The Basics of Partnership Taxation
By Kenneth H. Bridges, CPA, PFS December 2019
The partnership form of doing business (which, for income tax purposes, includes most LLCs with more than one member) offers a combination of flow-through treatment and great flexibility.
Similar to a Subchapter S corporation, a partnership generally does not pay any income tax, and, instead, its items of income, gain, loss, deduction and credit flow through to the tax returns of its owners. Unlike an S-corp, however, a partnership is not limited in terms of the number or types of owners it can have or the classes of stock it can have, appreciated property can generally be distributed to the owners without triggering the gain, the partners can include in their tax basis debt of the partnership, and items of income, gain, loss, deduction and credit can be allocated amongst the partners in any manner they choose; so long as the allocations have “substantial economic effect”. Along with this great flexibility, however, often comes great complexity and confusion.
Beyond just the tax ramifications, the economics of an arrangement (including the amounts and timing of distributions) may hinge on tax accounting concepts, as the allocation and distribution provisions of partnership agreements and LLC operating agreements are often based on references to the Internal Revenue Code and regulations thereunder.
In a very simplistic situation, two individuals may come together to form a venture, contributing equal amounts of cash, expertise and services, with an agreement to split the fruits thereof equally. In this situation, partnership taxation is not overly complex. However, in the real world, often the partners enter and exit the venture at differing times, some may contribute cash while others contribute appreciated property or services, those contributing cash may be entitled to a priority return of their investment plus a return thereon, there may be debt in the capital structure, etc. Simplicity can quickly give way to complexity.
At the heart of partnership taxation is the concept of “capital accounts”. A partner’s capital account is essentially a measure at any point in time of the cumulative capital contributed by the partner plus income allocated to the partner minus losses allocated to and distributions received by the partner. A partner may have several different capital accounts; a “tax basis capital account”, a “704(b) book economic capital account”, and a “GAAP basis capital account”. In a very simplistic situation, all three of these may be the same. In more complex situations, they may all three be different.
The tax basis capital account tends to be more of a historical cost basis amount; whereas the 704(b) capital account tends to be more of a fair market value amount. E.g. assume you have a tract of land which you acquired many years ago for $100,000, which you contribute to a partnership at a time when it is valued at $1,000,000. Your tax basis capital account would be $100,000, while your 704(b) capital account would be $1,000,000. Your 704(b) capital account tends to govern the economics of your arrangement with your partners (and also determines whether allocations meet the “substantial economic effect” test), while the tax basis amount governs how much gain you have for income tax purposes.
Partnership rules permit a partner to include in the tax basis of their partnership interest their allocated share of the liabilities of the partnership, and the “at-risk” rules permit inclusion of such so long as the partner is personally at risk for the debt (e.g. under a personal guarantee or as the maker of the loan) or the debt is “qualified nonrecourse” (e.g. bank debt secured by real estate). While these rules are generally advantageous and can permit a partner to deduct tax losses in excess of their actual investment or permit tax-free distributions to the partner in excess of their investment plus income allocated to them, they can also, unfortunately, result in “phantom income” down the road for the partner when the debt goes away. So, careful planning is required in this area.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP, an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.