 Hello, and welcome to the session in which we'll discuss the income allocation for a partnership. First, we need to review some basic concepts about partnership. A partnership is not a tax-paying entity, so the partnership itself as a business don't pay any taxes. The partnership is called a pass-through or a flow-through entity. It means the income, the deduction, the gain, the losses pass through or fall through, flow through to the shareholders. So we have the shareholders and they will get the income, they will get the deduction, so on and so forth. However, what we have to understand in a partnership is there are two steps in allocating income, deductions, expenses, gains, losses, so on and so forth. The first step is to compute net ordinary income that's associated with the business, associated with business income, business expense that is related to what the partnership is all about, the partnership, trade or business operation. And for these type of income and expenses, we report them on form 1065. Don't worry, we're going to see a form with numbers to see how this works. So the first thing what we do is we say, okay, is this an overall business activity? If the answer is yes, it goes on for 1065, whether it's an income or an expense. Then we have certain activities that affect each partner separately. It affects each partner separately and differently. Those items, what we have to do is we have to list them separately and specifically they are called separately stated items. So we're going to isolate and individually report certain partnership component. We're going to report them on schedule K, which we'll see schedule K. Then from schedule K, we're going to report each one of them to schedule K1, which we'll also see an example. These items are called separately stated. What does it mean separately stated? It means this item, whether it's income, expense, gain or a loss or a certain credit. But let's take a look at an expense. This item will have a varying impact on the tax liability of the two distinct partners, assuming we have two partners. So if we have two partners, the expense will affect each partner separately. Therefore, we report those expenses to the partners themselves. We don't include them with form 1065. I'll give you the most obvious, the most obvious example to illustrate this concept. Let's assume we have a charitable contribution. So the business, the partnership contributed $10,000 to charity. So the business itself contributed $10,000. Well, how do we deduct this $10,000? If we deducted this $10,000 on form 1065, then the $10,000 is buried within the income and the expenses of the business. And it affects both partners, assuming we have two partners the same. Because at the end of the day, the partners would look at ordinary income and income that's reported from the partnership included the $10,000. But that's not really true. Because here's what's going to happen. We could have two partners, one partner that's really a generous partner. This partner like to contribute to partnership. And we have another partner that don't like to give any money to charity. Here's what's going to happen. The business contributed $10,000. Let's assume they are 50-50% owner. We're going to contribute $5,000 to partner A and $5,000 to partner B. Again, we have two partners. Here's what's going to happen. Partner A, let's assume partner A is the generous partner that gives money to charity. And partner A, because he or she gives money to charity, he or she has other itemized deduction. And what they do, they itemize their deduction and they will take advantage of the $5,000. Taxpayer B, now they have $5,000 in charitable contribution, but taxpayer B don't file schedule A, don't itemize their deduction. Therefore, they don't use the $5,000. Therefore, the way partner A treated the $5,000 is differently than the way partner B. So any items that could be treated differently between two partners will be reported separately. Don't worry, we're going to see a list of those. The reason I give charitable contribution is that it's the most obvious example in my opinion. So the character is determined at the partnership level. We have a charitable contribution here. The taxation of that item, the charitable contribution is determined at the partner level. So some partners, they take advantage of this charitable contribution because they do have other itemized deduction and other charitable contribution. They bunch them together and they take their itemized deduction. Other partners, they receive that $5,000 and receive means they are informed about it. They don't do anything about it. It doesn't affect their tax liability. And this is what we meant by it affect each of the two tax payer differently. The impact under tax liability is differently. The best way to illustrate this is to look at form 1065, see what goes there, look at schedule K, see what goes there, look at schedule K1 and see what goes there and how does it end up on the individual tax return. What else do we need to know? Well, if we have separately stated item, we're going to call the items that go on 1065, non separately stated items. Before we proceed any further, I have a public announcement about my company farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions, as well as exercises. Go ahead, start your free trial today. So let's take a look at form 1065. So the form 1065 are what are they called, we're going to call them non separately stated, except one of them, it's going to be separately stated, but for them, generally speaking, it's non separately stated. The form 1065 looks like an income statement for a business. Simply put, we report income, then we report deduction. For example, this this this