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Chapter 19 Partnerships —Formation and Operation

Chapter 19 Partnerships —Formation and Operation. ©2008 CCH. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 1 800 248 3248 www.CCHGroup.com. Chapter 19 Exhibits. 1. Partnerships—Overview 2. Partnerships—Types of Partnerships 3. Partnerships—Tax Formula

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Chapter 19 Partnerships —Formation and Operation

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  1. Chapter 19Partnerships—Formation and Operation ©2008 CCH. All Rights Reserved. 4025 W. Peterson Ave. Chicago, IL 60646-6085 1 800 248 3248 www.CCHGroup.com

  2. Chapter 19 Exhibits 1. Partnerships—Overview 2. Partnerships—Types of Partnerships 3. Partnerships—Tax Formula 4. Code Section 702(a)(8) Income or Loss 5. Separately Stated Items 6. Inside Basis Computations 7. Outside Basis Computations 8. Outside Basis Computations—Example 9. Formation of Partnerships—Partner Perspective 10. Formation of Partnerships—Overview of Code Sec. 721 11. Contribution of Part Property/Part Services 12. Contribution of Part Property/Part Services—Example Chapter 19, Exhibit Contents A CCH Federal Taxation Comprehensive Topics

  3. Chapter 19 Exhibits 13. Disguised Sales—General Rules 14. Disguised Sales—Example 15. Contribution of Encumbered Property 16. Contribution of Encumbered Property—Example 17. Partnerships—Tax Years 18. Partnerships—Accounting Methods 19. Code Section 465 At-Risk Rules 20. Code Section 469 Passive Activity Loss (PAL) Rules 21. At-Risk and Passive Activity Loss Rules—Example Chapter 19, Exhibit Contents B CCH Federal Taxation Comprehensive Topics

  4. Partnerships—Overview Definition of Partnership. An unincorporated association with two or more persons who associate for a profit motive. For income tax purposes, partnerships are generally treated as pass-through entities, i.e., the partnership pays no taxes, and partnership income (loss) and separately stated items are allocated to each partner according to the partnership’s profit sharing agreement. The partners receive separate K-1 schedules from the partnership. Each K-1 reports each partner’s share of the partnership net profit and separately reported income and expense items. Partners report these items on their own 1040 tax returns, even if none of the items have been distributed to them. Chapter 19, Exhibit 1 CCH Federal Taxation Comprehensive Topics

  5. Partnerships—Types of Partnerships General Partnership [GP]. A GP has one or more general partners who is personally liable for partnership debts; a general partner can be bankrupted by a malpractice judgment brought against the partnership, even though the partner was not personally involved in the malpractice. Limited Liability Partnership [LLP]. An LLP is a general partnership in which the general partners are not liable for any malpractice committed by the other general partners. Limited Partnership [LP]. An LP is comprised of at least one general partner and often many limited partners. Limited partners may not participate in the management of the LP, and their risks of loss are restricted to their equity investments in the LP. Limited Liability Limited Partnership [LLLP]. An LLLP is a limited partnership in which the general partners are not liable for the negligence or misconduct of the other general partners. Chapter 19, Exhibit 2a CCH Federal Taxation Comprehensive Topics

  6. Partnerships—Types of Partnerships Limited Liability Company [LLC].An LLC is a state-registered association generally taxed as a partnership if it “checks the box.” LLC members, like corporate shareholders are not personally liable. Unlike limited partners, LLC members may participate in management without risking personal liability. However, guaranteed payments are subject to self-employment tax, along with the members’ share of ordinary income or loss from the LLC. Chapter 19, Exhibit 2b CCH Federal Taxation Comprehensive Topics

  7. [Taxation at Owner Level] Ordinary Income “From Whatever Source Derived” (including Code Sec. 1245 recapture) – Exclusions and Cost of Goods Sold = Gross Income from Business Operations – Operating Expenses = Code Sec. 702(a)(8) Ordinary Income Tax Formula Chapter 19, Exhibit 3 CCH Federal Taxation Comprehensive Topics

  8. Code Section 702(a)(8) Income or Loss Definition. Earned income from operations generally follows the same rules as for individuals (i.e., all income from whatever source derived, unless specifically excluded). It is offset by cost of goods sold and operating expenses to produce a single reporting item, “Code Sec. 702(a)(8) income or loss.” The following items are included in the Code Sec. 702(a)(8) computation because they always get ordinary treatment: • Code Sec. 1245 depreciation recapture • Cost of goods sold • Depreciation and other operating expenses • Amortization of organizational expenditures Chapter 19, Exhibit 4a CCH Federal Taxation Comprehensive Topics

