 Hello and welcome to the session in which we will discuss the concept of a partnership as a flow through entity. What does that mean? Well, here's what we need to know about partnership. Partnership is not required to pay federal income tax. Well, that's excellent. So why don't we all operate as a partnership if that's the case? Well, the partnership don't pay the taxes, but someone else will pay the taxes. Each partner is responsible for reporting their proportionate share of a partnership income or loss on their personal tax return and pay any tax liability that arises. Well, yes, the partnership, they complete a form called 1065 an informational return is we will have the revenues minus their expenses, they will get to the net income. Let's assume this partnership will have two partners, Adam and Noah. And for simplicity, assuming 50% ownership. Now let's assume the revenue is $3 million, expenses were $1 million. So net income is $2 million for this company. Well, if that's the case of that $2 million, $1 million goes to Noah, $1 million goes to Adam and they pay taxes on that income. So the partnership itself, no taxes, but the partners Adam and Noah will pay the taxes. So this is what we mean by a pass through or a flow through entity, pass through or full through or flow through are the same. So a partnership is required to file form 1065 and I'll have a separate recording showing you form 1065 and schedule K1 where they report this information to the partners. I will do it at the end of the chapter so we can have a comprehensive review. And each partner will receive their own share. So the partner utilize schedule K1 to complete their tax return and pay their tax bill appropriately. 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. Let's take a look at a simple example. Noah provides a land with the basis of $60,000 and a value of $60,000 receiving a 4% interest in the profit and loss of ABC company. In 20x5, ABC earns $220,000 of taxable income and distributed dispenses a cash amount of $10,000 to Noah. Well, what is Noah's tax obligation? Well, here's what's going to happen. Noah's tax obligation is the partnership made $200,000, 40% goes to Noah, Noah is responsible for $88,000. Well, how about the $10,000? No, the $10,000 is not taxable to Noah, Noah is responsible for the $88,000. This is what we mean by pass through entity. The same principle applies if ABC incurs a loss. Noah would allocate 40% of the loss which he could then deduct provided there is no loss limitation, as we will discuss later. Now, what makes the partnership taxation a little bit unusual? Well, there are two principles that originate from two legal principles. One, we have to look at the partnership as an aggregate principle or known as conduit principle, which is its transfer principle. And the other concept is an entity principle. So a partnership will have those two principles. What do we mean by an aggregate principle or also known as conduit principle? Well, what is aggregate or conduit? It means something is being passed and you already know that the profit and other things profit deduction losses expenses are passed through as well as credit. So the aggregate principle basically state that the partnership as a conduit transfer, income, credit deduction, and after tax related items to the partners. So we have let's assume this is the partnership and what's going to happen? The partnership, it's going to transfer things to the partners. So the partnership is no more than a group of taxpayers united in a representative relationship. So all these individuals are basically independent. Each one of them is independent for tax purposes. But in a partnership, they look as one entity, but really each one of each one of them is getting their own share of the partnership income losses, credit and other items. So for example, income taxes is levied on the partners directly, not on the partnership. So they pay the taxes. This is called the conduit conduit means a transfer to something else. Also, the partnership has something called the entity principle. And that's why for a partnership, we file them form 1065 as an informational return, because the entity principles view the partners, which is the people who owns the partnership and the partnership itself as distinct entity, given the partnership, its own identity, but that identity not taxable. It doesn't pay any taxes. It has to file an informational return. It's required to submit form 1065, which we'll see later that provides summary of the transaction throughout the year. But on that form, there's no place where the partnership pays any taxes. All the items on that return is transferred to the owners. Now we have to be familiar with capital interests, profit interests and loss interest for partners. Starting with capital interest, usually the capital interest is not negotiable. It's what you get for what you own in the company, what you get for transferring assets. The partnership percentage ownership of capital, which is the ownership of equity or net asset of the company, this is what you get also in case of in case of liquidation. So the capital interest, for example, a company will have assets will have liabilities and will have equity under the equity. You could have partner A, you could have partner B, you could have partner C and each one of them, for example, this individual on 30, 30 and 40%. This is the capital interest. Usually that's not negotiable. That's not negotiable. We have a profit and loss also known as profit sharing ratio. Well, that's agreed upon between the partners. For example, here, if the company made $1,000 in profit, how are we going to distribute this profit? Well, we can distribute it 30, 30 and 40, or we can distribute it in some other form, which is 20, 20 and 60, 24A, 24B and 64C. It's negotiable. Same thing applies to the loss interest, which is how much of the losses are you going to absorb? That's based on the agreed upon agreement, the contract, it's negotiable, how we distribute the profit and loss. For example, we have an A, AMB form partnership, AB partnership, A contributed 40,000, B contributed 60,000. Well, guess what? The capital interest for each is 40% A, 60% B. Why? Because the total contributed is 100,000. A contributed 40 of the 140%. A gets 40, B gets 60. Now, year and AB partnership has not income of 10,000. How do we distribute this 10,000? Well, how do we do it? Well, if you said 40% to A, 60% to B, you are not wrong. Unless you are told otherwise, if there is no special allocation or in the agreement, in the agreed upon agreement, there is a way to distribute this, the profit or the loss for that matter. If it's a loss, then you would assume it's 40% to A, 40% to B. So the profit interest is based on a partnership agreement. It's negotiable