognizes no income until it is vested.