  9. Code Section 702(a)(8) Income or Loss (1) Amortizable expenditures. Organizational expenses qualify for amortization (and reduce Code Sec. 702(a)(8) income) if: (a) = incurred incidental to formation of the partnership. (e.g., legal fees for drafting the partnership agreement, cost of state filings, cost of required notice publications and organizational meeting costs.) and (b) = incurred before the end of the tax year in which the partnership commences business. At the election of the partnership, a deduction is allowed for the taxable year in which the partnership begins business in an amount equal to the lesser of (a) actual organizational expenses, or (b) $5,000 (reduced dollar-for-dollar by the amount by which such organizational costs exceed $50,000). The remainder of such organizational costs are allowed as a deduction ratably over the 180-month period beginning with the month in which the partnership begins business. (2) Nonamortizable expenditures. Organizational expenses DO NOT qualify for amortization if related to issuing and marketing partnership interests. Examples are prospectus preparation costs and commissions on sales of limited partnership interests. They are written off when the partnership is terminated. Chapter 19, Exhibit 4b CCH Federal Taxation Comprehensive Topics

  10. Separately Stated Items Items other than partnership operating income and expenses must be separately stated. The reason for showing these items separately is that their ultimate tax treatment may vary from partner to partner. Separately stated items are first computed at the partnership level (same computation method as with individuals). Next, each partner’s distributive share of each separately stated item is reported on his Schedule K-1 of the partnership return. Finally, the K-1 is sent to each partner who transfers his distributive share of Code Sec. 702(a)(8) TI and each separately stated item listed from the K-1 to the appropriate section of his individual return. For example, a distributive share of charitable contributions reported on the K-1 is transferred to Schedule A of Form 1040. There, it is subject to certain AGI limitations of the partner, which will differ from that of the other partners. Chapter 19, Exhibit 5a CCH Federal Taxation Comprehensive Topics

  11. Separately Stated Items Items that must be separately stated include the following: • Code Sec. 1231 gain and loss • Code Sec. 1250 depreciation recapture (Code Sec. 1250, unlike Code Sec. 1245, must be separately stated because corporate partners may be subject to an additional recapture adjustment under Code Sec. 291) • Capital gains and losses • Dividends eligible for a corporate dividend-received deduction • “Qualified” dividends eligible for the 5/15% tax rates • Tax-exempt income and related expense • Investment income and related expense • Passive income and losses from rental and other nonoperating activities • Recovery items (e.g., tax refunds, recovery of bad debts) • Distributions of unrealized receivables or inventory that have substantially appreciated • Tax credits • Charitable contributions • Foreign income taxes paid or accrued • Depletion on oil and gas wells • Other nonbusiness expenses Chapter 19, Exhibit 5b CCH Federal Taxation Comprehensive Topics

  12. Separately Stated Items Chapter 19, Exhibit 5c CCH Federal Taxation Comprehensive Topics

  13. Inside Basis Computations How is a partnership’s inside basis in property contributed by partners determined? Code Sec. 763 provides that the basis of property received by a partnership will be Partner’s basis in contributed property + Gain recognized by a partner on contributions of property (such as when other property is received by the partner). = Partnership’s inside basis in property Note that gain recognized by a partner on excess debt relief (i.e., debt relief - debt assumption - basis in assets contributed) does not increase the partnership’s inside basis in the contributed assets, even though it DOES increase the outside basis of the contributing partner in her partnership interest (to zero). Chapter 19, Exhibit 6 CCH Federal Taxation Comprehensive Topics

  14. Outside Basis Computations How is the partner’s outside basis in the partnership (P/S) determined? Code Sec. 722 and related regulations provide the following formula: + Basis in contributed property +/– Share of P/S’s taxable income or loss under Code Sec. 702(a)(8) (i.e., earned income/loss, both active and passive) +/– Share of “separately stated items” + Gain recognized by partner on services contributed + Gain recognized by partner on excess debt relief + Share of debt assumption (if recourse debt, % share is based on % share of P/S loss; if non-recourse debt, % share is based on % share of P/S profits. Both % are usually the same.) – Share of P/S losses – Debt relief – Basis of property distributions, including cash = Partner’s outside basis of partnership interest Chapter 19, Exhibit 7a CCH Federal Taxation Comprehensive Topics