between the partners. In the absence of that, you can go with those percentages. Unless otherwise told, if not, we have what's called a special allocation, which is, it's a different percentage, unless otherwise told, C i equal to P i in L i. Also, we need to be familiar with a term, two terms. One is called inside basis and one is called outside basis. What is inside basis and outside basis? Inside basis is the inside basis that refer to the adjusted basis of each asset owned by the partnership. So we have the partnership. This is the business. The business is the partnership and inside the business, they will have assets and these assets will have basis and this is what we mean by the inside basis. So this is the partnership. This is the business itself, the partnership. So it's the partnership adjusted basis for each asset it owns. So the partnership itself will have its own basis and every partner effectively hold a proportionate share of the inside basis of all partnership assets. And guess what? Those shares are owned by partners and those partners own a proportionate share of these assets. This is the inside basis. What are the outside basis? Outside basis represent the basis of each partner in their interest in the partnership. So these individuals on the outside, this individual, the partners, they own interest a percentage in the partnership. This is the outside basis. So notice the inside basis is the basis of the assets that the partnership owns outside basis. Most likely we'll be dealing with outside basis initially. It's the basis of the partners themselves. How much do they own of the partnership? Now it's very important that the partners keep track of their individual outside basis. Initially, when initially the partnership is formed, the inside basis equal to the outside basis. So whatever assets you contributed, it has an adjusted basis and you own part of those assets. So initially the inside basis equal to the outside basis. Then the inside basis and the outside basis might differ down the road. Why? Many reasons we'll talk about that later, but it could be a new partner acquire share through a sale or an exchange that's different than the inside basis. So they pay a different amount. Or there was a distribution of cash or property with inside basis that exceed the outside basis. That's another reason. Or a partner dies. A partner dies will have to give their share or their interest to someone else. We have to give them some interest in the company. And what happened is the interests that were given them would represent, because we're giving them the fair market value, it's going to represent a larger share than the interest itself. The third reason could be when a partner dies. When a partner dies, the people that inherited their share, their percentage, they could be receiving an interest that's different than the inside basis. So the outside basis and the inside basis will be different. Don't worry, we'll talk about that later. Let's talk a little bit more about outside basis of partners. Because when we mean basis of partners, we mean outside basis. When the partner receives income or profit from the partnership, their basis will increase. Why? Because remember when we talked about the first example, in the first example, the partner gets allocated some income to them. And that income increased our partners. Why? Because the income was taxed. Let's go back to that example real quick. If you go back to the example that we worked on early on in this presentation, we looked at this example. And remember NOAA got 40% of the 220,000. That 40% and we said NOAA paid taxes on that 88,000. That's NOAA share of taxes. Once you receive that income, whether you receive it or not, it doesn't matter. Once it's allocated to you, because you may never receive it in cash, it's allocated to you, you pay taxes on it. Once you pay taxes on it, it's going to increase your basis, increase your basis. On the other hand, if there's any deduction or any loss from the partnership, your basis will go down. And we'll talk about much, much more about the basis. And these changes guarantee that the items related to the partnership are only taxed once. Because remember what happened to NOAA. NOAA received what allocated 88,000 in income for that particular year. Now, if NOAA takes this money, NOAA would draw $50,000. NOAA wants to put a down payment on a new home. NOAA took $50,000 out as a distribution. That's when NOAA receives the cash. That transaction is no longer taxable. Why? Because NOAA already paid taxes on this income when it was allocated to them. Also, keep in track of the outside basis are important for the deductibility of partnership losses. So if you have losses, you want to make sure we can take the losses and deduct it against our basis. Tax treatment of partnership distribution, I just told you, when NOAA took $50,000, well, that's a distribution. We want to make sure it's not taxable. Also, calculating gains and losses when NOAA actually sells their interests on outside party. And let's take a look, an example, an exchange for 40% interest in XYZ, which operate as a partnership, calendar year partnership. NOAA contributed $100,000. This year, XYZ generates 80% of regular taxable income with no individually stated income or expenses. So we have no separately stated item. During the year, NOAA takes out $10,000 from the partnership. What's the tax effect to NOAA? So how much is NOAA will have to pay taxes? Now, what's wrong is to take $10,000, say the tax effect is $10,000, because NOAA takes $10,000. No, it does not matter. If the partnership generated $80,000, NOAA share is 40%, NOAA will have to allocate $32,000 to their income as taxable. Now, NOAA took $10,000. Well, that's not taxable because the whole $32,000 is taxable. Of the $80,000, NOAA shares a $32,000, and we can assume this $10,000 is coming from that $32,000. Now, what's the basis in the partnership for NOAA? Well, NOAA started with $100,000, started with $100,000 contribution, then NOAA absorbed or increased their basis. So they started with $100,000, increased their basis by how much? By $32,000. Then they took $10,000. Remember, I told you, they took $10,000. When you take the $10,000, it's coming out of reducing your basis. You want to keep track of this. Therefore, NOAA's basis is $122,000. What should you do now? Go to Fahat Lectures, look at additional lectures, MCQs, true, false, notes, that's going to help you do what? Learn this concept better. The idea, the concept that a partnership is a flow through or pass through entity is important. How inside basis of a partnership and how outside basis work is important as well. Good luck, study hard whether you are a CPA candidate, enrolled agent, or an accounting student, and stay safe, of course.