Why are allocations of Partnership Liabilities so complicated?

Partnership liabilities are complicated BUT they are important and can lead to over-payment of tax if done wrong!

Under Section 704, a partner in a partnership may only utilize a loss allocated to that partner to the extent of the partner’s “basis” in the partnership interest. This is generally equal to the amount of cash plus the adjusted tax basis of any property contributed by the partner to the partnership.

Unique to subchapter K, a partner includes in his tax basis his share of the partnership's liabilities. This is accomplished by virtue of Section 752, which provides that a partner’s allocable share of the liabilities of the partnership is treated as a cash contribution to the partnership. Conversely, Section 752 also provides that any reduction in a partner’s share of the liabilities of the partnership is treated as a cash distribution to the partner. This deemed distribution may create taxable gain to the partner if it exceeds the partner’s outside basis in his interest.

Determining a partner’s allocable share of the liabilities of the partnership is often critical, as it may enable the partner to utilize a loss or take a tax-free distribution that would otherwise be unavailable. But how do we do it?

Step 1: Identify the Type of Liability

The first step towards properly allocating partnership liabilities is to understand the nature of the three liabilities listed on Schedule K-1.

a)    Recourse Liability

b)    Nonrecourse Liability

c)    Qualified Nonrecourse Liability (QNR)

Step 2: Identify the Type of Partnership

Those three definitions are only useful when understood in conjunction with the types of limited legal liability associated with certain forms of partnerships. Let’s take a look.

Step 3: Allocating Liabilities

The short-hand version is:

“Allocate recourse liabilities according to loss ratio, and nonrecourse liabilities according to profits ratio”, but let’s see:

Allocation of Nonrecourse Debt

The regulations require that nonrecourse liabilities be allocated according to three steps:

1.    First, to the extent of partnership minimum gain,

2.    Next, to any partner that contributed appreciated property to the partnership secured by a liability to an amount equal to the excess of the liability over the tax basis of the property at the time of contribution. (Section 704(c) gain)

3.    Lastly, to each partner based on profit ratio.

Step 1: Partnership Minimum Gain

First, nonrecourse liabilities must be allocated to each partner equal to the partner’s share of “partnership minimum gain.” This will only apply if the partnership owns depreciable property secured by the nonrecourse loan.

“Partnership minimum gain” is the amount by which the principal balance of the nonrecourse loan exceeds the depreciable basis of the property. It is coined as such because under Section 1001, if the partnership simply transfers the property back to the lender for no additional consideration other than the extinguishment of the debt, the partnership will be treated as if it sold the property for the principal amount of the loan, thus giving rise to gain.

Step 2: Section 704(c) Gain

Under Step 2, if a partner contributed appreciated property to the partnership that secured the liability, the contributing partner must be allocated the liability to the extent of the excess of the liability over the tax basis at the time of the contribution.

Step 3: Profit Ratio

If there is no minimum gain or Section 704(c) gain, the allocation of nonrecourse liabilities is straightforward. If the loan was made directly by a partner or if the partner personally guaranteed the liability, that portion of the nonrecourse liability should be treated as a recourse liability and allocated specifically to that partner. Any remaining nonrecourse liability should be allocated according to the rules above. If there is no minimum gain or Section 704(c) gain to be allocated, the entire nonrecourse portion of the gain should be allocated according to the profits ratio.

Summary

After all of that, here are a few shortcuts:

·         General partnership: all liabilities are recourse unless a debt is specifically nonrecourse at the partnership level. Thus, it will be rare to see a number on the "nonrecourse liability" line of Schedule K-1. Allocate according to hypothetical loss analysis.

·         Limited partnership: all liabilities are recourse unless a debt is specifically nonrecourse at the partnership level, but only to the general partners. Allocate recourse liabilities solely to the general partners unless a limited partner has a deficit capital account or guarantees the debt. Once again, it will be rare to have an allocation of a "nonrecourse liability," on Schedule K-1, and, it would follow, equally rare to have an allocation of any liability to a limited partner.

