ELITE ADVISOR BEST PRACTICES
Comparing Taxation of Partnerships and S Corporations - Part Four
What advisors frequently overlook
By Janice Eiseman
- Partnership taxation is complex, as illustrated by the examples set forth in this article.
- To understand the complexity, it is helpful to think of the partnership as being an aggregate of partners who bring together property—the tax attributes of which remain with the contributing partners.
- The concepts of partnership taxation make the taxation of partners different from the taxation of S shareholders. Some of the differences are illustrated by examples discussed in the article.
On November 11, Ms. Eiseman will be participating in the webinar discussion “ Mastering Tax Complexities in the Sale of Partnership and LLC Interests” (CPE, CLE, CFP credit available).
She is happy to answer your questions at firstname.lastname@example.org
In my prior articles about the income taxation of partnerships, I gave an overview of partnership taxation, then explored the “outside basis” and the “inside basis” of your client’s partnership interests. Here we’ll discuss in detail some of the ways in which partners are taxed and contrast those with how shareholders of S corporations are taxed. As you know, both partnerships and S corporations are tax efficient because there is no income tax at the partnership level or at the S corporation level. Consequently, you may think that the taxation of S shareholders and partners is similar. However, that is not always the case.
Built-in gain or built-in loss property
Let’s start with a simple example. Say your client contributed appreciated stock with a cost basis of $100 and a fair market value of $1,000 at the time it was contributed to the partnership. Now say the partnership sells the stock for $1,500. Is the taxable gain of $1,400 allocated among the partners based upon their percentage interest in profit? The answer is no. The built-in gain of $900, or the gain inherent in the stock at the date of its contribution, must be allocated for tax purposes to your client. The appreciation in the stock after its contribution, $500, will be allocated for tax purposes among the partners based upon either their profits interest or some specific provision set forth in the partnership agreement.
Partnership tax law does not allow partners to shift built-in gain among themselves. Similarly, partnership tax law does not allow partners to shift built-in loss among themselves. Say the stock had a tax basis of $1,000 and a fair market value of $500 at date of contribution, and the stock was sold for $300 by the partnership. Of the $700 of tax loss recognized by the partnership, $500 of tax loss in the stock must be allocated to the contributing partner. Because of these partnership tax rules, when a partner contributes property to a partnership that has a fair market value at the date of its contribution that differs from its tax basis, the partnership must keep track of this difference. This requirement adds to the complexity of partnership taxation.
By contrast, under S corporation rules, property contributed to an S corporation by a shareholder with built-in gain or built-in loss does not cause special gain or loss to be recognized by the contributing shareholder. The corporation’s gain or loss is allocated among the shareholders based upon their percentages of stock ownership.
Real estate issues arising from built-in gain or built-in loss property
Because real estate has historically been held by entities that are taxed as partnerships, let’s discuss a real estate situation to illustrate how careful you must be when advising your clients about investing in partnerships. Let’s say your client wants to invest $1.95 million of cash in a partnership for a 25 percent interest in profits and losses. Another individual will also contribute $1.95 million of cash for a 25 percent interest, and a third person will contribute an office building with a fair market value of $3.9 million and a tax basis of only $390,000 for a 50 percent interest. As we discussed above, the partnership must keep track of the book account of the building, which is the building’s fair market value at date of contribution ($3.9 million) and the tax basis of the building ($390,000). As we also discussed above, if the partnership sells the building for $4 million, the contributing partner will have to pay gain on the built-in gain in the building at the time of its contribution to the partnership. Thus, the contributing partner will have gain of $3.51 million ($3.9 million less $390,000), and your client will have gain equal to 25 percent of the $100,000 of appreciation in the building since its contribution, or $25,000.
This is a very favorable tax consequence to your client because none of the built-in gain will be allocated to him or her. Note, however, that if your client is buying a partnership interest, he or she must be aware of the tax issues attached to the partnership interest. For instance, if your client bought the 50 percent partnership interest, he or she would succeed to the built-in gain in the building, which would be taxed to him or her when the partnership sells the building, unless the partnership has made an election, which allows your client to take into account the built-in gain based upon the price paid for the partnership interest.
As pointed out above, if the appreciated building were held by an S corporation, there would be no separate accounting of the gain to the S shareholder who contributed the property. The gain would be shared among the three shareholders based upon their respective percentage interests. Similarly, there is no election under the S corporation rules, which would allow a purchasing shareholder to account for appreciation in the building.
Assume that the remaining annual tax depreciation in the building equals $10,000. An S corporation would also have tax depreciation of $10,000. However, under the traditional method, partnership tax law requires that all of the tax depreciation must be allocated equally to the cash partners ($5,000 to each), and the partner contributing the building will get no tax depreciation allocated to him. The partnership tax law, however, does allow the partners to change the amount of tax depreciation by stating in the partnership agreement that the cash contributing partners will be allocated tax depreciation equal to the book depreciation allocated to them, provided the contributing partner picks up an equal amount of remedial income to offset the added depreciation. To compute book depreciation for this purpose, the tax depreciation of $10,000 is added to the excess of book over tax ($3.51 million) divided by 39 years of straight-line depreciation, which is $90,000, to give total book depreciation of $100,000. The cash contributing partners would each be allocated $25,000 of book depreciation, $20,000 of which is from a remedial allocation. The contributing partner would have to pick up $40,000 of additional income. There is no parallel concept in the S corporation world; that is, depreciation is determined at the corporate level, and different amounts are not allocated to shareholders based upon what the shareholders contributed to the corporation. The chart below illustrates this example of depreciation under both the traditional method and the remedial allocation method:
Even though this example illustrates complexities caused by partnerships, there are very favorable outcomes in the partnership tax world. For example, the building can be distributed to its partners without any income tax consequence. On the other hand, the distribution of the building by an S corporation to its shareholders would generate gain equal to the amount of the difference between its fair market value and its tax basis at the time of distribution to its shareholders.
There will be a “constructive termination” of the partnership if, within a 12-month period, there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits. The tax year of the partnership will end, and two partnership tax returns will need to be filed. In addition, elections made by the partnership will end. The “new partnership” will be required to restart depreciation of its property. This means that the depreciation on the building in the above example will be calculated using 39 years rather than the number of years remaining in the depreciation schedule prior to the constructive termination of the partnership. There is no concept of constructive termination in the S corporation world.
The point of this discussion is to show that partnership taxation often views a partnership as an aggregate of people joined together to make a profit, and the partnership itself is not viewed as a separate entity. Another way of thinking about partnership taxation is that the partnership has a porous boundary. The tax attributes of property contributed to a partnership remain with the contributing partner. This is in contrast to the taxation of shareholders of an S corporation. The S corporation inherits the tax basis of property contributed to the corporation by its shareholders, but other attributes of the contributed property do not remain with the shareholder. The S corporation boundary is not as porous as that of a partnership.