  15. Outside Basis Computations Special basis rules: 1. Losses may not reduce basis below zero. Instead, they remain suspended until more basis is acquired, for example, through contributions or income. 2.  Basis is reduced by the amount of any released losses previously suspended under the at-risk rules. 3. No separate adjustment to basis is generally made for guaranteed payments received by a partner from his P/S. The reason: Guaranteed payments are included in the partner’s income, which would increase his basis, but they are accompanied by a cash distribution, which simultaneously reduces basis. Chapter 19, Exhibit 7b CCH Federal Taxation Comprehensive Topics

  16. Outside Basis Computations Chapter 19, Exhibit 7c CCH Federal Taxation Comprehensive Topics

  17. Outside Basis Computations—Example Chapter 19, Exhibit 8a CCH Federal Taxation Comprehensive Topics

  18. Outside Basis Computations—Example ASSUMPTIONS: • None of the property was contributed by the partners (therefore no built-in gains) • Year-end partnership debt payable to unrelated parties is $24,000. QUESTIONS: • What is Mary’s outside basis at the beginning of the year? • What is Mary’s outside basis at the end of the year? • What is Mary’s capital account balance at the end of the year? Chapter 19, Exhibit 8b CCH Federal Taxation Comprehensive Topics

  19. SOLUTION (A): $25,000 [$10,000 capital account + (1/2 x $30,000 P/S debt)] (B): $41,275 [see below] (C): $29,275 [see below] + Mary’s beginning basis (A) $25,000 + Share of P/S’s TI under Code Sec. 702(a)(8) $24,000 =[1/2 x $48,000] + Share of “separately stated items” $5,275 =[1/2 x (5+6.2+.5-.1-.25-.8)] – Share of debt relief $ (3,000) =[1/2 x ($30,000 - $24,000)] – Basis of land distributions to Mary $(10,000) = [100% x $10,000] Mary’s ending basis (B) $41,275 Mary’s ending capital acct bal. (C) $29,275 =[$41,275 - (1/2 x $24,000 debt] Outside Basis Computations—Example Chapter 19, Exhibit 8c CCH Federal Taxation Comprehensive Topics

  20. Outside Basis Computations—Example Note: The Code Sec. 1245 gain was already included in Code Sec. 702(a)(8) TI. Recall that Code Sec. 1245 gain gets ordinary treatment and is not part of the netting process. With its “automatic” ordinary treatment, there is no need for it to be “separately stated.” Doing so in this problem would have resulted in its being counted twice. Chapter 19, Exhibit 8d CCH Federal Taxation Comprehensive Topics

  21. Formation of Partnerships—Partner Perspective Chapter 19, Exhibit 9 CCH Federal Taxation Comprehensive Topics

  22. Formation of Partnerships—Overview of Code Section 721 1. No gain or loss. Generally, Code Sec. 721 requires that no gain or loss is recognized if property is transferred to a partnership in exchange for a partnership interest. It does not matter whether the transfer is during partnership formation or after the partnership had already been formed. Similar nonrecognition rules govern corporate shareholders in a Code Sec. 351 contribution, except for the 80% control requirement. Mandatory nonrecognition. Notwithstanding the exceptions in the following slide, nonrecognition treatment for qualified transactions under Code Sec. 721 is mandatory, not elective for partners. Similarly, nonrecognition treatment under Code Sec. 351 is mandatory for corporate shareholders. Chapter 19, Exhibit 10a CCH Federal Taxation Comprehensive Topics

  23. Formation of Partnerships—Overview of Code Section 721 Three exceptions to nonrecognition. Gain is recognized in either event below: • Services. A partner’s contribution of services in exchange for a partnership (P/S) interest creates ordinary income (OI) to the partner (P). • Disguised sale. A partner’s contribution of property to a P/S followed by a P/S’s distribution of property (other than a partnership interest) to a partner within 2 years is presumed by IRS to be a disguised sale. • Excess (XS) of P’s debt relief over P’s basis. XS debt relief enjoyed by a partner over the basis of contributed property is treated as capital gain. Similar treatment holds for corporate shareholders. Recall that a shareholder relieved of debt by a corporation has taxable boot if the debt relief exceeds that shareholder’s basis in contributed property Chapter 19, Exhibit 10b CCH Federal Taxation Comprehensive Topics

