General implications for Form 1040

Understanding how PTP investments are taxed is crucial. Whereas stocks return cash to investors in the form of dividends, PTPs return cash to investors through partnership distributions. Partners in a PTP are taxed on their share of the partnership’s income and deductions, while stock investors are taxed on their share of dividends received. To be clear, as with any flowthrough entity, a PTP’s investors are not taxed based on the cash they receive; they are taxed based on the income allocated to them. The income is reported on Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc.

Often, the Schedule K-1 packages are lengthy, containing not only federal information that needs to be accounted for on the investor’s tax return but also foreign reporting and state income tax reporting. Investments in PTPs can cause investors to file additional foreign reporting forms such as Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, or Form 965, Inclusion of Deferred Foreign Income Upon Transition to Participation Exemption System. Further, a single PTP investment can result in the need for multiple state income tax filings per year, when the partner’s share of income is allocated across the various states in which the PTP operates or invests. Some PTPs also invest in underlying PTPs, which, for reasons discussed later in this article, can significantly complicate loss tracking and income tax reporting.

Sec. 199A: The Sec. 199A qualified business income deduction has added complexity to PTP K-1s. Sec. 199A attributes have to be reported on an activity-by-activity basis, and PTPs can have many underlying activities (many of which may be PTPs that the PTP has invested in) that then must be accounted for on the individual’s tax return.

Basis: The cash distributions from PTPs may make this all worth the effort, but investor beware: You should make sure you are not out of basis. When a PTP reports a loss to its partner in a tax year, loss limitation rules need to be considered, just as they must be for any partnership investment. Routinely, in their practice, the authors have seen PTPs generate losses and make distributions year after year, which can cause Sec. 704(d) tax basis and Sec. 465 at-risk basis issues. If the PTP makes a distribution in excess of the partner’s basis, there will be gain to report under Sec. 731. Additionally, to the extent the PTP allocates the partner losses in excess of basis, those losses will be limited. Or if a partner’s at-risk amount has gone to zero and the partner later has a distribution, making the partner’s at-risk amount negative, the partner may have at-risk recapture under Sec. 465(e).

Passive-activity-loss rules: Assuming a taxpayer has enough tax basis and at-risk basis to allow a loss from a PTP, he or she still has an additional limitation under Sec. 469. PTPs are subject to the passive-activity-loss (PAL) rules under Sec. 469 just like other partnership investments but with added limitations. The PAL rules generally limit the deductibility of losses from passive activities to the extent of income from passive activities. However, each PTP is viewed separately for applying the PAL rules under Sec. 469(k). This means that a PAL from a PTP can be offset only against other income/gain from that specific PTP. PALs from PTPs must be tracked separately and reported on Worksheet 5, 6, or 7 of Form 8582, Passive Activity Loss Limitations. The practical problem is that PTPs usually generate tax losses year after year. Without offsetting income, PALs remain suspended and provide an investor no current tax deduction.

As a result, losses allowable for tax and at-risk basis but limited under Sec. 469 are carried forward to future years and are allowable to the extent of passive income from the PTP. Note that even if a loss is allowed under Sec. 469, it could be further limited by the Sec. 461(l) excess business loss rules; however, that topic is beyond the scope of this article. Given that losses from a PTP can be offset only by income or gain from that specific PTP, how could an investor go about monetizing a loss? One answer involves getting rid of those extra pounds of lemons.

Monetizing passive activity losses

One option for monetizing PALs from a PTP is to fully dispose of the PTP investment in a taxable transaction. Then, the PALs will be allowed as a current tax deduction under Sec. 469(g) and Sec. 469(k)(3). However, by disposing of the asset, the investor loses any additional appreciation that may occur by continuing to hold the property. Investors should consider whether disposing of a PTP investment to recognize a tax loss is a better strategy than holding the investment for further appreciation and cash flow.

When disposing of a PTP investment, be aware, too, that selling a PTP interest with “hot assets” — unrealized receivables or inventory items of the partnership — may result in ordinary income. Sec. 751 requires the gain attributable to disposition of these assets to be characterized as ordinary, meaning that the preferential capital gains tax rates will not apply; this may come as a surprise to investors. Sec. 751(c) defines “unrealized receivables” and Sec. 751(d) defines “inventory” to include items that if sold by the partnership would result in ordinary income, such as tangible and intangible personal property held by a business (Sec. 1245 depreciable property).

