Have you ever wanted to be able to talk like a tax lawyer? Come on, not even a little bit? Below are ten tax code sections which govern entities taxed as partnerships distilled into their most basic concepts.
For illustrative purposes throughout, let’s pretend you have a patent worth $40K that you bought for $5K. You want to contribute the patent to TechCo, LLC, an entity taxed as a partnership, in exchange for a 10% ownership interest.
1. Section 701
The partners, not the partnership, are subject to tax. That’s why it’s called a pass-thru entity. [1] Beware—this means if you become an owner of TechCo, you will owe tax based on TechCo’s earnings, regardless of whether or not TechCo distributes any money to you.
2. Section 721
You can contribute property to a partnership in exchange for equity of the partnership and not owe tax until later. “Hey, TechCo, here’s my patent. Thank you for the 10% membership interest. Uncle Sam, you get nothing.”
3. Section 704(b)
A partnership not choose willy-nilly how to allocate partnership earnings to the partners. If TechCo makes $1M this year, the profit should generally be reported as gain to partners in a way that matches their economic right to the cash on a liquidation. Or as a tax lawyer might say, the allocations must have “substantial economic effect.” So, if you own 10%, you’re likely going to have $100K in taxable income reported to you on a K-1 for that year.
4. Section 704(c)
Remember how in #2 I said you would not owe tax until later with respect to the patent’s built-in gain? Later is when TechCo sells the patent. If the partnership sells it for $40K or more, the $35K of earmarked gain will be reported as income to you at the time of your sale, as will your pro-rata share of the rest of the gain. If TechCo sells the patent for less than $40K, you still will be allocated $35K in gain, but some of the allocation will occur over time under either the traditional, curative, or remedial method.
5. Section 706(d)
If you sell your partnership interest mid-year, there are specific rules which govern how Techco should split allocations of profit or loss for the year of sale between you and the new partner.
6. Section 707
Payment by a partnership to a partner for services is referred to as a “guaranteed payment” and will cause ordinary income. These compensatory payments to partners are reported on a K-1, instead of a W-2. This means, by virtue of becoming an owner in TechCo, you suddenly are on the hook for both the employer and employee-side of Medicare and Social Security taxes. “Congrats, you’re an owner. Sorry your paycheck has gone down by 7.65%!”
7. Section 731
Have you heard the saying “It’s the allocations, not distributions that cause tax in a partnership”? That’s mostly true. But if you are distributed cash, it will cause you gain to the extent the cash exceeds your tax basis in your membership interest.
8. Section 751
Believe it or not, “hot assets” is actually a tax term. Hot assets are assets which cause ordinary income. Specifically, if TechCo has unrealized receivables or inventory (broadly defined to mean any ordinary income asset)[2], a sale of TechCo’s assets or a sale of your TechCo partnership interest will cause you a proportionate amount of ordinary income. Compare this to the corporate context where selling stock generally results entirely in capital gains.
9. Section 752
Remember how I said in #7 that a distribution of cash can cause gain? Section 752 says that for this purpose we pretend like a reduction in a partner’s obligation on partnership debt is a distribution of cash. It’s not as unfair as it sounds however, because TechCo taking out the debt in the first place would have increased your basis, so TechCo paying off some debt should only cause you gain if you used that basis to take a prior tax benefit.
10. Section 754
You may have heard folks say, “Hmm, maybe we should make a 754 election.” This has to do with increasing the basis of the partnership’s assets. It usually happens after a cash investor comes in midstream. It’s often not a big deal.
Bonus Bite
Rev. Proc. 93-27 and 2001-43: These two pieces of IRS guidance govern profits interests. A profits interest is generally any interest granted to a service provider which would result in a distribution of $0 to such service provider were the partnership liquidated immediately post-grant. Profits interests are an amazing way to get executives big grants even after TechCo has real value, because for tax purposes you get to pretend like they are worth $0 on the date of grant.[3]
Mike Baker frequently advises with respect to entities taxed as partnerships. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] Never mind that the new partnership audit rules now allow the Internal Revenue Service to collect tax at the partnership level!
[2] See Treas. Reg. 1.751-1(d)(2)(ii).
[3] Note that new Section 1061 has taken some of the fun out of profits interests that more closely resemble carried interests in a fund/portfolio setting. The new rule prevents capital gain unless the interest or assets being sold by the partnership (or possibly both) have been held more than 3 years.