  24. Formation of Partnerships—Overview of Code Section 721 2. No 80% control requirement. The 80% control requirement for corporate shareholders is not required of partners contributing property to a P/S. 3. Partner’s outside basis increases with P/S debt assumption. A partner’s outside basis increases by his pro rata share of a P/S’s increase in both recourse and non-recourse debt. The debt may include debt transferred by a contributing partner. (In contrast, a corporate shareholder’s stock basis is not affected by corporate debt assumption.) 4. Partner’s outside basis decreases with debt relief. Debt transferred by a contributing partner to the P/S results in debt relief to the contributing partner. The partner must reduce his basis in the P/S by the amount of debt relief. (Similarly, shareholders must reduce their basis in stock for the amount of their debt assumed by the corporation.) Chapter 19, Exhibit 10c CCH Federal Taxation Comprehensive Topics

  25. Formation of Partnerships—Overview of Code Section 721 What was Congress thinking when it enacted Code Sec. 721? Same reason as with Code Sec. 351 for corporate shareholders. First, as partners receive only a partnership (P/S) interest, they may not have the wherewithal to pay taxes. Second, the formation of a partnership is not an economic transaction, but a change in legal form only. Does the partnership recognize gain or loss in a Code Sec. 721 exchange? No. Chapter 19, Exhibit 10d CCH Federal Taxation Comprehensive Topics

  26. Formation of Partnerships—Overview of Code Section 721 What is “property”? “Property” includes just about everything except services (i.e., cash, inventory, receivables, land, other tangible assets, nonexclusive licenses and industry know-how.) [Note: Since neither Congress nor the Treasury Dept. have offered a definition of property, the courts have been guided by analogous interpretations under Code Sec. 351. Recall that Code Sec. 351 provides for non-recognition treatment on the transfer of “property” to an 80% controlled corporation in exchange for stock.] Chapter 19, Exhibit 10e CCH Federal Taxation Comprehensive Topics

  27. Contribution of Part Property/Part Services How does Code Sec. 721 apply if a person contributes both property and services? The receipt of a partnership (P/S) interest attributable to services will generally be treated as a separate transaction outside the scope of Code Sec. 721. The transfer of property remains protected from income recognition within the scope of Code Sec. 721. Chapter 19, Exhibit 11 CCH Federal Taxation Comprehensive Topics

  28. FACTS: “A” transfers the following items to XYZ Partnership in exchange for a capital interest: Asset FMV Basis Land $50,000 $10,000 Services $35,000 $ 0 QUESTION:How much income is recognized on the transfer? Contribution of Part Property/Part Services—Example Chapter 19, Exhibit 12a CCH Federal Taxation Comprehensive Topics

  29. Contribution of Part Property/Part Services—Example SOLUTION: Services: $35,000 OI as compensation. Land: $0. The $40,000 [$50,000 – $10,000 = $40,000] realized gain on transfer of land is NOT recognized, consistent with Code Sec. 721; rather, it is a built-in gain. Chapter 19, Exhibit 12b CCH Federal Taxation Comprehensive Topics

  30. Disguised Sales—General Rules What is a disguised sale? Code Sec. 707(a)(2)(B) and Reg. §1.707-3 provide that any contribution and distribution of property (other than a capital interest) between partner and partnership (P/S) within 2 years of each other is presumed to be a disguised sale. The burden is on the taxpayers to prove otherwise. Chapter 19, Exhibit 13a CCH Federal Taxation Comprehensive Topics

  31. Disguised Sales—General Rules If a contribution of property by a partner to a P/S followed by a distribution by the P/S to the partner is a disguised sale, then it is treated as if the partner sold a fraction of the contributed property to an unrelated 3rd party. The fraction treated as sold is equal to the amount of cash and FMV of property distributed divided by the FMV of the property contributed. The partnership’s basis in the property contributed will be the sum of (1) the FMV of the fraction of the property “sold” to the partnership, plus (2) the basis of the fraction of the property still treated as a contribution. The partner’s basis in the partnership interest will be the basis of the fraction of the property still considered to be contributed, rather than sold. Chapter 19, Exhibit 13b CCH Federal Taxation Comprehensive Topics

  32. Disguised Sales—General Rules If a disguised sale involves the transfer by a partnership of a capital interest, does part of the transaction qualify for Code Sec. 721 non-recognition treatment? If so, how much? Yes, % of total transfers that get Code Sec. 721 nonrecognition treatment, are: [(a) - (b)]  (a), where: (a) = FMV of property contributed by the partner to the P/S; and (b) = FMV of property other than a capital interest distributed by the P/S to the partner within two years of new partnership. Chapter 19, Exhibit 13c CCH Federal Taxation Comprehensive Topics