Also be aware that, due to the nature of the business of most PTPs, depreciation can be a big factor in creation of the losses that flow through to investors. This ordinary income recapture is reported on the sales statement attached to the PTP’s Schedule K-1. For example, in the situation illustrated in the table “Ordinary Income Recapture,” below, the individual thinks she has a capital gain from the sale of her 50,000 PTP units of $175,000 ($200,000 proceeds less $25,000 basis). She assumes the tax on the sale is $35,000, based on a 20% preferential capital gain rate (ignoring for this example the 3.8% net investment income tax and state taxes). What she might not realize is that $100,000 of the gain is related to recapture property. This results in ordinary income rather than capital gain for that portion. If the taxpayer’s ordinary income tax rate is 37%, this means that the total tax on the sale is $52,000 ([$100,000 × 37%] + [$75,000 × 20%]). The extra $17,000 of tax can come as an unwelcome surprise.

Gifting or transferring the PTP interest

Taxpayers sometimes think that they will be able to realize the PALs by making a gift of the PTP interest. However, gifting the units will not allow the losses to be recognized currently; instead, PALs on gifted PTP units will be added to the basis of the PTP interest in the donee’s hands under Sec. 469(j)(6). Further, when gifting units encumbered by liabilities, a taxable event may occur. The donor will recognize gain if the amount of liabilities assumed by the donee exceeds the transferor’s basis in the units (including liabilities). At least the gain can be offset by a PAL of the same amount.

The investor’s death: There are similar problems with unrealized PALs at the investor’s death. If income is never realized to offset the limited losses, then upon death, the PALs are recognized on the investor’s final tax return to the extent that the losses exceed the difference between the date-of-death fair market value (FMV) and the investor’s basis prior to death (the step-up in basis). If the PALs do not exceed the step-up in basis, they are lost and never provide a tax benefit.

Donating a PTP interest to a charity or a private foundation

Can you get a tax benefit from donating a PTP interest? Many taxpayers are charitably inclined, and so when life gives them lemons, they make lemonade by making a donation to charity. A donation of a PTP investment to a public charity may be an effective way to dispose of the investment with the added benefit of assisting a public charity; however, additional tax implications should be considered when donating PTP units.

When gifting a partnership interest to a charity, the donor is deemed to have proceeds equal to the amount of liabilities on the partnership interest gifted, resulting in a transaction that is part sale and part gift (commonly referred to as a “bargain sale”). Under Sec. 1011(b) and Regs. Sec. 1.1011-2(b), the donor’s basis is allocated to the sale portion in proportion to the sale/gift amount, so in most cases, a donation of partnership units will result in some gain recognition on the transfer. This is not what most people would expect — it is not the same as giving publicly traded stock.

For example, say a client wants to gift PTP units he has held for over one year with an FMV of $40,000 and a basis of $25,000 (including $10,000 of allocated debt). The amount of the gift in this instance would be $40,000, the actual FMV of the interest, or 80% of the value of the assets on a lookthrough basis ($40,000 gift ÷ $50,000 total gross FMV of assets). The amount realized on the $10,000 of debt relief is then reduced by an allocation of basis of $5,000 (20% (ratio of debt relief to FMV of assets) × basis of $25,000). As a result, the client would recognize $5,000 of gain (which would represent 20% of the total gain had the entire interest been sold) from the donation. This gain may be partially or fully offset by the suspended PALs.

Additionally, when donating a PTP interest to a charity, the charitable deduction will be limited due to “hot asset” ordinary income recapture items under Sec. 751, such as depreciation recapture or depletion recapture. The charitable deduction for the contribution of a PTP interest to a charity is the remainder of the FMV for the units, less liabilities, less ordinary income recapture, and less any short-term capital gain. In effect, this could limit the deduction to basis in the units given.

