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.
The recent emphasis by the Internal Revenue Service (IRS) to stop abusive tax shelters has brought about an onslaught of regulation [citation needed].
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.
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.
Thus a partnership for tax purposes is a person, it can sue and be sued and can conclude legal contracts in its own name.
"[2] 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.
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).
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;[3] (2) members and/or partners must be "at risk" pursuant to;[4] and (3) they must actively participate pursuant to.
1.704-1(b)(2)(iv); (2) Liquidation distributions are required in all cases to be made in accordance with the positive capital account balances of the partners.
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.
[14] The idea here is that the IRS is looking for partnerships whose sole goal is to improve the tax situation of the partners.
For more information on the effect of partnership liabilities, including rules for limited partners and examples, see sections 1.752-1 through 1.752-5 of the regulations.
351 [21] in the corporate world, there is no demand for control (80%) immediately after the transaction and there is no minimum percentage of interest that the contributing partner must acquire for the non-recognition rule of Sec.
[24] If it was an ordinary asset in his hands, the holding period of the partnership interest begins the day after the contribution.
Generally, a partnership interest can be acquired in exchange for services, but this transaction does not qualify under Sec.
[20] With the transfer of services rather than property, the transaction results in taxable income to the contributing partner under Sec.
[20] On the other hand, a partner can contribute ordinary income assets, like unrealized receivables or inventory items.
[31] 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.
[32] 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.
[33] When a partner receives a distribution, they may not recognize gain up to the adjusted basis of their capital account in the partnership.
[34] They recognize gain to the extent that the distribution exceeds their adjusted basis in the capital accounts of their partnership interest.
This gives the partner time to bump-up his adjusted basis in the partnership and avoid the 731(a)(1) gain.
To determine each partner's economic risk of loss, a constructive liquidation analysis must be performed.
As a result of each A and B taking a $60,000 distributive share of the loss, their respective capital accounts are decreased by $60,000 from $10,000 to ($50,000).
For more information on the effect of partnership liabilities, including rules for limited partners and examples, see sections 1.752-1 through 1.752-5 of the regulations.
A popular implementation guide is the book Understanding Partnership Accounting by Advent Software and American Express (2002).
The book Taxation of US Investment Partnerships and Hedge Funds: Accounting Policies, Tax Allocations and Performance Presentation by Vasavada (2010) codifies partnership accounting into linear algebra and uses the engineering algorithm of convex optimization to solve for partner tax allocations.