I. Aggregate and Entity Theories of Partnership Taxation. II. Taxing Partnership Operations. A. Partnership Level Determination of Tax Results. B. Partnership Taxable Income. C. The Partner’s Basis....

I. Aggregate and Entity Theories of Partnership Taxation.
II. Taxing Partnership Operations.
A. Partnership Level Determination of Tax Results.
B. Partnership Taxable Income.
C. The Partner’s Basis.
D. Partnership Distributions.
E. Example.
AGGREGATE AND ENTITY THEORIES OF PARTNESHIP TAXATION
A recurring issue throughout Subchapter K is whether a partnership is treated for tax purposes as an aggregate of its individual partners or an entity separate and apart from its partners. The Code does not exclusively use either approach. Partnerships are treated as entities for some tax purposes and aggregates for others. For example, partnership income is taxed directly to its partners under an aggregate theory. At other times, the Code blends the two theories and adopts a modified aggregate or entity approach to determine the tax results to the partners.
TAXING PARTNERSHIP OPERATIONS
Partnership Level Determination of Tax Results
A partnership is not technically a taxpayer. Its primary function for tax purposes is to facilitate the computation of each partner’s share of the venture’s profit or loss. This is primarily an accounting function: once income or loss from partnership operations is calculated, those amounts are passed through to the partners who are responsible for reporting their shares on their own tax returns.
Because it is the partnership, not the individual partners, that is carrying on the enterprise, it would be unduly cumbersome to require each of the partners to keep her own set of books for the enterprise’s activities. This would require each partner to account for the enterprise’s accounts receivables, cost-of-goods-sold, depreciation, etc. This could certainly become an accounting, as well as an auditing, nightmare. For these reasons, a partnership must adopt a taxable year, choose a method of accounting, and make certain elections just as if it were a taxpayer. The partnership is also required to compute its taxable income and to file an information return (Form 1065), that informs the IRS and the partners about the entity’s operations. At the same time the partnership provides each partner with a statement (Form K-1) which informs them of their respective shares of the income and deduction incurred at the partnership level. This process enables the partners to report their shares of partnership income, and also allows the IRS to audit the operations of the enterprise as a whole.
Partnership Taxable Income
A partnership computes its taxable income in the same manner as an individual except it is not permitted certain deductions, such as personal exemptions, medical expenses, alimony and expenses for the production or collection of income. A partnership is not permitted a net operating loss deduction because a partnership’s losses pass through to its partners.
The characterization of tax items is determined at the partnership level. The partnership must separately state certain items to preserve their unique character as they pass through to the partners. This enables the partners to combine the passed through items with their non-partnership tax items when computing tax liability. The tax items required to be separately stated include (but are not limited to): short-term capital gains and losses, long-term capital gains and losses, charitable contributions, and dividends taxed as net capital gain.

Example Abby and Bob are equal partners in the AB partnership. During December 2009, each partner received a Schedule K-1 showing the following results of partnership operations from October 1, 2008 through September 30, 2009. Ordinary income from business activities (partnership taxable income) $42,300 Dividend income $2,300 Net long-term capital loss ($4,000) Investment interest expense ($5,500) Charitable contributions ($1,900) Abby will include her $42,300 share of ordinary business income on Schedule E; her $2,300 share of dividend income on Schedule B, and her share of the long-term capital loss on Schedule D of her 2009 Form 1040. Per §163(d), Abby's $5,500 share of investment interest expense is deductible only to the extent of her net investment income for 2009. The deductible portion of the interest expense and Abby's share $1,900 share of the charitable contribution must be reported as itemized deductions on Schedule A, Form 1040.

The Partner’s Basis
A partner’s basis in his or her partnership interest is a crucial element in partnership taxation. When a partner makes a contribution to a partnership or purchases a partnership interest, he or she establishes a beginning basis. Because partners can be personally liable for partnership debts, a partner’s basis in his or her partnership interest is increased by his or her share of any partnership liabilities. Accordingly, each partner’s basis fluctuates as the partnership borrows and repays loans or increases and decreases its accounts payable. In addition, a partner’s basis in his or her partnership interest is increased by the partner’s share of partnership income and decreased by his or her share of partnership losses. Because a partner’s basis in his or her partnership interest can never be negative, the basis serves as one limit on the amount of deductible partnership losses.
Partnership Distributions
When a partnership makes a current distribution, the distribution generally is tax-free to the partners because it represents the receipt of earnings that already have been taxed to the partners and that have increased the partners’ bases in their partnership interests. Subsequent distributions reduce a partner’s basis in his or her partnership interest. If a cash distribution is so large, however, that it exceeds a partner’s basis in his or her partnership interest, the partner recognizes gain equal to the amount of the excess.

Additional Note The increase in a partner’s basis for earnings prevents double taxation of those earnings upon a subsequent distribution, sale of the partnership interest, or liquidation of the partnership.

When the partnership goes out of business or when a partner withdraws from the partnership, the partnership makes liquidating distributions to the partner. Like current distributions, these distributions cause the partner to recognize gain only if the cash received exceeds the partner’s basis in his or her partnership interest. A partner may recognize loss if he or she receives only cash, inventory, and unrealized receivables in complete liquidation of his or her partnership interest.
Example
LES HICKS, Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
UNITED STATES TAX COURT
Filed May 7, 2009
BACKGROUND
II. PHHA
PHHA is a Texas limited liability company. PHHA reports its operations for Federal income tax purposes as if it were a partnership and on the basis of a calendar year. Taxpayer owned a 10-percent interest in PHHA. An unrelated individual owned the remaining 90-percent interest.
PHHA issued taxpayer a Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., for 2005. The Schedule K-1 reported that taxpayer's share of PHHA's ordinary business income for 2005 was $54,819. Taxpayer did not receive any actual distributions from PHHA during 2005.
III. 2005 Tax Return
Taxpayer filed a Form 1040, U.S. Individual Income Tax Return, for 2005 using the filing status of "Single". Taxpayer did not report on that return, or otherwise include in his gross income for 2005, any of the $54,819 PHHA reported to him.
IV. IRS's Determination
IRS determined in the notice of deficiency that taxpayer's gross income for 2005 included the $54,819 and increased taxpayer's gross income accordingly.
DISCUSSION
I. Income Tax Deficiency
B. Distributive Share of PHHA Income
Taxpayer argues that the $54,819 is not taxable to him in 2005 because he did not receive any actual distributions from PHHA during that year. We disagree with taxpayer's argument that the $54,819 is not taxable to him in 2005. A partner such as taxpayer must take into account his distributive share of each item of partnership income even if no partnership income is actually distributed to him during the year to which the distributive share relates. See sec. 702(a).