We would usually tell our clients that contingent income, income you may well not receive, isn’t taxable. However, that is not necessarily the case under our increasingly complex tax rules, such as IRC Section 702.
The “A,B,C’s” of our discussion are the subsections of the statute. Section 702(a) provides a brief eight-point listing of items a partner is to “take into account separately”:
- capital gains and losses that are short-term (one year or less holding period)
- capital gains and losses that are long-term (more than one year holding period
- Section 1231 gains and losses
- charitable contributions
- certain dividends
- foreign taxes
- other items, whether income, gain, loss, deduction, or credit to the extent so provided in the regulations
- taxable income or loss, exclusive of items requiring separate computation.
The regulations add to the list of items requiring separate reporting. Examples include soil and water conservation payments, intangible drilling costs, and recoveries of bad debts and prior taxes. Partnership flow-through can even reach such non-business items as alimony payments (Regs. 1.702-1(a)(8)). Non-business deduction flow-through from a partnership can affect such matters as measuring the partner’s net operating loss deduction. (Regs. 1.702-2.)
The last section (Section 702(a)(8)) is where most partnership items get summed and reported in one general grouping.
The next-to-last group (Section 702(a)(7)) is the one that requires separate reporting for items that may have tax significance at the partner level. This is a particularly important subsection in modern times because of the increasingly narrow focus of our tax provisions.
There are myriad items that might have different carryforward and carryback rules when distinguished. For example, a one-year carryback may be possible with the research and development credit. (Sec. 41, Form 6765).
There are different rules for the “oil and gas well production credit.” (Sec. 39(a)(3); Form 8904.) Any item that would affect the partner’s tax return generally requires separate reporting.
These items, whether separately reported or grouped under section 702(a)(8), then flow-through according to that partner’s distributive share. The language is “distributive,” – not “distributed.” Flow-through items are taxable or deductible or creditable whether or not the partnership actually distributes them.
Section 702(b) focuses on the character of items in the partner’s distributive share, saying such character is determined “as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership.”
Section 702(c)’ has similar distributive share rules when it is necessary to measure the partner’s “gross income.” There is a Section 702(d) whose job is cross referencing.
The taxability of income in the Supreme Court’s 1973 Basye decision concerned a medical partnership. The IRS succeeded in persuading the court that payments into a retirement plan represented income earned by a partnership (Permanent) and only “deflected” into a retirement trust to benefit physicians.
“A portion of Kaiser’s compensation to Permanente was in the form of payments into a retirement trust for the benefit of Permanente’s physicians, none of whom were eligible to receive the amounts in his tentative account prior to retirement after specified years of service. No interest in the account was deemed to vest in a particular beneficiary before retirement, and a physician’s preretirement severance from Permanente would occasion the forfeiture of his interest, with redistribution to the remaining participants. Under no circumstances, however, could Kaiser recoup the payments once made.” (Basye, 410 U.S. 441 (1973).)
The deflection was from a partnership, but that partnership ended up being the tax-reporting “entity.” The court basically found that income had been earned by the partnership, wasn’t going back to the party paying and thus was not contingent income.
The partners were taxable on each partner’s “distributive share” under section 702(b)’s language characterizing the income “as if” each medical professional had realized it in the same fashion as the partnership.
There was undoubtedly tax planning in the structure but the end result was also potentially harsh given some of the physicians would obviously be taxed on income they wouldn’t receive. The partner’s distributive share of partnership income would increase the partner’s basis in his/her partnership interest. (Sec. 705(a)(1)(A).)
The author still believes what he wrote years ago: “The entity-aggregate conflict has been, and will continue to be, one of the most controversial areas of taxation.” (“The Partnership as an `Entity’: Implications of Basye,” 54 Taxes 143, 158 (1976), quoted in “Practitioner Summarizes Partnership Aggregate-Entity Authorities,” Tax Notes, 7/25/17.
The details of the partnership tax rules can be important under the 20 percent of business income rules in finding an active business.
“S corporations and partnerships are generally not taxable and cannot take the deduction themselves. However, all S corporations and partnerships report each shareholder’s or partner’s share of QBI (qualified business income) items, W-2 wages ,… and whether or not a trade or business is a specified service trade or business (SSTB) on a statement attached to the Schedule K-1 so the shareholders or partners may determine their deduction.” (“Tax Cuts and Jobs Act, Provision 11011 Section 199A – Qualified Business Income Deduction FAQs,” IRS.gov.)
Partnership classification is an important first point of review (Regs. 1.761-1). For example, it might be possible for a particular co-owner of realty to engage in a like-kind exchange of a partial interest in realty whereas upon finding a partnership, it isn’t possible to like-kind exchange partnership interests. (Sec. 1031.)
Upon finding a partnership, the practitioner needs to keep in mind importance of understanding the details of Section 702.
Particularly important is identifying all of the items at the partnership level that need to be distinguished because separate reporting may affect the partner.