William Lyons - Partnership Income Taxation, 5th (Concepts and Insights Series)

FIFTH EDITION

By

WILLIAM H. LYONS

Richard H. Larson Professor of Tax Law
University of Nebraska College of Law

JAMES R. REPETTI

William J. Kenealy, S.J. Professor of Law
Boston College Law School

CONCEPTS AND INSIGHTS SERIES

This publication was created to provide you with accurate and authoritative information concerning the subject matter covered; however, this publication was not necessarily prepared by persons licensed to practice law in a particular jurisdiction. The publisher is not engaged in rendering legal or other professional advice and this publication is not a substitute for the advice of an attorney. If you require legal or other expert advice, you should seek the services of a competent attorney or other professional.

Nothing contained herein is intended or written to be used for the purposes of 1) avoiding penalties imposed under the federal Internal Revenue Code, or 2) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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This book attempts the simplest possible introduction to an intricate body of law. Any simplified description of the rules of partnership taxation would be so misleading as to be useless. We have therefore tried to make the subject accessible not by paraphrasing the rules, but by including numerous illustrations that are as straightforward as possible. The text focuses on simple partnerships holding few assets and engaging in routine transactions. It places the rules in context by pointing out the purposes of the statute and regulations and presenting background information about practical matters such as how partnerships maintain capital accounts and how nonrecourse financing works. Using many examples, it then shows the operation of the rules in everyday cases encountered by practitioners.

This is not a reference book: many interesting and difficult issues have been ignored. Some matters, such as the application of 736 to noncash distributions and tiered partnerships, are not discussed at all, and some problems, like mandatory basis adjustments under 732(d), receive only passing mention. Most of the points that are dealt with are, however, discussed at considerable length. Our goal has been to give students background material and illustrations so that they can begin to understand and work with a statute that was drafted for (and by) experienced practitioners.

Most chapters end with a section comparing the tax treatment of partners with that of the shareholders of S corporations. Many students encountering partnership taxation for the first time have already studied subchapter S. We expect that an examination of some of the basic differences between subchapters S and K should help those students understand both subjects.

We thank our previous coauthor, Alan Gunn, for all of his contributions to this book. We greatly benefitted from Alans invaluable insights about partnership taxation and his good humor. He is a masterful teacher to whom we owe much. We also thank James E. Tierney and Larry D. Ward for helpful comments on previous editions.

Lastly, William Lyons gratefully acknowledges the generous support for a portion of this project provided by the McCollum Fund at the University of Nebraska College of Law and James vi Repetti gratefully acknowledges support provided by the Paulus Endowment for Tax.

The cover picture is John Tenniels drawing of the mad tea party. It seems a perfect match for a subject that has grown so intricate as to have become, in practice, almost a legal fiction.

January 2011

FIFTH EDITION

The central principle underlying the federal income taxation

To illustrate the considerations raised above, think about a laundry business conducted by Alice and Bill as equal partners. Each of them contributed equal amounts of cash, each does identical work, and each takes the same amount of money out of the business. In this very simple case, it is easy to apply the aggregate approach and tax Alice and Bill as if each were conducting half of the business: Each of them can include in income half of the income of the laundry.

Treating the partnership as an aggregate, as in the example above, is not always practical; sometimes an entity approach must be used. Suppose that the laundry building burns down, and that Alice wants to reinvest the insurance proceeds in a new building, electing nonrecognition of gain under 1033. Bill (who has a large, deductible loss from another activity) would prefer that the gain be recognized. Can both partners get the tax treatment they want? No: Section 703(b) adopts the entity approach and allows nonrecognition only if the partnership itself makes the election and replaces the building. Section 703(b), with three exceptions, provides that elections affecting the computation of partnership income must be made by the partnership, and 1033(a)(2)(A) allows nonrecognition only if the taxpayer which realized the gain (in this case, the partnership) purchases qualifying replacement property.

As a rule, the amount and character of a partnerships income are calculated using an entity approach. The income, however, is taxed to the partners, not to the entity, using the aggregate approach. For example, if a partnership realizes gain of $10,000 from the sale of an asset, the entity approach causes the character of that gain to be determined at the partnership level. The gain will be capital gain if the partnership does not hold the property for sale to customers in the ordinary course of business and the other exceptions for capital asset treatment in 1221 are inapplicable. The aggregate approach will then cause that gain to be taxable to the partners regardless of whether the gain is actually distributed to them.

Application of the aggregate method to partnership income is one of the most attractive features of partnerships because it results in a single tax being applied to partnership income. When a partnership recognizes taxable income, such income is taxed directly to the partners. The partnership, itself, does not pay a tax on its income. In addition, the subsequent distribution of that income to the partners does not usually trigger an additional tax liability because the aggregate method treats each partner as though she had directly conducted her share of the rental business and had already received her share of the income.