Chapter 20

Forming and Operating Partnerships

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Learning Objectives
1.

2.

3.
4.

5.
6.

Determine whether a flow-through entity is taxed as a

partnership or S corporation, and distinguish the entity approach
from the aggregate approach for taxing partnerships
Resolve tax issues applicable to partnership formations and
other acquisitions of partnership interests, including gain
recognition to partners and tax basis for partners and
partnerships
Determine the appropriate accounting periods and methods for
partnerships
Calculate and characterize a partnerships ordinary business
income or loss and its separately stated items, and demonstrate
how to report these items to partners
Explain the implications of a partners tax basis and the
adjustments that affect it
Apply the basis, at-risk, and passive activity loss limits to losses
from partnerships
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Flow-Through Entities

Income earned by flow-through entities is not

taxed at the entity level
Owners of flow-through entities are taxed on
the entity-level share of income allocated to
them
Income from flow-through entities is taxed only
once when it flows through to owners of
these entities

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Aggregate VS Entity Concepts

Entity approach

Treats tax partnerships as entities separate from their partners

Partnerships, rather than partners, making most tax elections
represents the entity concept

Aggregate approach
Treats

tax partnerships as an aggregation of partners separate

interests in the assets and liabilities of the partnership
Partnerships dont pay taxes and partners pay taxes - reflects the
aggregate approach

20-4

Partnership Formations and

Acquisitions of Partnership Interests

Acquiring partnership interests when partnerships are

formed
Partnership interest
When a partnership is formed, partners may transfer
cash, other tangible or intangible property, and services
to it in exchange for an equity interest
Partnership rights
Right to receive a share in the partnership assets if the
partnership were to liquidate, called a capital interest
Right or obligation to receive a share of future profits or
future losses, called a profits interest

20-5

Partnership Formations
Contributions

of Property (when partnership

does not assume debt)
Include

both cash and non-cash property, but not

services
GR: neither partners nor partnerships recognize
gains or losses when they contribute property to the
partnership
When

FMV of property>A/B property, built-in gains

When FMV of property<A/B property, built-in losses

20-6

Example 20-1 (calculate gain or loss

for each situation)
Assume Nicole contributes land to CCS with a fair
market value of $120,000 and an adjusted basis of
$20,000.

No gain is recognized. Built-in gain=FMVA/B=120,000 20,000 = 100,000.

Suppose Chanzz Inc. contributed equipment with a

fair market value of $120,000 and a tax basis of
$220,000 to CCS.

No loss is recognized. Built-in loss=FMV A/B =

120,000 220,000 = 100,000.

20-7

Partnership Formations
Contributions of Property (when partnership does not
assume debt)
Partners tax basis

Outside basis: partners tax basis in the partnership interest

Inside basis: partners basis in the partnerships assets (chapter 21)

Partners initial tax basis (outside basis after formation)

The initial tax basis is determined after cash and
property is contributed
Required to compute partners taxable gains and losses
when they sell their partnership interests
Partners initial tax basis when partnership doesn't have
any debt = tax basis of property + cash contributed by
partners
20-8

Partnership Formations

Contributions of Property (when partnership assumes debt)

Recourse debt

Debts for which partners have economic risk of loss.

Partners might satisfy the debt with their own funds.
Usually allocated to the partners who will ultimately be
responsible for paying it

Nonrecourse debt

Does not provide the legal recourse against partners.

Usually allocated according to partners profit-sharing
ratios

20-9

Partnership Formations

Calculate partners initial basis when partnership assumes the debt

secured by property that partners contribute to the partnership

First increase partners basis by debt assumed and then decrease

contributing partners basis by debt assumed (debt relief)

Step one: attribute recourse debt to the partners providing personal

guarantees and increase their initial basis
Step two: To the extent that nonrecourse debt is less than the basis
of property, allocate among partners based on profit-sharing ratios
and increase individual initial basis accordingly
Step three: for nonrecourse debt in excess of the basis of the
property, increase initial basis of contributing partner by the excess
amount

20-10

Partnership Formations

Step four: subtract contributing partners initial basis by

the amount of debt secured by the property and
assumed by the partnership (debt relief)
If the result is positive, the result is the contributing
partners initial basis.
If the result is negative (debt relief in excess of
contributing partners basis), recognize capital gains
for contributing partners.
Debt relief is equivalent to cash distribution from
partnership, reducing partners basis

20-11

Adapted Example 20-3/4

CCS borrowed $60,000 from a bank when CCS was
formed. The bank required Nicole, Sarah, and Chanzz Inc.
to personally guarantee the bank loan (one-third each).
Nicole actually contributed $10,000 of cash and land with a
fair market value of $150,000 and adjusted basis of
$20,000 to CCS when it was formed. The land was
encumbered by a $40,000 nonrecourse mortgage executed
three years before. The partners share profits equally. What
tax bases do Nicole, Sarah, and Chanzz Inc. initially have
in their CCS interests?

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Example 20-5
Nicole contributed $10,000 of cash and land with a
fair market value of $150,000 and adjusted basis of
$20,000 to CCS when it was formed. The land was
encumbered by a $40,000 mortgage executed
three years before. Assume Sarah and Chanzz
Inc., but not Nicole, personally guarantee all
$100,000 of CCS's debt ($60,000 bank loan +
$40,000 mortgage on land). How much gain, if any,
would Nicole recognize on her contribution to CCS
and what would be the basis in her CCS interest?
20-13

Example
Troy, Peter, and Sarah formed Picture Perfect general
partnership. When it was formed, the partners received equal
profits and capital interests and the following items were
contributed by each partner. Calculate tax basis for Troy and
Peter
Troy - cash of $3,000, inventory with a FMV and tax basis of
$5,000, and a building with a FMV of $22,000 and adjusted
basis of $10,000. Additionally, the building was secured by a
$10,000 nonrecourse mortgage.
Peter - cash of $5,000, accounts payable of $12,000
(recourse debt for which each partner becomes equally
responsible), and land with a FMV of $27,000 and tax basis of
$20,000.
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Partnership Formations
Contribution

of Services

Capital

intereststhe right to share partnerships

capital if it liquidates

Service partners receiving capital interests report ordinary

income
Service partners tax basis in the capital interest = amount
of ordinary income he/she recognizes

Profits interestsonly the economic right to share

future profits of partnership

No liquidation value to receive

Service partner will not recognize income and non-service
partners will not receive deductions

20-15