  33. FACTS: Fred transfers land [$400 fair market value (FMV), $120 adjusted basis (AB), held long-term for investment purposes] to a partnership (P/S) in exchange for: 1. A capital interest worth $100; 2. $300 cash. QUESTIONS: A.  What portion of the exchange represents a disguised sale? B.  What portion of the exchange represents a Code Sec. 721 contribution? C.  What is the tax treatment to Fred? D. What is the tax treatment to P/S? Disguised Sales—Example Chapter 19, Exhibit 14a CCH Federal Taxation Comprehensive Topics

  34. Disguised Sales—Example Chapter 19, Exhibit 14b CCH Federal Taxation Comprehensive Topics

  35. Disguised Sales—Example Chapter 19, Exhibit 14c CCH Federal Taxation Comprehensive Topics

  36. Disguised Sales—Example COMMENTS Even if Fred had received the $300 cash up to two years after receipt of a P/S interest, IRS would still presume that Fred’s contribution was partially a disguised sale as per above. Fred would have to prove otherwise. Chapter 19, Exhibit 14d CCH Federal Taxation Comprehensive Topics

  37. Contribution of Encumbered Property What is the tax effect to partner (P) and partnership (P/S) from contributing encumbered property to a P/S? When a partnership assumes the debt of a contributing partner, the partner relieved of debt is treated as if having received a distribution of money from the partnership in the amount of the debt relief. Code Sec. 752(b). The P’s debt relief is the P/S’s debt burden. That burden is shared by ALL P’s, in accordance with their ownership %’s. The term “ALL P’s” includes the partner relieved of 100% of the debt. In essence, he is relieved of 100% of the debt, then assumes his pro rata share of that same debt assumed by the P/S. The amount of partnership debt assumed by a partner is treated as a cash contribution by the partner to the partnership. Chapter 19, Exhibit 15a CCH Federal Taxation Comprehensive Topics

  38. Contribution of Encumbered Property The P’s “net” debt relief (total debt relief minus pro rata debt burden) is non-taxable to the relieved P to the extent of his basis in the P/S. Any net debt relief in excess of basis is capital gain (i.e., same effect as if the amount of excess net debt relief were a cash distribution.) The capital gain is short-term or long-term depending on the holding period of the partnership interest. Refer to the Examples for an illustration of the tax effect on P and P/S from encumbered property contributions. Chapter 19, Exhibit 15b CCH Federal Taxation Comprehensive Topics

  39. FACTS: Ann, Bob and Cal decide to pool their efforts and form a partnership. They make the following contributions to the partnership: Partner Contribution FMV AB to P P’s % int.. in P/S Ann Services $30,000 $0 30% Bob Land 70,000 20,000 60% Cal Equipment 10,000 11,000 10% Totals $110,000 100% Bob’s land is subject to a $10,000 mortgage that the partnership assumes. The FMV of the P/S is $100,000 [$110,000 FMV assets – $10,000 debt assumed.] Contribution of Encumbered Property—Example Chapter 19, Exhibit 16a CCH Federal Taxation Comprehensive Topics

  40. Contribution of Encumbered Property—Example QUESTIONS: (a) Does this transfer of assets qualify for Code Sec. 721 treatment? (b) What is each partner’s gain or loss on contributions to the partnership? (c) What is the resulting basis of each partner in the P/S (“outside basis”)? (d) What is the P/S’s basis in the assets received (“inside basis”)? Chapter 19, Exhibit 16b CCH Federal Taxation Comprehensive Topics

  41. Contribution of Encumbered Property—Example SOLUTION Ann’s transfer of services falls outside the scope of Code Sec. 721. However, Bob and Cal’s transfers still qualify for Code Sec. 721 treatment, since they represent property contributions. Note that Bob and Cal get non-recognition treatment under Code Sec. 721, even though they do not have 80% control immediately after the exchange. As previously pointed out, the 80% control rule applies only to corporations. Chapter 19, Exhibit 16c CCH Federal Taxation Comprehensive Topics

  42. Contribution of Encumbered Property—Example Chapter 19, Exhibit 16d CCH Federal Taxation Comprehensive Topics

  43. Contribution of Encumbered Property—Example COMMENTS: The results in this partnership problem differ from a similar corporate problem in two ways: • No 80% control requirement for non-recognition treatment under Code Sec. 721 (Not so for shareholders under Code Sec. 351.) • Debt assumption is added to a partner’s basis in the P/S. (Not so with a shareholder’s stock basis. However, note that debt relief does reduce the basis of both partner and shareholder.) Chapter 19, Exhibit 16e CCH Federal Taxation Comprehensive Topics

