Unlike a corporation, a partnership is not a taxable entity. Rather, each partner is taxed directly on his or her share of partnership profits or losses. This is an advantage over operating as a corporation where profits could be taxed twice, once at the corporate level and again at the owner level when dividends are distributed to shareholders.
A new business often has losses in the early years. By operating as a partnership, you can use your share of the partnership’s losses to offset income from other sources, such as investments and compensation from employment. However, to be able to deduct losses currently, you must satisfy the so-called passive activity loss (PAL) rules. As a general rule, as long as you materially participate in the business conducted by the partnership, you will meet the PAL rules.
A partner is not considered an employee of the partnership. However, the partnership can set up a qualified retirement plan and other types of benefit plans that cover partners as well as employees.
Partners pay the equivalent of social security taxes in the form of two components of self-employment tax, which can be very steep. One component is the Social Security portion, up to $118,500 for 2015, and the Medicare portion, which has no upper limit.
One legal downside of operating as a partnership is that general partners are exposed to unlimited liability from lawsuits that arise in connection with the business even when they are based on the acts or omissions of a partner. This is to be contrasted with operating a business as a corporation where, as a general rule, only the corporation’s funds are at risk.
Fortunately, you do not have to forgo the tax advantages of operating as a partnership to limit your potential liability. You can operate as an S corporation to minimize your liability exposure and yet be taxed similarly (but not identically) to the way you would be taxed if you operated as a partnership. Another option is the limited liability company (LLC). With this choice, your liability exposure also would be reduced and you would be taxed even more like a partnership than if you operated as an S corporation. Our Manhattan CPAs can help you determine if an LLC or S-corp is a right fit for you.
Partnership Anti-Abuse Rules
Prior to issuing the final partnership anti-abuse rules, the IRS basically had said that it had the power to change legitimate partnership transactions in any way it saw fit to eliminate what it believed to be abusive uses of the partnership form. The destabilizing effect on partnership planning was made worse because the IRS gave few details. Generally, the finalized rules provide significantly more specifics and clarify the situations in which the IRS can disregard the form of the transaction. They also change the focus of their much-criticized discussion on the intent of the partnership provisions and the requirement that the tax consequences under the partnership provisions clearly reflect income.
The focus in the anti-abuse rules is on the inappropriate treatment of a partnership as an entity, and confirmation of the IRS’s authority to treat the partnership as an aggregate of its partners. It’s important to note that this does not require the IRS to look at the intent and activities of the individual partners but it can look at the aims and activities of the partnership.
The IRS examines the participants’ intent when it wants to disregard the form of a transaction, but this inquiry is now less burdensome for taxpayers. Specifically, not only must the taxpayer have a principal purpose to achieve substantial tax reduction, but the tax reduction also must be inconsistent with the intent of the partnership provisions. As a result, the IRS no longer asserts that it can recast a transaction in which a bona fide partnership conducts business activities in a tax-efficient manner that is not inconsistent with the intent of the partnership provisions.
The anti-abuse rules only apply to income taxes, not gift and estate taxes. The IRS does, of course, have other weapons at its disposal, but for the most part their effect can be predicted with more certainty.
Partnerships – Retiring Partner Distributions
In general, a retiring partner who receives a series of liquidating distributions does not recognize gain until the entire basis in the partnership interest is recovered. Similarly, a loss on a series of liquidating distributions is not recognized until the year in which the retiring partner receives the final liquidating payment.
A special choice is available, however, when a retiring partner is to receive a fixed amount of liquidating payments over a period of years. In such a case, the retiring partner may elect to report gain or loss ratably as each liquidating distribution is received. If the election is made, a proportionate share of the partner’s basis in the partner’s partnership interest is applied against each liquidating payment. The example that follows shows how a retiring partner is taxed both when the election is not made and when it is made.
Example. Jones retires from the ABC partnership. He is to receive a total of $300,000 from the partnership over three years ($90,000 in 2009, $150,000 in 2010 and $60,000 in 2011) in exchange for his interest in partnership property. His basis in his partnership interest is $180,000. Thus, 60 percent of the total ($180,000 divided by $300,000) is a return of basis and 40 percent of the total is capital gain. (Any substantially appreciated inventory would be subject to tax as ordinary income.)
As a general rule, you would not make the election and instead defer recognition of gain as long as possible. By deferring, you achieve what amounts to an interest-free loan from the government in the amount of the deferred tax. However, there are instances when it would be better to accelerate your gain. For example, if you have already realized a loss from another transaction, you might want to make the election so that you could currently make use of the loss to offset the gain.
Also, the normal deferral approach could cause a greater loss as tax breaks are reduced as adjusted gross income reaches a higher level. The election could spread out gain so as to minimize loss of these tax breaks.
What if you are being bought out at a loss? In that case, you may want to make the election to accelerate recognition of your loss so that you can more quickly use it to offset gains from other transactions.
For more information on partnerships, S-Corps or LLCs in NYC, please contact our office at your convenience.