By Kenneth H. Bridges, CPA, PFS December 2019
The partnership form of doingbusiness (which, for income tax purposes, includes most LLCs with more than onemember) offers a combination of flow-through treatment and great flexibility.
Similar to a Subchapter Scorporation, a partnership generally does not pay any income tax, and, instead,its items of income, gain, loss, deduction and credit flow through to the taxreturns of its owners. Unlike an S-corp,however, a partnership is not limited in terms of the number or types of ownersit can have or the classes of stock it can have, appreciated property cangenerally be distributed to the owners without triggering the gain, thepartners can include in their tax basis debt of the partnership, and items ofincome, gain, loss, deduction and credit can be allocated amongst the partnersin any manner they choose; so long as the allocations have “substantialeconomic effect”. Along with this greatflexibility, however, often comes great complexity and confusion.
Beyond just the taxramifications, the economics of an arrangement (including the amounts andtiming of distributions) may hinge on tax accounting concepts, as theallocation and distribution provisions of partnership agreements and LLCoperating agreements are often based on references to the Internal Revenue Codeand regulations thereunder.
In a very simplistic situation,two individuals may come together to form a venture, contributing equal amountsof cash, expertise and services, with an agreement to split the fruits thereofequally. In this situation, partnershiptaxation is not overly complex. However,in the real world, often the partners enter and exit the venture at differingtimes, some may contribute cash while others contribute appreciated property orservices, those contributing cash may be entitled to a priority return of theirinvestment plus a return thereon, there may be debt in the capital structure,etc. Simplicity can quickly give way tocomplexity.
At the heart of partnershiptaxation is the concept of “capital accounts”.A partner’s capital account is essentially a measure at any point intime of the cumulative capital contributed by the partner plus income allocatedto the partner minus losses allocated to and distributions received by thepartner. A partner may have several different capital accounts; a “tax basiscapital account”, a “704(b) book economic capital account”, and a “GAAP basiscapital account”. In a very simplisticsituation, all three of these may be the same. In more complex situations, theymay all three be different.
The tax basis capital accounttends to be more of a historical cost basis amount; whereas the 704(b) capitalaccount tends to be more of a fair market value amount. E.g. assume you have a tract of land whichyou acquired many years ago for $100,000, which you contribute to a partnershipat 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 yourarrangement with your partners (and also determines whether allocations meetthe “substantial economic effect” test), while the tax basis amount governs howmuch gain you have for income tax purposes.
Partnership rules permit apartner to include in the tax basis of their partnership interest theirallocated share of the liabilities of the partnership, and the “at-risk” rulespermit inclusion of such so long as the partner is personally at risk for thedebt (e.g. under a personal guarantee or as the maker of the loan) or the debtis “qualified nonrecourse” (e.g. bank debt secured by real estate). While these rules are generally advantageousand can permit a partner to deduct tax losses in excess of their actualinvestment or permit tax-free distributions to the partner in excess of theirinvestment plus income allocated to them, they can also, unfortunately, resultin “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 purposesonly, and is not intended to constitute legal, tax or accounting advice. The article provides only a very generalsummary of complex rules. For advice onhow these rules may apply to your specific situation, contact a professionaltax advisor.