business has 2.2 million in income, 600,000 of cost of goods sold gross profit 1.6 million. Now, if we have any other ordinary income net farm profit net gain for the business other income, we list them here, we list them here, then we have total income 1.6 million, then we come to the deductions. This partnership might have employees, they're going to pay them salaries and wages and its amount to 600,000. Then we have a deduction called guaranteed payment to partners. So notice this is a guaranteed payment to partners, guaranteed payment to partners is deductible. It's not salaries. Notice we have salaries and wages right here for the people that work for the company, but the partners might get what's called a guaranteed payment. Now, this guaranteed payment is a deduction. Notice here, it's with the deduction. We're going to see later, although it's with the deduction, this item here, it's going to be separately stated. It's going to be reported separately to each partner. And I'm going to have a separate recording because I believe guaranteed payment with with merit, a separate recording just to explain how does it fit because it's one of those odd items. You don't have an NS corporation, but you have an a partnership. Therefore, I want to emphasize this point. If the partnership had had any repairs and maintenance that will be listed there, bad debt, rent, taxes and licenses. For example, here we have a rent of 60,000. We're paying rent for something, depreciation 100,000, retirement plan, employee benefit program, other deductions, we have other deductions of 30,000. Then what we do is we add all these deductions and they will add up to 1,000,000 and 30,000. We have income of 1,000,000, 1.6. The difference between them is 570,000. Everything that you saw on this page, whether it's income or deduction, this is with the exception of guaranteed payment, they are called non separately stated or these income and expenses represent the trade or the business that this partnership is in. They generate revenues, they incur expenses and as a result, they have an operating income and this is basically what we are looking at here. This is form 1065. So on form 1065, we report income and expenses for the business as a whole, for the business as a whole. Now we're not done yet. Now we're going to look at sexual schedule K. What is a schedule K? Schedule K would report items that are called separately stated, items that could affect each individual separately, each individual, each partner differently. It will affect them differently. Therefore, we would report those items to them separately. What are some separately stated items? Look, we have some income, we have deduction, we have self employment, we have credits, we have international items, we have international items, we could have AMT, we could have other information. So let's take a look at the sample schedule K1, but this is all of them, basically list of all of them. I'm going to show you some common ones, ones that you are comfortable and familiar with, but notice, you know, there's a bunch of them. First is remember the income, the ordinary income here, the 570,000. This 570,000, remember the partnership did not pay any taxes. That's going to go to the partner themselves and we're going to see how in a moment. So copy this number down if you would like to, 570. Now the partnership, they had the net rental and real state income. So they do have, in addition to the income that we reported here, somehow they have a rental property. That's fine. Now rental property, because it will affect each individual differently, each partner differently, it's not blended with the 570, it's reported separately. We could have expenses from other rental activities again, because it affects each item separately. Notice the guaranteed payment. I told you the guaranteed payment are listed with all the business expenses, but they will also be reported separately to the partners. Now the guaranteed payment, what you have to do is you have to break them into two components. One component is the service component and one component is the capital component. When a partner contribute money to a partnership, they expect to get some money in return or they expect to live off the partnership. Therefore, what they do, they take guaranteed payment. Now on the agreement, for example, here, the partners took overall, the partners took overall 240,000. And what we are saying is 50% of that withdrawals were due to them providing services to the partnership and getting compensated for that. And the 120,000 remaining, the other 50%, is for capital contribution. They basically invested in the company. They want to earn some return and therefore this could be a different percentage. I happen to make them 50-50 for simplicity. So the total guaranteed payment is 240. This company has dividend, ordinary dividend of 8,000. Dividend is taxed differently. How are you taxed on dividend? You may not be taxed on dividend. You could be taxed at 15%. You could be taxed on 20%. Depending on your adjusted gross income. So that's why this partnership generated some dividend from some investment, but we did not included the dividend in the 570,000. It's not part of the ordinary income of the business. The dividend will be reported separately to the various partners because some partners might pay 15% on it. Some partner might pay 20% and some partners will pay none depending on your tax bracket. Net short-term capital gains, same concept. 