The rules governing partnership taxation, for purposes of the U.S. Federal income tax, are codified according to Subchapter K of Chapter 1 of the U.S. Internal Revenue Code (Title 26 of the United States Code). Partnerships are "flow-through" entities. Flow-through taxation means that the entity does not pay taxes on its income. Instead, the owners of the entity pay tax on their "distributive share" of the entity's taxable income, even if no funds are distributed by the partnership to the owners. Federal tax law permits the owners of the entity to agree how the income of the entity will be allocated among them, but requires that this allocation reflect the economic reality of their business arrangement, as tested under complicated rules.
Background While Subchapter K is a relatively small area of the Internal Revenue Code, it is as comprehensive as any other area of business taxation. The recent emphasis by the Internal Revenue Service (IRS) to stop abusive tax shelters has brought about an onslaught of regulation.
Aggregate and entity concept The Federal income taxation of partners and partnerships is set forth under Subchapter K covering Sections 701–777 of the Code. Subchapter K represents a blending of the Aggregate and Entity concepts. Aggregate concept An aggregate concept looks at a partnership as a collection of partners and treats each partner as if he owned an undivided interest in the partnership assets and its operations. For tax purposes, under this concept, a partnership is not a person, it cannot be sued or sue. It is merely a conduit passing income through to the partners for reporting on their individual tax returns. "The aggregate approach reflects the underlying notion that the partnership form generally should affect the tax treatment of the partners as little as possible. Thus it is useful to compare the treatment of a similar non-partnership transaction under general income tax principles."William S. Mckee, William F. Nelson, Robert L Whitmire: Federal Taxation of Partnerships and Partners; Volume 1 (2004) Entity concept An entity concept on the other hand looks at a partnership as a separate entity for tax purposes with partners owning equity interest in the partnership as a whole. This treatment is similar to corporations entity approach. Thus a partnership for tax purposes is a person, it can sue and be sued and can conclude legal contracts in its own name. The entity concept governs the characterization "income, gain, losses and deductions from the partnership operations, are initially determined at entity level. These items are then passed through to the partners through their distributive shares."104JTAX 124, 2006 WL 1819989
Taxation based on type of Partnership In the absence of an election to the contrary, multi-member limited liability companies (LLCs), limited liability partnerships (LLPs) and certain multi-member trusts are treated as partnerships for United States federal income tax purposes. Certain non-U.S. entities may also be eligible for treatment as partnerships. Individual states of the United States do not universally accord "flow-through" taxation to partnerships, and some distinguish among different kinds of entities that are treated the same under federal tax principles (e.g. Texas taxes LLCs as corporations, while according flow-through treatment to partnerships). Local jurisdictions may also impose their own taxes on entities taxed as partnerships at the federal level (e.g., New York City unincorporated business tax).
Certain threshold issues bear mentioning here: (1) members of an LLC, or partners in a partnership which has elected to be treated as a partnership for Federal income tax purposes, may use a proportionate share of the partnership debt in order to increase their "basis" for the purpose of receiving distributions of both profits and losses; (2) members and/or partners must be "at risk" pursuant to; and (3) they must actively participate pursuant to.
There is little published authority on these matters. On the issue of material participation in LLCs there are only the Gregg (U.S.D.C. Oregon 2000) and AssafAssaf v. C.I.R., T.C. Memo. 2005-14 (2005) cases. These cases generally seem to agree that the least onerous test for qualifying for material participation for an LLC member is the same as that for a General Partner in a Limited Partnership, or 100 hours annually.
Determination of distributive share
A partner's distributive share of the partnership's income or loss, and its deductions and credits, is determined by the partnership agreement. However, the partner's distributive share is measured by their partnership interest if the partnership agreement does not provide for such a distributive share, or the allocation under the partnership agreement does not have substantial economic effect.26 USCA 704(b) The partnership interest can be discerned through an analysis of the capital accounts of the partners to determine in what proportion to the rest of the partnership each partner contributed capital to the partnership.
Substantial economic effect tests The determination of "substantial economic effect" for allocations is split into two main tests. The first is called the economic effects test. The second is the substantiality test. Both tests are complicated and require a detailed examination in the Treasury regulations 1.704-1(b).
Economic effects test
The fundamental principle for the economic effects test is that for an allocation to have economic effect it must be consistent with the underlying economic arrangement of the partners.26 CFR 1.704-1(b)(2)(ii)(a) The partner must bear the economic benefit, or burden, of the allocation. There are now three methods, or "tests," for determining whether an allocation has economic effect.
