Partnership - Audit Technique Guide - Overview (Published 12-2002)
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
Each chapter in this Audit Techniques Guide (ATG) can be printed individually. Please follow the links at the beginning or end of this chapter to either return to the Table of Contents or proceed to the next chapter.
Overview - Table of Contents
back to the top
This Market Segment Specialization Program (MSSP) Guide is designed to assist examiners in classifying and examining partnership returns. The focus is on issues that fall within sections 701 through 761 of the Code (Subchapter K). Subchapter K deals primarily with the formation, operation, and termination of partnerships. Many issues arise during the initial or final year of the partnership.
If your return relates to an operating business (as opposed to rentals), you should also look for an MSSP Guide for that type of business.
The Tax Equity and Fiscal Responsibility Act of 1982 created the “TEFRA Entity.” Returns qualifying as TEFRA Partnerships and their partners are subject to these “unified procedures” which are contained in IRC sections 6221 6234. The procedures are briefly explained in Chapter 13.
back to the top
IRC section 761(a) defines a partnership as any organization through or by means of which any business, financial operation, or venture is carried on which is not a corporation, trust or estate.
A partnership is formed when two or more “persons” agree to carry on a joint venture. A written agreement, although preferred, is not required. State law now generally requires that a partnership have a written agreement. Partnership agreements should cover initial capital contributions, required services, life of the partnership and other important items. Such agreements must always be inspected when examining a partnership return.
Pre-opening expenses must be capitalized just as with any other business. In addition, certain expenses of organizing the partnership must also be capitalized (see Initial Year Return Issues, Chapter 1).
Where a partnership is engaged in an investment activity (not a trade or business), or where used for the joint extraction, production or use of property, a partnership can elect out of the provisions of Subchapter K. For example, if two brothers own a parcel of land and farm it, it is a partnership; if they each take their share of the crop, and expenses, they can elect out of Subchapter K.
back to the top
Partnerships, like corporations, are creatures of the State, whose laws provide for their creation, operation and liquidation. Initially, all partnerships were “General Partnerships” where each and every partner was jointly and severally liable for all partnership debts. For example, Lloyds of London is a group of syndicates engaged in the insurance business. Recently, many of the investors were surprised to discover that they were general partners subject to liabilities from claims of environmental damages and the like.
Because of the dangers of unlimited liability, it became difficult to find investors for joint ventures. This resulted in the creation of Limited Partnerships under state statutes where a class of partners who were not active in the business but were merely investors, could receive limited liability for partnership debts and actions. Under these Uniform Partnership laws, professionals could not be limited partners since they were “active” in the business. This meant that partners engaged in law, medicine, or accounting could not have limited liability and each partner was jointly and severally liable for the errors, omissions, and malpractice of any partner. As a result of pressure from these groups, states enacted statutes to provide for Limited Liability Company’s (LLC’s) and Limited Liability Partnerships (LLP’s). Using these entities, professional partners can now use a partnership form and not be liable for the “sins” of other partners; they would still be completely liable for their own malpractice. As a result of these state law changes, the Service issued regulations providing that these entities would be taxed as partnerships unless they elected to be taxed as a corporation by checking a box on Form 8832 and attaching it to their initial return (the “Check-the-Box Regulations”). These entities are partnerships for tax purposes, but see Self-Employment Tax in Chapter 12.
Note that a single member LLC is generally a sole proprietorship if the member is an individual. In the case of a corporation or partnership owning a single member LLC, the LLC is considered a “Division” and is not required to file a return if the income and expenses are reported on the return of the member.
During the operating years of a partnership, the tax issues are generally the same as a corporation or sole proprietorship. The amount of income determined at the partnership level and allocated to the partners according to the partnership agreement must be reported whether or not there are any cash distributions. Income allocated disproportionately among the partners may be adjusted on examination if the allocation was done solely for tax purposes and does not reflect economic reality. Partnership losses are passed through to partners, whether general or limited partners, and are allowed to the extent of the partner’s basis in their partnership interest. It is important to remember that a partner’s share of liabilities is included in the calculation of their basis in their partnership interest. When inspecting a partner’s Schedule K-1, it may be disconcerting to see that the partner has a negative capital account; that is, the partner has deducted losses in excess of their cash investment. This occurs because the capital account does not include the partner’s share of liabilities. If the amount of liabilities allocated to the partner (shown on Schedule K-1 just above the ending capital account) is not greater than the capital account, the partner’s losses should be limited. In addition to basis limitations, partnership losses are subject to limitations for “at-risk” basis and passive losses. See Loss Limitations.
back to the top
Care must be taken to ensure that any negative capital account is reported in income in the year of liquidation. Although partners are happy to include liabilities in basis during the operating years in order to deduct losses, they frequently forget to include those liabilities in the amount realized on the disposition of their interest. Since the partner is “deemed” to be relieved of liabilities on the disposition of his partnership interest, even a gift or charitable contribution of a partnership interest will result in a gain where the capital account was negative. Sometimes the final partnership return will show that some partners have negative capital accounts and others are positive- the total of the ending capital accounts being zero. The regulations require that final year income be allocated to those with negative capital accounts until they reach zero such that all ending capital accounts are zero.
There is a basic tension between the “Entity” and “Aggregate” Theories of partnership accounting for tax purposes. Under the Entity Theory, the amount and character of partnership income is determined at the partnership level as though it was an entity separate from its partners. This includes elections such as accounting method and other initial year elections. According to the Aggregate Theory, each partner is treated as the owner of a direct and undivided interest in partnership assets, liabilities and operations. Tax is actually paid at the partner level. For tax rules that provide separate elections or limitations, such as IRC section 108 cancellation of debt (COD) income exclusions, itemized deductions, and tax preferences, partners are treated as a group of individual sole proprietorships.
The Service and the Courts have struggled at times to try to determine which concept should apply in different circumstances. Many tax shelters, including Abusive Corporate Tax Shelters rely on the Entity Theory to determine the character or allocation of income; they use (or abuse) subchapter K to achieve a result that could not occur without a partnership cloak. If you believe the partnership you are examining is a tax shelter carefully review the Tax Shelter chapter.
Another example of these separate approaches is IRC section 179, depreciation; Congress specified that the $17,500 limitation would apply at the partnership level (Entity) and that the partner would also be subject separately to the limitation (Aggregate). That is, the partner’s share from the partnership would be added to any IRC section 179 depreciation the partner had from other businesses in computing the limitation, even though it had already been limited at the partnership level.
With increased filings of partnership returns, this area of tax law has taken on increased importance. Although this guide is not all-inclusive, we hope that it will serve the needs of the examiners in the field.back to the top