Tax Treatment of Limited Partnerships

From Tax Facts Online, details how limited partners must report income, losses and deductions

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As part of AdvisorOne’s Special Report, 22 Days of Tax Planning Advice for 2012, throughout the month of March 2012, we are partnering with our Summit Business Media sister service, Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format. In the first article in the series, we looked at the tax treatment of an incentive stock option. In this article, we look at tax treatment of limited partnerships.

How do limited partners report partnership income, gains, losses, deductions, and credits?

The federal income tax laws recognize a partnership as an entity having its own taxable year (within limits) and having its own income and losses. It computes its income much as an individual does. However, once its income for its tax year is determined, the partnership does not, in general, pay taxes. Certain publicly traded partnerships and electing 1987 partnerships are nonetheless subject to tax at the entity level. An electing 1987 partnership is also subject to the “flow through” rules described below. The “flow-through” rules for electing large partnerships are somewhat different than those described here. Also, a partnership may be required to make an accelerated tax payment on behalf of the partners, if the partnership elects not to use a required taxable year.

The partnership reports its income on an information return (Form 1065). It also reports to each individual partner his share of items of partnership income, gains, losses, deductions, and credits (on Schedule K-1, Form 1065). Schedule K-1 identifies separately the partner’s share of combined net short-term capital gains and losses, combined net long-term capital gains and losses, combined net gains and losses from sales or exchanges of “IRC Section 1231 property,” miscellaneous itemized deductions, each class of charitable contributions, taxes subject to the foreign tax credit, and certain other items required by regulation to be stated separately (including: intangible drilling and development costs; any item subject to special allocation that differs from allocation of taxable partnership income or loss generally; and the partner’s share of any partnership items “which if separately taken into account by any partner would result in an income tax liability for that partner different from that which would result if the partner did not take the item into account separately”). Finally, the schedule reports the partner’s share of the partnership taxable income or loss exclusive of separately stated items.

A multi-tiered partnership may not be used to avoid the separately stated requirement. Items that might affect the tax liability of a partner owning his interest indirectly through a multi-tiered partnership arrangement retain their character while flowing through an intermediate partnership. Consequently, such items must be separately stated by each of the different tier partnerships. 

A limited partner then reports on his individual income tax return, subject to any limitations applicable to him, his distributive share of the partnership’s taxable income or loss, and separately stated items of partnership income, gain, loss, deductions, and credits. For example, he includes his share of partnership long-term and short-term capital gains and losses and “IRC Section 1231” gains and losses with his own.  A partner’s share of partnership miscellaneous itemized deductions is combined with his individual miscellaneous deductions for purposes of the 2% floor on such deductions. A partner’s share of the partnership’s investment interest expense is combined with his individual investment interest expense to determine the amount deductible as investment interest. A partner’s distributive shares of income, losses, and credits that are passive to the partner enter into the calculation of the taxpayer’s passive income and losses, and tax attributable to passive activities, to determine whether passive credits may be taken and passive losses deducted.

As a consequence of this “flow through” system of taxability, distributions he may have received during the year are not the measure of a partner’s share of partnership income for a year. A partner may have taxable income without having received a distribution. The existence of conditions upon actual or constructive receipt is irrelevant for this purpose. Similarly, he may have a deductible loss even though he received a distribution. 

As a general rule, the character of items for tax purposes is determined at the partnership level and they retain that character for a partner’s tax computations. Whether or not an activity is passive with regard to a partner is determined at the level of the partner.

Computing Partnership Income

Partnership income is computed using a cash or accrual method of accounting, whichever the partnership uses, regardless of the accounting method used by the individual partners in reporting their own incomes. However, in some cases a partnership may not use the cash method. In general, a partnership that has average gross receipts in excess of $5,000,000 and has a C corporation (other than a personal service corporation) as a partner may not use the cash method. Also, a partnership that is a “tax shelter” may not use the cash method.[12] A limited partnership is a “tax shelter” within this rule if (1) at any time interests in it have been offered for sale in any offering required to be registered with any federal or state agency having the authority to regulate the offering of securities for sale, (2) more than 35% of the losses during the taxable year are allocable to limited partners, and (3) a significant purpose of the partnership is the avoidance or evasion of federal income tax. 

Especially because items of partnership loss, deductions, and credits are “passed through” and treated as items of the individual partners, the partnership was historically the most popular form for tax shelter syndications. (These syndications have largely disappeared, however, after enactment of the passive activity loss rules.) The limited partnership was particularly popular because it offers limited liability to limited partners.

For further details and citations on this topic, we invite you to sign up for a 15-day free trial of Tax Facts Online by clicking here.

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See all six articles from Tax Facts Online, part of AdvisorOne's 22 Days of Tax Planning for 2012 Special Report.

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