U.S. Investment Tax Rules: Dividends, Capital Gains & Partnerships

Portfolio Investments and Dividends

Portfolio investments: Interest, dividends, or capital gains are taxed when you receive them; interest is taxed at ordinary rates. Dividends are taxed and so are corresponding capital gains. Qualified dividends: Investors must hold the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (the first date on which a purchaser of the stock would not be eligible to receive a declared dividend). These are taxed at 0%, 15%, or 20%. Nonqualified dividends are taxed at ordinary rates.

• Interest from U.S. Treasury bonds is exempt from state tax, while interest from corporate bonds is not. Treasury bonds always pay interest periodically; corporate bonds may or may not.

Capital Assets and Holding Periods

Capital assets: Assets you buy and hold with appreciation potential, including alternative investments and personal-use assets. Bonds are capital assets even though they generate interest income. Gains are deferred until sale or disposal. Preferential rates compared to ordinary income mitigate multiple taxation and encourage long-term investment.

• Capital assets include stocks. Use FIFO to determine tax basis of shares a taxpayer sells; if you track lots, you can use the specific identification method to determine the tax basis of shares sold. With specific identification you can choose to sell high tax-basis shares first, minimizing gains or increasing losses on dispositions. For brokerage accounts, you can elect a default method such as LIFO where permitted.
• Holding period of capital assets: Starts the day after acquisition and includes the day of disposition. If you sell capital assets you've held for a year or less, the result is a short-term capital gain or loss; short-term capital gains (STCG) are taxed at ordinary rates. Long-term capital gains (LTCG) are taxed at preferential rates (0%, 15%, 20%).
• Amount realized from sale = selling price less fair value of items received and broker's fees, minus tax basis (historical cost plus cost of subsequent improvements).
• Individuals can recognize up to $3,000 in net capital losses against ordinary income annually. Net capital losses carry forward indefinitely but cannot be carried back. Short-term capital losses are applied first against the $3,000 annual capital loss limit before long-term capital losses apply.
• Unrecaptured Section 1250 gains are subject to a 25% rate; collectibles held > 1 year are subject to a 28% capital gain tax rate.

Netting Capital Gains and Losses

Step 1: Group all gains and losses into short-term and long-term items. Net the gains and losses within each group.

Step 2: If there is a net long-term capital loss in Step 1, offset it against any net short-term capital gain in Step 1.

Step 3: Separate long-term items into 28%, 25%, and 0%/15%/20% groups. Net the gains and losses within each group. Net long-term capital loss carried from prior years is included in the 28% group.

Step 4: If there is a net short-term capital loss in Step 1 and only long-term capital gains after Step 3, offset the net short-term capital loss against the highest-taxed long-term capital gains.

Step 5: If the 0%/15%/20% amount < 0, offset it first against 28% capital gain, then against 25% capital gain.

Step 6: If the 28% amount < 0, offset it first against any 25% capital gain, then against 0%/15%/20% capital gain.

Step 7: If there is a net short-term capital loss from Step 1 and any long-term capital gains remain from Steps 5 and 6, offset the net short-term loss against the highest-taxed long-term gains.

Step 8: After netting, qualified dividend income is taxed with the 0%/15%/20% long-term capital gains. Note: taxpayers cannot net capital losses against qualified dividend income (qualified dividends do not enter the netting process).

Wash Sales and Net Investment Tax

Wash sale: Selling or trading stock at a loss and, within 30 days before or after the sale, buying substantially identical stock or securities. The wash sale provisions disallow recognition of realized losses; the unrecognized loss is added to the basis of the newly acquired stock. Wash sale rules require a 61-day holding period (30 days before + day of sale + 30 days after).

Net investment tax: A 3.8% tax on the lesser of: (a) net investment income, or (b) the excess of modified adjusted gross income (MAGI) over the threshold ($250,000 MFJ; $200,000 single). Net investment income includes gross income from interest, dividends, annuities, royalties, rents, passive income, and net gain from property sales, less related expenses.

Partnership Taxation Basics

Unincorporated entities such as general partnerships (GPs), limited partnerships (LPs), and limited liability companies (LLCs) are treated as partnerships for tax purposes unless they elect corporate taxation. Partnerships are flow-through entities; income flows through to owners, who report and pay tax on their personal returns.

• GP: Comprised of general partners with unlimited liability for entity liabilities.
• LP: At least one general partner (unlimited liability) and at least one limited partner (liability limited to investment); LLP is common for professional services.
• LLC: Formed by articles of organization; owners/members have limited liability. LLCs are generally treated as partnerships unless they elect otherwise.

Both the "entity" and "aggregate" concepts apply to partnership tax law. The entity approach treats a partnership as separate from its partners (e.g., partnerships make most tax elections). The aggregate approach treats a partnership as the sum of partners' interests (e.g., partnerships don't pay tax—partners do). Each item of partnership income and loss (reported on Schedule K) is generally allocated according to the profit-sharing ratio. Allocations can differ if partners agree to "special allocations" that have "substantial economic effect"; provided the sole purpose is not tax avoidance, special allocations generally have substantial economic effect.

Separately Stated Items

• Short-term and long-term capital gains and losses
• Charitable contributions
• Dividend income
• Section 179 deduction

Guaranteed Payments and Partnership Interests

Guaranteed payment: Payment for services performed by a partner or for use of partner capital. Deducted in computing ordinary partnership income (loss). Guaranteed payments cannot be determined by partnership taxable income for a given year. A partner treats a guaranteed payment as received on the last day of the tax year; the payment is always taxable as ordinary income. Both ordinary deductions and separately stated items may apply to the receiving partner.

