Salomien is a Chartered Accountant (South Africa) and has a degree in Accounting and Auditing. She has worked in public practice for 25 years and was also responsible for training staff and clients.
The Taxation of a Partnership
A partnership is an enterprise form in which two or more persons join to operate a business, with each person contributing money, property, labor, or skill, and the partners sharing in the profits and losses of the business. A partnership is not a taxpayer in its own right, but rather acts as a flow-through entity that passes on each partner's share of its revenue, deductions, gains on losses to the relevant partner, who then includes it in their personal income tax returns.
To calculate the amount to flow through to each partner accurately, the partnership must keep its proper accounting records and is required to file an information return on Form 1065 with the Internal Revenue Service. This return includes information about the partnership's business and other income. To calculate the items on Form 1065 the partnership must apply various income tax provisions.
Partnership Elections for Federal Tax Purposes
Most of the elections that the Internal Revenue Service allows taxpayers to make must be made on a partnership level. This means that partners cannot, for example, decide to use different taxable year ends for calculating their share of the partnership income, but rather the partnership must elect a tax-year (using the guidelines issued by the IRS) and the partners must comply with that.
On the formation of the partnership, it elects:
- The tax year of the partnership
- The accounting basis of the partnership
- The treatment of organizational and startup expenditures
The partnership, and not each partner, also make various elections that are used to calculate the ordinary business revenue and separately stated items that flow through to the partners. These include:
- The partnership's depreciation method and the related estimates (like the useful lives and residual values of assets).
- Section 179 deductions for certain tangible personal property.
- Cost or percentage depletion method for natural resources, except for oil and gas wells.
- The inventory method the partnership uses, for example, FIFO, LIFO, or weighted average cost.
- Treatment of research and experimental expenditures.
- Optional basis adjustment election allowed by section 754 of the revenue code. This basis adjustment applies when a partner sells his/her interest either to another person or the partnership and the fair market values of the underlying assets differ from the tax basis in the partnership.
Partner Elections for Federal Tax Purposes
Section 703 of the Internal Revenue Code allows for three instances where each partner can individually decide on how they wish to treat an item for income tax purposes. These are:
- Discharge of indebtedness: When a creditor relieves a partnership from a debt, meaning that they do not demand repayment of the debt in full, the amount that is forgiven is included in taxable revenue. Taxpayers have the option to first reduce their basis in the related assets (in this case the partner's outside basis in the partnership), and only recognize the excess of their share of the discharged amount in the year the debt was relieved, thereby deferring payment of income tax on the discharge. Partners are allowed to exercise this option individually.
- Deduction and recapture related to oil or gas wells: Partners can individually decide whether they want to use the cost of percentage depletion method to calculate their deduction for the cost of oil and gas wells. This decision obviously influences the recapture calculations as well.
- Foreign tax deduction: When taxpayers that earn income in another country pay income tax in that country, they must include the income in gross income and can elect to treat the tax paid as either a deduction or a tax credit. Taxpayers make this election based on what will be most beneficial to them, and this depends on the taxpayer's other income and losses and their income tax rate. When a partnership has paid income tax in a foreign country, each partner can decide whether they wish to treat their share of the tax as a deduction or tax credit.
A partnership is an enterprise form in which two or more persons join to operate a business, with each person contributing money, property, labor, or skill, and the partners sharing in the profits and losses of the business. A partnership is not a taxpayer in its own right, but rather acts as a flow-through entity that passes taxable income to partners.
To calculate the amount the flow through to partners, the partnership, and not each partner, makes various selections available in the Internal Revenue Code. These include choosing the partnership's taxable year, its accounting, depreciation and inventory method, and its treatment of research and experimental expenditures.
Partners are allowed to individually make the following elections:
- Whether to reduce the basis of depreciable property first when the partnership was discharged of indebtedness
- How to calculate the income tax deduction and recapture for oil and gas wells
- Whether to take a deduction or a credit for foreign income taxes paid
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