Partnership taxation in the United States

The rules governing partnership taxation, for purposes of the U.S. Federal income tax, are codified as 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 on an onslaught of regulation, as most abusive shelters utilize partnerships in some form.

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 of 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; [usc|26|752(a)] (2) members and/or partners must be "at risk" pursuant to; [usc|26|465] and (3) they must actively participate pursuant to. [usc|26|469]

There is little published authority on these matters, and on the issue of material participation in LLCs there is only the Gregg (U.S.D.C. Oregon 2000) and Asaph cases (U.S. tax Ct. 2005). 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.Fact|date=September 2007

Determination of distributive share

A partner's distributive share of the partnership's income or loss, deductions and credits is determined by the partnership agreement. [usc|26|704(a)] 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 that each partner contributed capital to the partnership.

ubstantial economic effect tests

The substantial economic effect tests for allocations are split into two main tests. First is the economic effects test and 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. [26 CFR 1.704-1(b)(2)(ii)(a)] There are three 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:

(1) The partners must maintain their capital accounts. [26 CFR 1.704-1(b)(2)(ii)(b)(1)]

(2) 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)]

(3) Lastly, if a partner has a deficit balance in his capital account following the liquidation of his interest in the partnership then he is 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 test that follows the first two requirements but replaces the last requirement. The alternative economic 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 that requires 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 the a hypothetical liquidation would create the same results, the economic effect is preserved. This is most useful during transitional stages of the partnership.

ubstantiality 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 were 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 were not contained in the partnership agreement. [26 CFR 1.704-1(b)(2)(iii)]

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)]

Increases

The basic rules provide for increases to be made in a partner's capital account for his money contributions, the fair market value of property the partner contributed, and undistributed allocations of partnership income. [26 CFR 1.704-1(b)(2)(iv)(b)]

Decreases

The basic rules provide for decreases to be made in a partner's capital account for money distributed to him, allocations of expenditures and allocations of pp loss and deductions. [26 CFR 1.704-1(b)(2)(iv)(b)]

Assumption and contribution of recourse liabilities

Recourse liabilities assumed by the partner are treated as money contributed to the partnership, which increases the partner's capital account in the same manner as money. [26 CFR 1.704-1(b)(2)(iv)(c)] Meanwhile recourse liabilities that other partners assume from the contributing partner shall decrease his or her capital account in the same manner as money. [26 CFR 1.704-1(b)(2)(iv)(c)]

Assumption and contribution of nonrecourse liabilities

Loss limitation

There is a limitation on a partner's distributive share of partnership losses. A partner may only recognize a loss to the extent of their adjusted basis in the partnership. [26 USCA 704(d)] The excess may be distributed to the partner when that excess is repaid to the partnership. [26 USCA 704(d)]

Gain recognition

Capital contributions

When a partner contributes capital to the partnership neither the partnership nor the partner recognize a gain or a loss by the mere fact of contributions of property for an interest in the partnership. [26 USCA 721] Instead, the value of contribution is reflected in the capital accounts, which defers taxation until distributions to the contributing partner.

ervice contributions

If a partner contributes services for capital interest in the partnership, then that interest is taxable should it be subject to ready valuation. [Revenue Procedure 93-27(relying upon 26 USCA 83)] If a partner contributes services for a profits interest then that interest is not taxable upon the date of the exchange because any valuation would be too speculative unless it is for an asset that has low risk and a guaranteed return like a Treasury bill or the partner sells that interest within two years of the exchange. [Revenue Procedure 93-27(relying upon 26 USCA 83)]

Recently the Treasury proposed a safe harbor valuation procedure whereby a "service provider" (a partner who contributes services for a partnership interest) may be taxed on the valuation of the fair market value of the liquidation value of the property received. [Notice 2005-43(referring to proposed regulations 26 CFR 1.83-1)] According to this proposal a service provider will likely pay a tax on the receipt of a capital interest because it is subject to a liquidation valuation. [Notice 2005-43] Meanwhile a profits interest has no liquidation value because only capital interests have interests in the liquidation of capital, instead, the profits interest is just the speculative value of a share in future profits. [Notice 2005-43]

Distributions

When a partner receives a distribution they may not recognize gain up to the adjusted basis of their capital account in the partnership. [26 USCA 731] They recognize gain to the extent that the distribution exceeds their adjusted basis in the capital accounts of their partnership interest. [26 USCA 731]

Federal tax regulations, revenue rulings, and other pronouncements

The Internal Revenue Service publishes a substantial number of official pronouncements called "revenue procedures" (Rev. Procs.) and "revenue rulings" (Rev. Rul.), and both temporary and permanent regulations annually. [http://www.irs.gov/businesses/small/article/0,,id=98214,00.html IRS website on Partnerships]

ee also

*Partnership taxation
*Partnership accounting
* [http://www.irs.gov/businesses/partnerships/index.html IRS Partnership Index]
*IRS

Further reading

There have been uncountable volumes published on partnership taxation, and the subject is usually offered in advanced taxation courses in graduate school.

A well recognized authority on this subject was the late Professor Arthur Willis, whose work is still being carried on by his legal associates at Northwestern University, including "Willis on Taxation", updated annually.

Notes