Partnership interests can include:

• Capital interest — the right to receive partnership assets on liquidation.
• Profits interest — the right or obligation to receive future profits (or losses).

Contributions of Property and Basis Rules

Contributions of Property

• General rule: Neither the partner nor the partnership recognizes gain or loss on transfer of property from the partner to the partnership.
• Partner's basis in the partnership equals the basis they had in the contributed asset(s) (substituted basis).
• Partnership's basis in received asset(s) equals the contributing partner's basis in the contributed asset(s) (carryover basis).
• Reasoning for nontaxable treatment: only form of ownership changes; no substantive change in partner's economic position or ability to pay tax; policy to not discourage business formation.

No gain or loss is recognized by a partner when property is contributed to a partnership in exchange for a partnership interest. Inside basis is the partnership's adjusted tax basis in each partnership asset as determined by the partnership's tax accounts. Outside basis is each partner's adjusted tax basis in their partnership interest. Outside basis changes yearly as it is adjusted for the partner's share of income and losses, changes in debt, and contributions and distributions; conceptually, it represents a partner's share of the inside basis for each partnership asset.

If a partner contributes property with built-in gain (FMV > adjusted basis) or built-in loss (FMV < adjusted basis) at contribution, the built-in gain or loss must be allocated to the contributing partner when the partnership disposes of the property; any remaining gain or loss is allocated to all partners based on profit-sharing ratios.

Debt Allocation and Liability Rules

If the partnership has debt, each partner's outside basis includes his or her share of debt. How debt is allocated depends on the type of debt.

• Recourse debt: Allocated to partners with ultimate responsibility for paying the partnership's debts (partners with economic risk of loss), commonly accounts payable. Allocation depends on partnership agreements and guarantees.
• Nonrecourse debt: Secured by partnership property; individual partners are not personally liable. Nonrecourse debt is generally allocated based on profit-sharing ratios because partners are responsible only to the extent partnership generates profits. LLC debt is generally nonrecourse unless an owner personally guarantees the debt.

If a partner contributes property that has a liability attached to it, the partner must first allocate the liability to partners that share in partnership debt, then subtract the liability from the contributing partner's outside basis as a deemed distribution of cash. If the liability is nonrecourse, the amount of debt in excess of the tax basis of contributed property is generally allocated solely to the contributing partner. Any remaining debt (not in excess of basis of contributed property) is allocated to all partners according to profit-sharing ratios.

Section 721(a) generally prevents gain recognition on contribution to a partnership. However, if liabilities shifted to the partnership result in relief of debt that exceeds the contributor's basis, gain is recognized.

Example: Contribution with Liability

Joe contributes property (tax basis $30,000; FMV $235,000) and $60,000 cash to JM Partnership in exchange for a 50% partnership interest. The contributed property is subject to a $45,000 liability. Joe's recognized gain = $0. Calculation: $45,000 - $15,000 = $30,000; $30,000 / 2 = $15,000 share. Joe's basis in the partnership interest = $60,000 + $30,000 substituted basis + $15,000 liability in excess of tax basis of property + $15,000 share of remaining liabilities - $45,000 liability = $75,000 outside basis.

Liability Excess and Deemed Distributions

If (1) a partner contributes property with an attached liability and (2) the liability exceeds the partner's outside basis prior to the deemed distribution of cash, then the contributing partner recognizes a capital gain for the excess liability (capital gain = liability - outside basis). Remember: if a partnership assumes a liability from a partner, that partner is deemed to have received a cash distribution. The deemed distribution occurs after the partner has increased outside basis for any allocations of debt.

Compensation via Partnership Interests

If a partner receives only a capital interest in the partnership as compensation for services, the partner recognizes the fair market value of the services as ordinary income. Capital interest equals the right to receive a share of partnership capital upon liquidation. The partner's initial basis in the partnership interest equals the fair market value of the services. The partnership deducts or capitalizes the value of the capital interest depending on the nature of services provided; deductions are generally allocated to partners not providing services.

If a partner receives only a profits interest as compensation, the partner will not recognize ordinary income related to the services. A profits interest is the right to share future profits. The partner's initial basis equals the amount of debt allocated to the partner; other partners' outside basis is reduced proportionately by the allocated debt. The service partner's outside basis increases as the partnership earns income and allocates it among partners. Because the contributing partner does not recognize ordinary income, non-service partners do not receive tax deductions.

Distributions, Loss Allocation, and Limitations

Because partnership income is taxed as earned on each partner's return, cash distributions are generally considered: (a) distribution of profits already taxed, (b) return of contributed capital, and/or (c) distribution of cash borrowed by the partnership. Thus, cash distributions are generally tax-free events so long as they do not exceed the partner's outside basis. Cash distributions that exceed outside basis are generally treated as taxable capital gains (and reduce outside basis to zero).

A partnership's ordinary loss and other items are allocated to each partner (on Schedule K-1) based on profit-sharing ratios. Whether a partner can deduct their share of partnership losses on their personal return depends on the following loss limitations:

1. Tax basis limitation — A partner can only deduct losses to the extent of sufficient outside basis. Outside basis is determined at the end of the partnership tax year, prior to consideration of losses but after income, contributions, and distributions. Excess losses are suspended until positive outside basis exists.
2. At-risk limitation — Deductible losses are limited to the amount of outside basis that is considered "at-risk"; generally, recourse debt is at-risk, most nonrecourse debt is not.
3. Passive loss limitation — Activities are classified as active (material participation), portfolio (investment), or passive (no material participation). Passive activities include rental activities and limited liability ownership in flow-through entities. Passive losses can only offset passive income; excess passive losses are suspended and carried forward until passive income exists or the activity is disposed.