  44. Partnerships—Tax Years The following rules govern tax years of partnerships: Majority Interest Taxable Year. Partnerships are generally required to elect the same taxable year as their partners who represent a majority interest on the first day of the partnership’s first tax year. Code Sec. 706(b). Five Percenters’ Common Tax Year. If there is no majority interest taxable year, the partnership must use the same year as that of the principal partners, i.e., those owning five percent or more interest in either profits or capital. Chapter 19, Exhibit 17a CCH Federal Taxation Comprehensive Topics

  45. Partnerships—Tax Years Calendar Tax Year. If there is no majority interest tax year and the principal partners do not have the same tax year, the partnership generally must use the calendar year. There are two exceptions, (1) the least aggregate deferral rules and (2) the business purpose rules. Under the least aggregate deferral rules, the following deferral calculation is made for each year-end any partner has: partner’s interest in profits × months of deferral. For each possible year end, the deferral calculations for all of the partners are aggregated. The year-end with the lowest aggregate is the one that must be used, unless a natural business year-end can be established (for seasonal businesses). Chapter 19, Exhibit 17b CCH Federal Taxation Comprehensive Topics

  46. Partnerships—Accounting Methods Cash method. The cash method is available to partnerships that do not have a C corporation partner. The cash method however, “MAY” be used by partnerships with C corporation partners if the partnership’s average annual gross receipts are $5 million or less in the 3 preceding years. The determination is made annually. Accrual Method.Once the three-year average annual gross receipts exceeds $5 million, a partnership with a C corporation partner must use the accrual basis thereafter. Chapter 19, Exhibit 18 CCH Federal Taxation Comprehensive Topics

  47. Code Section 465 At-Risk Rules A partner’s distributive share of partnership losses and deductions from both business and investment activities are “at-risk.” Code Sec. 465(b)(1) and (2). Such losses are allowed only to the extent of the partner’s at-risk amount at the end of the partnership’s tax year. (a) The at-risk amount is generally the partner’s outside basis defined at Code Sec. 704(d). (i) Nonrecourse loans from “non-qualified” lenders are generally excluded from the at-risk basis amount but included in the Code Sec. 704(d) outside basis. (b) If a partnership has more than one “activity,” then the at-risk rules must be applied to each activity separately (i.e., each activity must have its own “at-risk” basis). Code Sec. 465(c)(2)(A) and (3)(A). Chapter 19, Exhibit 19a CCH Federal Taxation Comprehensive Topics

  48. Code Section 465 At-Risk Rules (c)   What about alimony paid, charitable contributions and other non- business/non-investment expenses? Prop. Reg. 1.465-13 addresses this question by providing that, “ ...allowable deductions allocable to an [passive] activity are those otherwise allowable deductions incurred in a trade or business or for the production of income from the activity.” (In other words, alimony and charitable contributions paid by a partnership are generally NOT subject to the at-risk rules since they do not ordinarily serve a business or investment purpose to the passive activity incurring these expenses. However, facts and circumstances govern “purpose”.) Chapter 19, Exhibit 19b CCH Federal Taxation Comprehensive Topics

  49. Code Section 469 Passive Activity Loss (PAL) Rules As with the at-risk rules, the PAL rules are applied on a partner-by-partner basis, not at the partnership level. However, unlike the at-risk rules, the PAL rules apply only to business income and losses for which the partner does not actively participate. PALs are deductible to the extent of income from all passive activities in the aggregate.   “Portfolio income” (interest, dividends, annuities, royalties not derived from the ordinary course of business and gains or losses from assets that produce such income, less related expenses) are not considered as arising from a passive activity. Code Sec. 469(e)(1). Partnership ordinary loss is generally passive to a partner unless the partner materially participates in the partnership activity. Chapter 19, Exhibit 20 CCH Federal Taxation Comprehensive Topics

  50. At-Risk and Passive Activity Loss Rules—Example FACTS: 1/1/x1: Rhonda’s outside basis in her 25% partnership interest is $24,000. 20x1: The partnership incurred a $100,000 Code Sec. 702(a)(8) operating loss. 20x2: The partnership earned $12,000 Code Sec. 702(a)(8) operating income. Rhonda does not materially participate. QUESTION: Determine the tax effect on Rhonda for 20x1 and 20x2. Chapter 19, Exhibit 21a CCH Federal Taxation Comprehensive Topics

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