The first test is the primary test referred to as the safe harbor test, which requires the execution of three conditions: Maintenance of partners' capital accounts in accordance with Reg. 1.704-1(b)(2)(iv); Liquidation distributions are required in all cases to be made in accordance with the positive capital account balances of the partners.26 CFR 1.704-1(b)(2)(ii)(b)(2) Lastly, if a partner has a deficit balance in their capital account following the liquidation of their interest in the partnership, then they are unconditionally obligated to restore the amount of such deficit balance to the partnership by the end of such taxable year.26 CFR 1.704-1(b)(2)(ii)(b)(3)
The test above works for general partners in a partnership, but not for limited partners. Limited partners, by the nature of having limited liability, do not have to pay back deficits. Instead, there is another test called the "alternative economic effects test" that follows the first two requirements, but replaces the last requirement. The alternative effects test requires that, instead of a deficit restoration obligation, the partnership agreement provides for a qualified income offset provision. A "qualified income offset" is a provision requiring that partners who unexpectedly receive an adjustment, allocation, or distribution that brings their capital account balance negative, will be allocated all income and gain in an amount sufficient to eliminate the deficit balance as quickly as possible.26 CFR 1.704-1(b)(2)(ii)(d)(6)
However, if the allocation fails the safe harbor and alternative economic effects tests, the allocation may still have economic effect through the economic effect equivalence test. Partnerships failing the two economic effect tests above will still be deemed to have economic effect, provided that as of the end of each partnership taxable year a liquidation of the partnership at the end of the year or at the end of any future year would produce the same economic result to the partners as would occur had the test above been satisfied.26 CFR 1.704-1(b)(2)(ii)(h)(i) Since a hypothetical liquidation would create the same results, the economic effect is preserved. This is most useful during transitional stages of the partnership.
Substantiality test
Substantiality is the second part of the substantial economic effects test. Generally, an allocation is substantial if there is a reasonable possibility that the allocation will affect substantially the dollar amounts to be received by the partners from the partnership independent of the tax consequences.26 CFR 1.704-1(b)(2)(iii)
An allocation is not substantial if at the time the allocation becomes part of the partnership agreement, (1) the after-tax economic consequences of at least one partner may be enhanced compared to such consequences if the allocation was not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax consequences of no partner will be substantially diminished compared to such consequences if the allocation was not contained in the partnership agreement.
The idea here is that the IRS is looking for partnerships whose sole goal is to improve the tax situation of the partners. This is effectively the definition of a tax shelter.
Capital accounts The partnership must maintain the capital accounts of the partners in order to pass the economic effects test because many of the determinations for proper allocations rely on well-maintained capital accounts for discerning the partners' interests.26 CFR 1.704-1(b)(2)(iv)(a)
Generally, partners' book capital accounts reflect the value of each partner's interest in the partnership. Thus, capital accounts serve to reconcile the entitlements and obligations of the partners upon liquidation. For example, if all partnership assets were sold for a fair market value and all liabilities were paid, the remaining cash, if any, would be equal to the partner's equity in the partnership at fair market value. Tax capital accounts are partners' "outside basis" (however, unlike the outside basis, the partnership's recourse and nonrecourse liabilities are not included in partners' tax-basis capital accounts) and under Section 722 are initially determined by reference to the partner's contributed cash amount and the adjusted basis of the contributed property. Thereafter, other allocations that either increase or decrease a partner's basis will be reflected in the account. A partner's outside basis is separate and distinct from the partnership's inside basis. Under Section 723, a partnership's inside basis is the adjusted basis of the contributed property or the value of the contributed cash. "Generally the sum of the partner's outside basis will equal to the partnership's inside basis in its assets".MERTERNS §35F: 1. & James W Pratt, William N. Kulsrud: Corporate Partnership, Estate and Gift Taxation; Partners' Distributive Shares
Example A, B, and C are equal partners in ABC partnership. A contributes $50,000 cash, B contributes equipment with a basis of $15,000 and a FMV of $30,000 and C contributes land with a basis of $25,000 and a FMV of $35,000. Immediately after the contributions, ABC partnership's balance sheet would show the following assuming that ABC has no liabilities at formation:
Assets The total basis of all assets is $90,000, representing the contributed properties in the partnership's hands. This is ABC partnership's "inside basis". Representing the book value of the partnership assets, the total value of all assets is $115,000. Equity The total basis is $90,000, which represents the partners' tax capital accounts or the "outside basis" of the properties contributed. Lastly, the total of all book capital accounts is $115,000, representing the partners book capital accounts. Book capital accounts reflect partners' equal contributions and equal rights to any liquidation distributions.
Increases