Legal Status
Although not required to file documents to create a partnership, like a corporation, a partnership is treated as a separate legal entity. It can hold real and personal property, sue or be sued, or conduct business independently of its members. Each partner owns a partnership interest, but no partner owns a specific asset of the partnership. A general partnership does not have to file with the state, like corporations or limited partnerships do.
Although a partnership is not a taxable entity, it determines how taxable items are passed through to the shareholders. It determines such things as the character, amount, and time of income, gains or losses, deductions or credits. It decides accounting methods, depreciation methods and amortization costs. There may also be optional adjustments to the basis of partnership property or treatment as an electing large partnership.
The partnership is required to file Form 1065, U.S. Return of Partnership Income with the Internal Revenue Service each fiscal year and issue to each partner a Schedule K-1 (Form 1065) reporting the partner's share of income, gain, loss, deductions, and credits.
Partnership Basis
Partnerships are simple to form, but one of the most complex to administer. This complexity comes from keeping track of the basis of each partner's share during the life of the partnership, as the IRS has a long list of rules that governs how this is done. This is another reason why a partnership agreement should be written and a proper accounting system maintained. Anytime a partner's share of the business changes by withdrawal, death, injections of additional capital, buyouts, or dissolution - the basis need to be known to properly allocate the profits or losses.
When a group of individuals or entities form a partnership, they usually contribute money or property in exchange for a partnership interest. The partner's basis is the same as the basis of the money and/or property contributed.
There is a set of rules that determine the basis contributed, exchanged, or sold. A couple of examples include:
- If the property that a partner contributes has a liability attached to it, the basis is reduced by the amount of the liability the partner is relieved of. If the liability exceeds the basis of the partnership interest, the partner must recognize gain up to the date of the exchange; or
- If appreciated property is contributed, the partner is not required to recognize the gain on the transaction.
Because over the years, people have tried to avoid taxes by moving property in and out of partnerships, the IRS has created a complex set of rules like these to close the loopholes. It is therefore vital that a complete record of any changes in the partnership that affects partnership percentage/basis be documented and relayed to your tax advisor.