Partnership Tax Terms

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In a previous post, I discussed the benefits partnership tax rules can provide a small business, most importantly the ability to avoid double taxation. In this post, I will provide a brief description of the basic tax terms associated with the partnership tax.

Allocation

Allocation refers to the amount of partnership profits and losses credited—or allocated—to partners by the partnership for tax purposes. Consequently, allocation is one of the most important partnership tax terms. Partners can be allocated specific items of gain, loss, income, or otherwise.

This does not mean that the cash or property is actually transferred—allocation is an accounting transaction only and shows what the partners would be entitled to if all the property being allocated were actually to be distributed in accordance with the partnership agreement. The partners do not actually end up owning anything new. The allocation only affects the value of each partner’s partnership interest.

Of course, the partnership can choose to make distributions to the partners, but this may be less—and sometimes significantly less—than the amount actually allocated to each partner. This is important to recognize because partners pay tax on the profits allocated to them, not on the distributions they actually receive. Therefore, partners could owe income tax for the profits of the partnership, even if they did not personally receive a penny from the partnership that year.

Basis

When a business buys a piece of property, the cost of the property generally becomes its basis for tax purposes. If the business is given a piece of property, it takes the basis of the donor. Basis is important because when the business sells the property, the gain realized for tax purposes is determined by subtracting the basis from what the business received for the property.

Many things—including depreciation—can affect the basis in a piece of property, but in most cases it will be what the business paid for it. (Though depreciation is a significant concept in the context of running a small business.)

It is important to understand the concept of basis in the context of the partnership tax rules because you will need to understand the consequences of what can happen when a partner’s basis in a contributed piece of property is different from the property’s fair market value. You also need to know that when a partner contributes assets to the partnership, the partnership then takes the same basis as the contributing partner had. That partner then gets a basis in his partnership interest that is equal to the basis he had in the contributed property.

For purposes of basis, dealing with cash is easy. The basis in cash is always equal to the face amount of the cash.

Contributed Property

Contributed property is property that is given to the partnership in exchange for the partnership interest.

Contribution

A contribution occurs when a partner gives property to the partnership in exchange for a partnership interest.

Distribution

Distribution is another very significant concept included in this list of partnership tax terms. A distribution occurs when the partnership actually pays out income or otherwise distributes its property to the partners. Unlike allocations, when distributions are made the partners actually receive the property distributed.

Distributive Share

A distributive share is the same as an allocation. It is not an actual distribution but merely a statement of what each partner would be entitled to if the property in question was actually distributed.

Fair Market Value

Fair market value is what the property would sell for on an open market in an arms’ length transaction between a willing seller and willing buyer. Although the test is easy to state, its application is often complex.

Gain

Gain is the excess of the amount realized from a sale or exchange of property over the property’s adjusted basis. In most cases, it is easiest to think of this as the excess of the sales price over the cost.

Gross Income

Gross income is the money or other form of payment received from all sources before deductions, exemptions, or other tax reductions. It is possible to have positive gross income while still having a net loss.

Loss

A loss is a decrease in value. It is usually the amount by which the property’s original cost or adjusted basis exceeds its subsequent selling prices.

Understanding Partnership Tax Terms

Understanding partnership tax terms is important because it helps you plan your after tax profits and consequently your potential personal income. Since small business owners depend on the performance of their business for their livelihood, a clear understanding of taxes as another expense is critical.

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See Also:

The Benefits of Partnership Taxation

Dividends