12,000 will affect each individual separately. I also made an example for the charitable contribution, but notice those are not the only thing. Anything that you see here are potential separately stated items. I'm just showing you the most obvious, obvious ones. And I also had a tax-exempt interest income of 4,000 for the sake of illustration. But those are, this is Schedule K. Schedule K include the total of all separately stated items. Now, we're going to have different partners. Each partner will get a Schedule K1 of 1065. So notice Schedule K include all the items and notice here the 570 is considered non-separately stated. Then the other ones are basically separately stated. Then we're going to have the K1. Now on the K1, each individual, each partner will get a K1. For example, this K1 is for Adam Forhat who owns the capital account is 50% in the business. However, the profit and loss ratio is 40%. You can do that. The profit and loss ratio will be different than your capital account. Adam is a domestic partner with a limited partner or LLC member. Now, what's going to happen? We're going to start with this 570,000. Well, remember, Adam's share of profit and loss is 40%. Therefore, Adam will get this Schedule K1 with 228,000 of the ordinary income. And now Adam is responsible for paying 228,000. Remember, the total ordinary income for the partnership was 570. Adam's share is 40%. That's Adam's share. How much Adam will pay taxes on this 228? Well, depending on their tax bracket, that's why. And the other individual will get, let's assume two individuals will get the 60% of the profit and they will pay a different amount of taxes on that 60% because they are taxed on the individual level. Also, of the 300,000 of rental income, Adam will get 40% or 120,000. And these items goes on Schedule E of Adam, and Adam will have to pay taxes on that money differently. Remember, the guaranteed payment, let's go back to the guaranteed payment, we said the guaranteed payment are deductible, 240,000 are deductible on the partnership return, then they are reported separately to the individual. So Adam's going to get 40% of the guaranteed payment. 40% and of that 40%, 50% of it is for services, 50% of it is for capital. Now again, this item will go to their, it's considered income. It's considered income to the partner and sometimes what they do in here, you might include their health insurance premium. That's fine too. Also, the 3,200 here, Adam will get 40% of it and Adam will have to report 3,200 on their Schedule B as ordinary dividend and will have to pay taxes on that. Adam will also get 4,800 notification that they have a net capital gain, their share 40% of the net capital gain, the net capital gain was how much in total? The net capital gain was 12,000. Adam will get 4,800 and they would report this under Schedule D. Adam will get notification for the 4,800 charitable contribution that Adam will have to report on Schedule A as an alpha, Schedule A. Assuming Adam itemized, assuming Adam have other itemized deduction where they can bunch this 4,800 with the others, if they don't prepare Schedule A, then basically they don't use this information. The other individual, they get the remaining 60%, if they use, if they itemize, then they will use it. That's why these items will affect each partner separately. Now also, we have tax-exempt income of 4,000. Adam will get 40% of that and the other partner will get the 60%. That's exempt interest is tax-exempt interest. Nevertheless, you know what your share is. So notice Schedule K1, it gives you your capital balance. It's also, if you want, not also, what you will do is you keep track of your capital balances. What was the beginning capital? If there's any capital contributed during the year, net income or net loss, that's going to reduce it, other increases or decreases, any withdrawal, then it's going to give you the ending capital as well. So it keeps track of your capital account. And it's very important that also keep track of recourse and non-recourse that. How much do we have a beginning recourse versus non-recourse that? Very important to learn how to read Schedule K1. So remember, here's how it works. First, the business prepare form 1065 for the whole business. And on that, we'll have income and expenses for the business. And we'll get operating income or ordinary business income. Let's call it OI, ordinary business income. And the ordinary business income, we call it also non-separately stated, except again, except the guaranteed payment. That's form 1065. Then we have Schedule K. Schedule K, we list the non-separately stated item, which is the ordinary business income, plus all the separately stated items on Schedule K. Then whatever we list on Schedule K, non-separately and separately, based on that, we're going to send each individual form K1, show them their interests in ordinary income, guaranteed payment, ordinary dividend, whatever we have of items reported. So notice, then from Schedule K1, from Schedule K1, each individual would report this information, either on Schedule E, Schedule B, Schedule D, or Schedule A, and they prepare their taxes and life is good. And this is why we say a partnership is a pass through entity. We start with a partnership, income, expenses, we have certain separately stated items, get separately reported, and each individual, each individual means each partner is responsible for getting the deduction or paying taxes based on the share of Schedule K1. What I'm going to do, I'm going to create a separate recording just to explain guaranteed payment, what are guaranteed payments, so on and so forth, what should you do now? Got a far hat lectures, look at additional MCQs, true, false, additional resources, that's going to help you understand form 1065, Schedule K1, how income is allocated from the partnership to the partners, you know, the concept of pass through or flow through entity in a partnership. Good luck, study hard, invest in yourself and stay safe.