Let us continue the example above and say that there is $15,000 of ordinary income recapture related to the PTP unit contribution. Because 20% of the gain is recognized in the bargain sale, 20% of the ordinary income recapture would be recognized, so $3,000 ($15,000 ordinary income recapture × 20% (ratio of debt relief to FMV of assets) of the $5,000 gain would be ordinary. In this instance, the charitable deduction would be limited to $28,000 ($40,000 FMV, less $12,000 remaining ordinary income recapture). Modeling is key to determining the deduction allowable from a donation of a PTP interest to a charity — and whether it makes sense.

Taxpayers gifting partnership interests to private foundations are subject to greater limitations on their deductions. The deduction for a donation of appreciated property to a private foundation is limited to the lesser of the donor’s basis or the FMV of the interest, unless the property is qualified appreciated stock under Sec. 170(e)(5). Despite the fact that PTPs are often thought of as marketable securities, PTP interests are not considered to be qualified appreciated stock under Sec. 170(e) (5)(B). Remember, PTP units are not stock but rather partnership interests. As a result, gifts of appreciated PTPs to a private foundation are limited to the donor’s basis.

In addition, private foundations are prohibited under Sec. 4941 from engaging in acts of self-dealing (directly or indirectly) with a disqualified person. Thus, the contribution of partnership units to a private foundation that includes a bargain-sale component requires the donor to consider whether he or she is a disqualified person in relation to the private foundation. The definition of disqualified persons is broad and encompasses many contributors and individuals related to a foundation under Sec. 4946(a)(1), including someone who is a substantial contributor to the foundation; the foundation manager; an owner of more than 20% of a corporation, partnership, or enterprise that is a contributor to the foundation; or a family member of one of these people. Under Regs. Sec. 53.4941(d)-2(a)(1), if a disqualified person makes a gift of a PTP interest to a private foundation and there is a bargain-sale component, then the transaction will be a prohibited transaction — resulting in the transaction having to be unwound and excise taxes owed.

Be aware, too, that donations of a PTP interest will not result in the recognition of PALs other than to offset any gain/income recognized on the contribution. Any suspended PALs will be added to the basis of the interest gifted to charity. Also, these donations are subject to extensive and complex substantiation requirements, including a qualified appraisal, qualified acknowledgment letter from the charity, and completion of Form 8283, Noncash Charitable Contributions. The requirements above should not necessarily prevent charitably inclined persons from considering donating their PTP units. But the complications noted above require careful planning and modeling to determine the implications of a gift of a PTP interest to a charitable organization. As you can see, PTP units can be challenging assets to give away due to the extensive reporting requirements. These complexities may deter many taxpayers from gifting PTP units.

Recent legislative proposals

Changes might lie ahead for PTP investments. On March 28, 2022, Treasury released its Green Book² proposals to accompany the Biden administration’s budget. Included in the Green Book was a proposal to eliminate the corporate income tax exception for PTPs that realize qualifying income or gains from fossil fuels beginning after Dec. 31, 2027. While no specifics related to the proposal are currently available, it would presumably require PTPs with income or gains from fossil fuels to be taxed as corporations, and thus the investor’s reporting requirements would likely follow that of a public corporation versus a complicated PTP. However, the ideas contained in the Green Book are only proposals at this time. The recent Inflation Reduction Act³ notably did not contain a similar provision to the Green Book, so it appears this proposal may be less of a legislative priority at this time. Regardless of any proposals, congressional legislation is required to enact a change in tax law. PTP investors should be on the lookout for new developments and reach out to their tax advisers for guidance if new tax legislation is enacted that includes a provision like that proposed in the Green Book.

A worthwhile investment?

A PTP investment is a complex investment that may present opportunities to individual investors but requires tax planning to achieve an investor’s goals. Holding the units of a PTP requires basis tracking and planning for passive losses from the investment. The sale of PTP units necessitates planning around the type and treatment of gain but presents investors the opportunity to recognize suspended losses. Gifting units to a charitable organization may be desirable from a nontax perspective, but planning should be done to consider potential gain recognition on donation and the reporting requirements. If you make careful choices and plan wisely, a basket of lemons may not be a bad thing.