Taxation Essentials of LLCs and Partnerships. Larry Tunnell
it to the partnership. Likewise, if the partnership sells the property contributed by Jamie for its $50,000 fair market value, it will also recognize a $22,000 gain. Therefore, transfer of the property to the partnership does not change the tax consequences associated with a later sale of the property or of the partnership interest received in exchange for the property.
Partnership operations
Measuring and reporting partnership income
Although partnership income is taxed at the partner level, it must be measured and reported by the partnership. The partnership files an annual tax return, Form 1065, with the IRS. Attached to the return is a Schedule K-1 for each partner in the partnership, reporting that partner's share of each item of partnership income or loss. Two copies of each Schedule K-1 are filed—one with the IRS and one with the partner. The K-1 identifies the partner, his or her social security number (or other identification number), and his or her address, along with such partner's share of partnership items of income, loss, gain, deduction and other information (for example, alternative minimum tax preferences, and the like). The partners then include their shares of each item of partnership taxable income, as reported to them on Schedule K-1, on their individual tax returns. They pay tax on their shares of partnership taxable income whether or not those shares are distributed to them during the year.
The computation of partnership taxable income is complicated by the need to ensure that all items of partnership income are treated the same on the partners' returns as if those items had been earned or incurred by the partners directly rather than through the partnership. For example, for individuals, the deduction for net capital losses is limited to $3,000 per year. This limitation applies both to net capital losses incurred directly and those incurred by partnerships and allocated to the individual partners.
Lucy and Ethel are equal 50% partners in the LE Partnership. This year, Lucy incurred net capital losses of ($2,000) from the sale of stock (outside the partnership). Ethel realized a net capital gain of $4,500. In addition, the LE Partnership incurred a net capital loss of ($10,000). Lucy's share of this loss is ($5,000), as is Ethel's. On their individual tax returns, however, Lucy will be able to deduct only ($1,000) of her share of this loss because she already had ($2,000) of net capital losses before considering her share of the partnership loss. Individuals are not allowed to carry net capital losses back but may carry them forward indefinitely. Therefore, Lucy will carry the remaining ($4,000) net capital loss forward to next year. Ethel, on the other hand, can deduct her entire ($5,000) share of the partnership's net capital loss. When added to her net capital gains of $4,500 generated outside the partnership, Ethel's total net capital loss is only ($500), well within the ($3,000) annual limit.
There are many items of income, gain, loss, or deduction that may be subject to similar limitations or special treatment on the partners' individual tax returns. For example, charitable contributions are subject to limitations on the returns of individuals and corporations. Similarly, the Section 179 deduction available to individuals is subject to annual limitations. Losses from rental real estate are subject to the passive loss rules. To allow these limitations to be applied properly on the partners' tax returns, each partner's share of these items must be reported separately from other partnership taxable income.
Knowledge check
1 J.D. Rackmore received a Schedule K-1 from a partnership reporting the following items of income, gain, loss, and deduction for the current year:
| Share of partnership ordinary income | $ 4,500 |
| Capital gains (net) | 1,500 |
| Interest income | 700 |
| Charitable contributions | (1,000) |
J.D., who does not itemize deductions, has no other investments in partnerships or other pass- through entities. By how much will her investment in this partnership increase her taxable income for the current year?
$4,500.$6,000.$6,700.$5,700.
Other items may allow the partners to use a greater portion of expenses or losses incurred outside the partnership when preparing their tax returns. A partner with capital losses outside the partnership, for example, may be allowed to deduct some or all of these losses against his or her share of partnership capital gains. Partners with “excess” investment interest expense may be able to deduct some of this interest against investment income allocated from the partnership. Passive losses incurred outside the partnership may be deductible against passive income reported by the partnership. For corporate partners (that is, partners who are corporations), the dividends-received deduction may be increased by a portion of dividends received through the partnership.
Reflecting the numerous special provisions which must be considered when preparing the partners' individual tax returns, partnership income is reported to the partners in pieces, rather than as a single number labeled “partnership taxable income.” In essence, the partnership's taxable income is reported in three parts. The front page of Form 1065 reports those items of income and deduction that are not subject to special treatment on any partner's tax return. These items result in net partnership “ordinary business income (loss).” Note that although all of the items that make up partnership ordinary business income are ordinary (otherwise they would be subject to special treatment by the partners), there are some ordinary income items, such as interest income, which are specially treated and therefore not included in partnership “ordinary business income.” On page 4 of Form 1065 is Schedule K, which reports to the IRS both net partnership ordinary business income or loss (from page 1 of Form 1065), and the totals of each item of income, gain, loss, deduction, credit, and the like, which may be subject to special treatment on one or more of the partners' tax returns. Therefore, the partnership's actual total net income or loss is derived from Schedule K, rather than from page 1 of the Form 1065.
Finally, each line item on Schedule K is divided among the partners and reported to those partners on Schedule K-1s. Each partner receives a copy of his or her Schedule K-1 (an additional copy is attached to partnership tax return filed with the IRS) reporting his or her share of each of these items (net ordinary business income and each other item which may be subject to special treatment). From the K-1, each partner then determines how partnership activities affect his or her individual taxable income.
The JD Partnership reported the following items of income, gain, loss, and deduction for the current year:
| Sales | $450,000 |
| Cost of goods sold | (150,000) |
| Gross profit | $300,000 |
| Long-term capital gains (net) | 15,000 |
| Interest income | 7,000 |
| Salaries paid to employees | (50,000) |
| Depreciation expense | (25,000) |
| Taxes (payroll and property taxes paid to the state) | (18,000) |
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