U.S. Federal Partnership Tax Law Quiz

Answer: Subchapter K

The Internal Revenue Code (often referred to by tax professionals as "the Code") governs tax law in the U.S. The statute is codified in Title 26 of the U.S. Code. The Code is rather comprehensive; it has sections on income tax, deductions, compensation, accounting methods, banking, trusts, and many other topics. The subchapter that applies to Partners and Partnerships is Subchapter K, and its sections are identified by the number 700. This means that whenever you see a section number like 701, 721, or 761, you know that it concerns partnerships and that such a section is contained in Subchapter K.

The partnership is just one of the many business entities that one can create in the U.S., which is why the Code also covers other organizations. C Corporations (which are the typical corporations) are covered by Subchapter C, and S Corporations (a special type of corporation that is different from C corporations) are covered by Subchapter S.

Answer: A syndicate, group, pool, joint venture or other unincorporated organization

Section 761 of the Code provides helpful definitions that one must know in the world of federal income taxation. Though it may be intuitive, a partnership must have at least two members, and it cannot also be, per the Code, "a corporation or a trust or estate". The definition is somewhat broad and that is perhaps the goal, given that the formation of partnerships usually offers much more flexibility than that of regular corporations. The definition also requires the group or syndicate (or one of the other allowable variations) to be involved in a business or financial activity.

As redundant as it may seem, this section also defines the term "partner" as "a member of a partnership".

Answer: Partner

If you remember only one thing about U.S. federal taxation of partnerships, or from this quiz as a whole, this should probably be it: according to section 701 of the Code, a partnership (that is, the business entity) is *never* subject to any federal income taxes as outlined in the Code.

This is because the individual partners are the ones who pay taxes on their partnership income or losses. This concept is different from corporations, for example, for which the Code imposes a double tax: both the corporation and the shareholder pay taxes on their earnings. Because of this difference, incorporating as a partnership is sometimes more attractive to investors or entrepreneurs (at least for tax reasons).

Answer: True

This is another crucial concept to understand when dealing with partnerships and how they are taxed. One might think that when a partner receives a distribution, they have to pay tax on it just as if a corporate shareholder received a distribution. However, this is not the case: partners are taxed on their distributive share regardless of whether they actually receive any money as individuals. In other words, a partner whose distributive share is $100 but receives $0 in distributions still has to report and pay tax on the full $100.

Why is this the case? Think about what would happen if the rule was that partners were taxed on distributions. Would any partnership distribute money at all? Probably not, because the partners would probably prefer to concentrate the money inside the entity to keep it tax-free. Each partner's distributive share is determined by the partnership agreement.

Answer: Educational expenses

Section 702 is titled "Income and credits of partner" and provides a list of items that each individual partner must consider to determine their distributive share. The list, found in 702(a), includes short-term and long-term capital gain, what is known as "1231 property" (a special type of depreciable property that is usually advantageous to the taxpayer), and charitable contributions. The list does not include, however, educational expenses.

Section 702 also specifies that character flows through each item. For example, if a partner's distributive share of long-term capital gain was $5 but that same person had a long-term capital loss of $5 in an unrelated investment, the partner could use his or her proportionate share to "wipe out" the gains from the partnership, and therefore avoid being taxed on those $5.

Answer: $50,000

Remember: partners pay taxes on their distributive share, NOT on distributions. In this case, this partnership had only two members and their partnership agreement stated that each held a 50% interest in the entity. That means that their distributive share will amount to 50% of the partnership's gains or losses. Because they made a $100,000 profit, each partner has to report their respective 50% of that amount, which is $50,000.

The fact that they distributed money (or even if they hadn't done so) is irrelevant.

Answer: Inside Basis

One of the essential concepts of U.S. tax law is "basis" or "cost basis", which typically means the original cost of a certain asset. For example, if an individual purchased a car for $20,000 and then sold it for $50,000, that person's cost basis in the car would be $20,000 because that was the initial capital investment. However, basis can change depending on depreciation, amortization, or other events. This is why it is referred to as the "adjusted basis".

In the context of partnerships, there are two categories of adjusted basis: the outside basis (which is the individual partner's basis) and the inside basis (the partnership's basis on its assets). Both are important to calculate taxes, though the outside basis normally gets more attention because it is what ultimately determines a partner's interest.

Answer: Increase

According to section 722, a contributing partner's adjusted basis (or "outside basis") equals the amount of money contributed to the partnership plus the adjusted basis of any non-money property (for example, a machine or a building) contributed to the partnership. Essentially, the adjusted basis calculation is trying to make sure that partners are paying the correct amount of tax or deducting the appropriate amount of losses.

A partner's outside basis is increased by contributions and distributive shares of profit but decreased by distributions and distributive shares of losses.

Answer: 1065

An individual taxpayer in the U.S. will typically complete a Form 1040 to declare all of their income and losses and therefore determine how much tax they owe (or whether they are due a refund). A partnership is required to complete Form 1065 to report all relevant items, such as income, losses, and credits. The partnership also distributes what is known as a Schedule K-1 to each individual partner, so they can use that information to complete their individual tax returns (usually in a Form 1040).

Ferdinand I of Leon was the King of Leon between the years 1037 and 1065, when he died due to an illness.

Answer: Capital accounts

The substantial economic effect basically requires that an allocation of an economic benefit or burden matches the receipt or payment of actual money. In other words, if a partner reports a gain of $10 on his or her tax return, that partner logically must at some point receive that $10 for which he or she was already taxed. One of the requirements that must be satisfied to fulfil the substantial economic effect test, per section 704 and the relevant regulations in the Code, is that the partnership maintain capital accounts for each partner.

A capital account is calculated by adding money contributions, the fair market value of property contributions, and the distributive share of profits, and then subtracting money distributions, the fair market value of property distributions, and the distributive share of losses. The capital account may sometimes match the outside basis, but they will not always be equal.