Recall that the tax treatment of partnerships and partners stems
from both the aggregate and entity legal concepts.
For instance, section 701 follows
the aggregate approach by providing that a partnership is not a taxable entity.
Instead, it is treated as a conduit through which income, deductions, credits,
and other items flow through to the partners who
separately report their distributive shares of such items but,
consider a pure pass through environment where
each partner independently determines partnership income,
deductions, tax year, accounting methods,
and other tax attributes.
If left to their own devices,
the results would be pure accounting anarchy.
To minimize confusion, Congress applied
the entity concept for purposes of measuring and reporting partnership income.
Therefore, a partnership follows an informational tax return and is treated
as a separate entity for purposes of administrative and judicial procedures.
For these reasons, section 703(a) requires a partnership to determine it's
own taxable income and provides rules
designed to preserve the character of capital gains,
charitable donations, foreign taxes,
and other items that require special treatment
in the hands of partners for one reason or another.
Similarly, section 702(b) provides that
partnership items that flow through to partners are taxed,
as if such items were realized directly from
the source from which they were realized by the partnership,
or incurred in the same manner as the partnership.
So, what does all this really mean?
It means that partnerships measure and report two types of income;
Ordinary operating income and Separately Stated Items.
In the prior module, you learned that
separately stated items exists because they require special treatment.
However, in this lesson, you will learn more about specific items of income,
both separately stated and ordinary.
You will also learn about guaranteed payments paid by the partnership to a partner.
After learning these concepts,
you will apply them to Sunchaser Shakery.
Ordinary income simply consists of
income or expense items that do not need to be separately stated.
These items are reported on page one of Form
1065 and include items such as gross receipts or sales,
costs of goods sold, salaries and wages,
repairs and maintenance, interest expense, and depreciation.
Ordinary income or losses then carry to line one of
schedule K which reflects the partners' distributive share of partnership items.
Separately stated items are those with
special tax attributes that could affect different partners and different ways.
Therefore, these items cannot be combined with other income or
deductions because they require special tax treatment at the partner level.
Among the several items that pass through to
partners separately are the following examples;
rental activities, guaranteed payments,
portfolio income items such as dividends, interest, income,
and royalties, charitable contributions,
and a variety of property transaction related items.
Again, the Aggregate Legal concept is
a conceptual reason why some items are separately stated.
Ultimately, these items are special because they affect various exclusions, deductions,
and credits at the partner level and must
pass through the partnership without loss of identity,
so that the proper tax treatment for each partner can be determined.
For example, assume an individual is a partner in a partnership
that sold section 1231 assets during the tax year.
As you may recall from an introductory tax course,
gains and losses from all section 1231 assets are netted together.
Only then can the appropriate character be determined,
long term capital gain, or ordinary loss.
However, if a gain or loss on section 1231 assets was
combined with ordinary gains and losses at the partnership level,
the partner would not receive the proper tax treatment which can
be quite favorable when ordinary income passed through the partnership.
Thus, special items are separately stated as they pass through the entity.
Of the separately stated items just mentioned,
one likely stood out as unfamiliar, guaranteed payments.
A guaranteed payment is a payment to a partner of
the partnership for services rendered by the partner,
or for use of the partner's capital.
As the name suggests, these payments are fixed amounts paid to
partners regardless of the partnerships profitability during the year.
Guaranteed payments closely resemble salary payments.
Thus, many partnerships deduct them along with other salaries and wages when paid.
Although included in the ordinary business income or loss of a partnership,
guaranteed payments are separately stated to the partners that receive
them which serves as sort of a wage reporting system for the IRS.
Given their similarity to salary payments,
partners treat them as ordinary income on their tax returns.
Michael P Donohoe, PhD, CPAAssociate Professor of Accountancy and PwC Faculty Fellow
