ELITE ADVISOR BEST PRACTICES
The ABC’s of Partnership Taxation - Part One
It is essential to understand the basics of the federal income taxation of partnerships and limited liability companies in order to advise your clients regarding whether to invest in such companies.
By Janice Eiseman
- Partnerships are not taxed. All the income tax consequences generated by the partnership are reported on the income tax returns of the partners.
- The economic deal among partners must be properly reflected in the allocation provisions of profit and loss set forth in the partnership agreement.
- It is imperative to understand the difference between cash distribution and profit and loss allocations.
Your clients may have been advised by their estate planning attorneys to put assets in a family limited partnership or a limited liability company (“LLC”) for wealth transfer purposes. Or your clients may have a business they want to start and have been advised by their business advisors to commence operating in the form of a limited partnership or an LLC. Or, your clients may have received material inviting them to invest in a master limited partnership, a private equity fund or a hedge fund, all of which are investments that are usually set up as partnerships or LLCs.
What are the basic federal income tax concepts your clients should know about partnerships? (For the purposes of this article, I will refer to limited partnerships and LLCs as “partnerships” because both limited partnerships and LLCs are taxed as partnerships under the federal income tax law.)
First, partnerships are “tax efficient” because there is only one level of tax on profit, and that level is at the partner level. Even though profit and loss is determined at the partnership level, there is no income tax assessed against the partnership. Partnerships are complete “pass-through” entities, which means that every dollar of profit (and loss) in the partnership must be allocated each year among the partners. Each year the partnership gives its partners a Form K-1 that tells each partner the information they need to report on their income tax returns. For example, if the partnership’s profit consists, in part, of dividend income, the partnership reports the partner’s share of dividend income on the partner’s Form K-1 so the partner can pick up that amount of dividend income on his or her income tax return.
Because the partnership’s profit and loss must pass through to its partners, how is that profit and loss allocated (or shared) among the partners? The answer is that the profit and loss is allocated among the partners as set forth in the partnership agreement. These allocations must reflect the economic deal among the partners. When your clients ask you to review the allocations of the partnership and you say, “this is too good to be true,” then the allocations may not reflect “the deal” accurately or the allocations may not be valid for income tax purposes. For example, if your client is allocated all the tax loss generated by the partnership but the allocation of tax loss does not reduce your client’s equity in the deal, then the allocation of loss is suspect—the allocation may be reducing your client’s taxable income but not causing your client an economic loss and therefore will not be recognized as a valid allocation by the IRS.
A closer look at allocations
The allocations may be very simple or they may be very complicated. In a “straight-up” deal, profit and loss is allocated to each partner based upon his or her percentage of capital invested in the partnership. For example, if your client decides to go into business with another person, he or she may decide to contribute the same amount of cash and then share profit and loss equally. Your client and partner may agree to put in unequal amounts of cash because one of them is going to participate in the business of the partnership (as the “service partner”) while the other one is going to contribute cash (as the “money partner”). The money partner may demand a “preferred return” on his or her investment, and this return would be analogous to interest. Or the money partner may not demand a preferred return, but may demand that the partnership pay no money to the service partner until his investment is returned. Or, the business deal may be that the money partner wants a preferred return and a return of the investment before any money is paid out to the service partner. This is the structure of a typical private equity fund, which, in addition, may give the private equity sponsor an interest in the profits of the private equity fund if certain targets are met even though the sponsor has not contributed capital. Or, your client and any partner(s) may decide that one of them is going to put in cash and the other one is going to put in property with a fair market value equal to the cash contribution. The possible economic deals among partners are endless, and those deals must be accurately set forth in the allocation provisions of the partnership agreement.
Income allocations vs. cash distributions
One of the most confusing concepts about partnership taxation is that the allocation of income or loss is different from the distribution of cash. When deciding whether to invest in a deal taxed as a partnership, it is very important for you to explain to your client the difference between allocations of profit and loss and cash distributions. Your client may receive a Form K-1 showing an allocation of income but receive no cash to pay the tax on the income. When this happens to your client, you must explain that he or she is in receipt of “phantom income”—something no client likes. A profit for tax purposes does not necessarily mean there is cash to distribute. For example, the partnership may have a taxable profit for the year but no cash to distribute as a result of a partnership capital expenditure or a nondeductible expense. On the other hand, a tax loss allocated to a partner does not mean that there is no cash to distribute. In real estate deals, depreciation may cause a tax loss, yet the partnership will have cash to distribute. Just like the allocation of profit and loss, when cash will be distributed and who will get the cash is set forth in the partnership agreement.
Often the agreement gives the general partner (or the manager) the ability to determine when cash will be distributed so that the general partner (or manager) has the ability to determine how big of a cash reserve the partnership needs. Once the general partner or manager determines that a cash distribution should be or must be made, then they must determine how the cash will be distributed. Who gets the first cash distributions? For example, often under private equity fund agreements, the investors get their preferred returns back first and then their capital contributions (a typical waterfall agreement) before the sponsor gets any distributions. Because “cash is king,” your client will expect you to understand when and how cash will be distributed from the partnership.
Avoiding income tax triggers
Investing in a partnership usually does not trigger an income tax. Your client’s contribution to the partnership provides two important things: (1) an income tax basis in the partnership interest, which is analogous to having a tax basis in stock, and (2) a capital account on the partnership’s books, which is not analogous to investing in stock.
Your client’s partnership tax basis and capital account are increased by the income allocated to your client, decreased by the loss allocated to you client, increased by additional capital contributions made by your client, if any, and decreased by distributions, if any, made to your client. When your client contributes cash to a partnership, the income tax basis in the partnership interest and the amount shown on the partnership books as his or her capital account are the same, namely, the amount of cash contributed.
However, it is much more complicated when your client’s partnership income tax basis does not equal the initial amount in his capital account. This would occur, for example, if your client contributes property with a different fair market value than his income tax basis in the property. Say your client owns property with an income tax basis of $1,000, but a fair market value of $10,000. There is no income tax consequence to your client upon contribution of the property to the partnership. However, the partnership accounts for the property at its fair market value; thus, the capital account of your client will equal $10,000, the fair market value of the property, but his income tax basis in the partnership interest will be $1,000, the same amount as his income tax basis in the contributed property. This dichotomy will create income tax consequences to your client during the life of the partnership.
Distributions from the partnership may or may not have income tax consequences to your client. In general, a partner does not have taxable income when a distribution of cash is made to the partner unless the cash exceeds the partner’s tax basis in his partnership interest. In other words, a partner is allowed to recover his income tax basis prior to having to report a gain, a very favorable income tax consequence to your client. Likewise, in general, a partner does not have any income tax consequences when property is distributed to the partner; rather, under partnership income tax basis rules assigned to the distributed property, income tax is deferred until the partner disposes of the distributed property, another very favorable income tax consequence to your client. There are, however, important statutory exceptions to these generalizations that must be explored when your client asks you about the income tax consequences of a distribution to be made by the partnership.
The flexibility and favorable income tax treatment offered by limited partnerships and LLCs come with a price; namely, more complicated agreements and more complicated tax rules. Because many companies are currently taxed as partnerships, it is important for wealth advisors to understand the basic income tax concepts that apply to investors in these companies in order to explain to their clients the income tax consequences of their investments in such companies.