·         LLC: all liabilities are nonrecourse unless personally guaranteed by a partner, made by a partner, or the partner enters into a DRO. If there is no guarantee, loan from a partner, or DRO, there should never be a recourse liability allocated on Schedule K-1.

It’s complicated….and more than we have space to cover here. To know more, contact John L Mottram CPA LLC or contact John Mottram directly by telephone, text or email at 214-543-1855 or jlm@mottramcpas.com.

Can automating accounting and bookkeeping work for your business?

The Wall Street Journal reported today that “Firms Leave the Bean counting to the Robots”.

Roberta spends her days in this energy company’s treasury department searching for missing payment information and sending out reminders.

Roberta does not have a last name, a face or arms. She is a piece of robotic software to work in the company’s treasury department, part of a push toward automation, robotics and artificial intelligence.

These new technologies are designed to cut costs, liberate employees from time-consuming, repetitive tasks and reducing accounting and finance employee numbers.

Forecasting business performance is another area where humans can be replaced by an algorithm.

Accounting departments are seeing results from increased sophistication of robotics and automation tools.

The first step is to get rid of repetitive tasks that are not adding value.

A French information-technology firm is planning to hand over its reporting tasks…….for example, collecting and assembling data for monthly and quarterly reports, as well as calculating results …..to robots.

Because of robotization, finance jobs will evolve quickly. How quickly, no one really knows.

You can expect to have less people in charge of extremely basic functions, perhaps freeing up resources that you can invest in other areas of your business.

At John L Mottram CPA LLC, we have access to a wide range of accounting and bookkeeping software and tools that will automate many of your repetitive functions and reduce your labor and outsourcing costs between 30% and 35%. Call or email John L Mottram at 214-543-1855 or jlm@mottramcpas.com  or go to our website www.mottramcpas.com and learn more identifying repetitive tasks that can be automated.

Did you know that your partnership’s tax capital account may differ from your individual tax capital account? It’s all to do with outside and inside basis.

Types of Basis

If you want to avoid paying more tax than you should it is important that you know the difference between OUTSIDE and INSIDE basis.

To understand the taxation of partnerships and distributions, it is necessary to know the 2 types of tax bases concerning partnerships.

The inside basis is the partnership's tax basis in the individual assets.

The outside basis is the tax basis of each individual partner's interest in the partnership.

When a partner contributes property to the partnership, the partnership's basis in the contributed property is equal to its fair market value (FMV) – inside basis. However, the outside basis is generally the amount of the basis that the partner had in the property.

Here is an example:

You contribute land to a partnership with a tax basis of $10,000 and a FMV of $50,000. Your other partner contributes $50,000 cash. Since the FMV of the land is also $50,000, you each have equal equity in the partnership, and the total inside basis of the partnership is equal to $100,000, your combined contributions. However, your outside basis differs from your partner's, since your outside basis is $10,000, while that of your partner's is $50,000. If you sold your partnership interest for $50,000, you would recognize a gain of $40,000, whereas your partner, if she sold at the same price, would recognize no gain. Got it?

Property Distributions

When property is distributed to a partner, then the partnership must treat it as a sale at fair market value (FMV). The partner's capital account is decreased by the FMV of the property distributed. The book gain or loss on the distribution (which is called a “constructed sale”) is apportioned to each of the partners' accounts.

Generally, there are no tax consequences of a current property distribution — there is never a taxable gain or loss, either to the partnership or to the partner.

The partnership's inside basis of the property carries over to become the partner's basis, thereby reducing the partner's outside basis by the carryover basis.

As with the cash distribution, if the FMV of the property exceeds the partner's outside basis in the partnership, then the partner's interest in the partnership is reduced to 0 and the receiving partner's basis in the distributed property equals his outside basis in the partnership before the distribution. The property basis that remains after subtracting the outside basis is taxable as a gain.

