The chapter of Internal Revenue Code defines partnership as an association formed by two or more persons who perform trade or business together. Each group is expected to contribute equal capital, labor skills and any other required resource with the expectation of getting share profits or share benefits. There are different types of partnerships including the general partnership, a limited partnership among other types. The partnership is subjected to various tax regulations including the "Check-the-Box" regulations. It allows most unincorporated business entities including various kinds of partnerships to choose the federal tax status. The goal of the paper is to explore different key concepts in partners' liquidating taxation.
Partnerships are not taxable entities. The profit or the gains made the whole partnership cannot be subjected to tax. Rather, the partnerships individual flows are the ones that are taxable in the case of a partnership. The taxation is usually done at the end of the year or the agreed period. The partners report their gains or the allocable share, and they are taxed independently. It is correct to say that the partnership itself pays no federal tax to the government. Instead, the tax liabilities are levied on the partners that are usually affected by the partner's activities throughout the taxation year. There are different concepts in the taxation of partnerships. The taxation can be traced using the legal concepts, the aggregate theory, and the entity concept.
In the conduit theory, the entity is treated as a channel through which all the components flow in the partnership. The deduction, incomes, and the credit flow to the individual partners through the channel. Hoffman et al. (2007) define the partnership as a combination of different taxpayers who are distinct and have combined to carry out the transactions with the partnership.
The other important concept is an entity. Under this concept, the partners, and the partnership is expressed as independent units. It gives the partnership its tax known as personality tax. It requires the partnership to file a tax information return that treats the partnership as distinct and different from the entity through which it makes transactions. In some cases, the two concepts can be combined during taxation. Under the combined model, there are drafted rules that govern the liquidation, formation and operation that is a blend of aggregate and entity concepts.
The partner’s ownership and the allocation are separately stated. On the same concept of aggregate concept, the separate partner owns both profit interest and capital interest in the entity. The capital ownership is gauged by the calculation of capital sharing ratio. It is the percentage of the property of the capital to the whole amount of the capital present in the partnership. On the other hand, the profit interest is the percentage of the partner’s allocation of the profit or the loss realized. The sharing ratios are usually agreed during the formation of the partnership. They agree on the partner’s taxable income or loss and the separately stated items. In some cases, the agreement can form special allocation but only under specified items. The special allocations are only recognized in the event of taxation under a condition that it does not have an economic consequence to the partners who are receiving the share.
Besides, there is another concept of inside and outside bias. The inside bias means the tax is adjusted for each partnership’s tax based on the owned assets. Besides, outside basis is the representation of the partner’s interest in the entity and in most cases the inside basis equals o the outside basis. When items flow in the partnership the basis increases and when deductions are made on the items the basis decreases. There is a need for adjustment of the items to ensure that the items are taxed only once. To maintain entity principle, it is important for the firm to make an information return form. The form usually accumulates all the information related to the operations and all the separate stated items. Partners use the Schedule K-1 return which is use to show the partner’s share item. Using the Schedule K-1, each partner prepares a tax return (Willis, Hoffman, Maloney, & Raabe, 2007).
It is essential to understand the tax effects in the formation of the partnership. During the formation of the entity, the partners contribute cash and other properties that earn the associate a partnership interest. The Congress removed the tax on the partnerships as the entity so that it could be tax-neutral. It encouraged the partners to form partnerships without facing barring tax consequences. In the contribution of the partnership, there is the application of the gain or loss recognition under the general rule 721. In summary, it states “neither the partner nor the partnership recognizes any realized gain or loss that arises when a partner contributes property to a partnership”. It is applied when the contribution is made with an exchange of interest in the partnership are when the interest arises at a future date.
There are two reasons why there is gain or loss recognition. Firstly, the formation of partnership allows the investors to combine the effort and asset for larger economic goals that it would be if the partners invested independently. Therefore, the ownership of the assets is the only one that changes and not the amount owned. The second reason is that the asset is non-liquid, and thus he may not have enough cash to pay the tax. There are certain exceptions to Rule 721 application.
In some cases, the non-recognition rule does not apply, and they include the appreciation of the stocks. Also, the securities contributed to partnership do not recognize rule 721. Besides, in the taxable exchange of the property and the disguised sale of property the rule does not apply too. Finally, if the partnerships interest was received in exchange for the services performed, to the entity by a partner.
The other issue in the partnership taxation is the tax accounting elections. There are numerous elections made in a newly formed partnership, which is the formal decision on how the a particular transaction should be made. The elections are usually made by the partnership rather that the partners. Some of the decisions made include the selection of the taxable year, the accounting method, the treatment of startup and organizational expenditures. Upon the agreement of the accounting elections, each member is bound by these decisions. However, there are exceptions to this general rule, in which the partners are required to make an individual election for the some tax issues.
The other issue in the partnership taxation is the tax accounting elections. There are numerous elections made in a newly formed partnership, which is the formal decision on how the a particular transaction should be made. The elections are usually made by the partnership rather that the partners. Some of the decisions made include the selection of the taxable year, the accounting method, the treatment of startup and organizational expenditures. Upon the agreement of the accounting elections, each member is bound by these decisions. However, there are exceptions to this general rule, in which the partners are required to make an individual election for the some tax issues. One of the decisions is whether to take into account the taxes and the deduction paid to the foreign countries outside the United States. Again, it is the decision of the particular partner whether to reduce the basis of depreciable property.
Distributions from the partnership reflect the aggregate concept. It holds that a partner a certain share of the entity’s is underlying assets. A cash withdrawal paid to the partner usually reduces the partner's outside basis. In general, distributions are payments made by the partnership to the partner. The amount that is treated as contributions falls under two categories, and they can either be liquidating or non-liquidating. Liquidating distribution occurs when the partnership itself distributes all the properties to the partners. It can occur when the partner decides to redeem all the interests from the partnership. On the other hand, non-liquidating distribution occurs when there is a distribution from the continuing partner.
Liquidating distribution can be either proportionate or non-proportionate. The proportionate is the distribution, which that consist of single distributions that eventually leads to termination of the entire partners interest. In most cases, this situation occurs when the partners liquidate because the partnership is liquidating.
In summary, the partnership is not a taxable unit. Instead, the individual partners are taxed based on different concepts. The distribution, which is a payment by the partnership to the partner, can be either liquidated or non-liquidated. The liquidated distribution leads to the complete termination of the partnership. It can occur when a partner withdraws from the partnership by single deductions until the interests are exhausted or when the partner completely redeems his or interest from the partnership.
References
Willis, E., Hoffman, W., Maloney, D., & Raabe, W. (2007). West Federal Taxation 2008: Comprehensive Volume. Cengage Learning.
