Forming and Operating Partnerships
1. [LO 1] What is a flow-through entity, and what effect does this designation have on how business entities and their owners are taxed? Flow-through entities are entities that are not taxed on the entity level; rather, these entities are taxed on the owner’s level. These types of entities conduct a regular business; however, the income earned and deductions allowed are passed to the owners of these flow-through entities, and the owners are taxed on the amount allocated to them. Thus, flow-through entities provide a way for income and deductions to be taxed only once instead of twice.
2. [LO 1] What types of business entities are taxed as flow-through entities? The two main business entities that are taxed as flow-through entities are partnerships and S corporations. Partnerships are taxed under Subchapter K and consist of general partnerships, limited partnerships, and limited liability companies (LLC). S corporations are taxed under Subchapter S. Both these types of business entities are treated as flow-through entities and are taxed accordingly.
3. [LO 1] Compare and contrast the aggregate and entity concepts for taxing partnerships and their partners. The aggregate concept treats partnerships more like a conglomeration of individual owners. Each partnership is viewed as an aggregation of the partners’ separate interests in the assets and liabilities of the partnership. For example, each partner, rather than the partnership, pays tax on their individual share of partnership income.
The entity concept treats partnerships more like a corporation. Each partnership is an entity separate from its partners. For example, the partnership decides on which tax method to use and which tax elections to make rather than the individual partners.
4. [LO 2] What is a partnership interest, and what specific economic rights or entitlements are included with it? A partnership interest is an equity interest in a partnership. This interest is created through a transfer or sale of cash, property, or services in exchange for an equity interest in the partnership. A partnership interest gives each partner certain rights or entitlements. The two main economic rights are a capital interest and profit interest in the partnership. A capital interest is the right for a partner to receive a share of the
partnership assets during liquidation. A profit interest is the right or obligation for a partner to receive a share of the future income or losses of the partnership.
5. [LO 2] What is the rationale for requiring partners to defer most gains and all losses when they contribute property to a partnership? The rationale for requiring partners to defer most gains and losses when contributing property to a partnership is twofold. First, the IRS desires that entrepreneurs have a way to start their own business without having to pay any taxes upfront. Second, the partners are considered still owning the property they have contributed to the partnership. While they don’t own the property outright, each partner has a small percentage of the property contributed in her/his partnership interest she/he exchanged for. This second reasoning helps further support the idea that partnerships follow the aggregate concept.
6. [LO 2] Under what circumstances is it possible for partners to recognize gain when contributing property to partnerships? Partners have the potential of recognizing gain on the contribution of property when the property contributed is secured by debt. In determining whether gain must be recognized, the partner must assess the cash deemed to have received from the partnership distribution compared with the tax basis of the partner’s partnership interest prior to the deemed distribution. This happens if the assumption of the partner’s liabilities is in excess of the partner’s basis of the...