Here is a property distribution example.

Let’s say your adjusted basis in a partnership is $14,000. You receive a distribution of $8000 cash and land with a FMV of $3000 and an adjusted basis of $2000. Since the amount of cash received is less than your interest in the partnership, there is no taxable transaction. However, your outside basis in the partnership declines to $4000 (= $14,000– $8000 – $2000). Subsequently, you receive a distribution of land with an adjusted inside basis of $10,000. Since your outside basis in the partnership is only $4000, your adjusted basis in the land is also $4000, and you must report a gain of $6000 (= $10,000 – $4000). Got it?

Definitions:

Adjusted Basis or Adjusted Tax Basis refers to the original cost or other basis of property, reduced by depreciation deductions and increased by capital expenditures.

Example: Brad buys a lot for $100,000. He then erects a retail facility for $600,000, and then depreciates the improvements for tax purposes at the rate of $15,000 per year. After three years his adjusted tax basis is $655,000 [$100,000 + $600,000 - (3 x $15,000)].

Carryover basis is a method for determining the tax basis of an asset when it is transferred from one individual to another. 

At John L Mottram CPA LLC Certified Public Accountants we can make sure that you and your partners are always up-to-date on the inside and outside tax basis in your partnership capital accounts. Email, phone or text John Mottram CPA at jlm@mottramcpas.com, 214-543-1855 and let us start the process of better understanding.

Go on, dive into your Partnership Book and Tax Capital Accounts!

……but do it safely with John L Mottram CPA, LLC. Certified Public Accountants.

Book Capital Accounts

Each partner has separate capital accounts that represent the equity that a partner has in the partnership. The partners share of equity is the amount that would be received if the partnership were liquidated and all of the assets were sold at book value, all liabilities paid, and the net proceeds distributed.

As the partnership carries on trade or business, these capital accounts will change depending on the agreement between the partners as to how they will share in the profits and losses. The capital account should reflect the economic arrangement between the partners.

This balance should be reflected on the tax return balance sheet and Item L on the Schedule K-1 of Form 1065. This can be a negative figure because the liabilities are not included.

Tax Capital Accounts

Many times, the books will be maintained on the tax capital account basis that will reflect the adjusted basis of the assets contributed, instead of FMV. Because the tax capital account reflects the adjusted basis, barring any transfer of partnership interests, there is a close relationship to a partners outside basis for tax purposes.

This account can also be a negative figure because the liabilities are not included.

How book capital accounts compare to tax capital accounts:

1.    Book capital accounts reflect fair market value of the property at time of contribution and tax capital accounts reflect the adjusted basis of the property at the date of contribution.

2.    Book capital accounts reflect the market value of the property at the date distribution, and tax capital accounts reflect the adjusted basis of the property at the date of distribution.

3.    Book capital accounts and tax capital accounts do not include liabilities of the partnership. Both are reflected net of liabilities.

4.    Book capital accounts and tax capital accounts may both reflect a negative balance, however, it is important to note that outside basis cannot have a negative balance since outside basis includes liabilities.

5.    Generally, non-deductible expenses will reduce the capital accounts.

Partners capital accounts can be maintained on GAAP basis, a tax basis, and certain other bases specified by the Tax Code IRC $704(b).

The method used to maintain capital accounts on the tax return should be consistent with the partnership financial statements.

Capital accounts are adjusted when property is contributed or distributed. Unlike basis, which is calculated by using the adjusted basis of the contributed or distributed property, a capital account is increased or reduced based on the faire market value of any property contributed or distributed.

At John L Mottram CPA LLC, Certified Public Accountants, we make sure that we create and maintain for each partner both book capital accounts and tax capital accounts prepared in compliance with all provisions required by the US Tax Code.

Contact us at 214-390-7446 or go to our website at www.mottramcpas.com.

BTW - more on a partner's "outside basis" in an upcoming blog!

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