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Even simple capital accounts can get complicated

robbins largeThese questions came in rapid-fire succession! This is a complicated subject and very misunderstood, but I am asked these questions frequently. I hope this very basic discussion will help.

Q: We want to buy a building and plan on forming a partnership to hold it. The partners will put money into the company. How do we record this on our books?

A: A “capital” account is established for each partner to track the investment in the partnership. Some of my clients like to keep contributions, allocated income, and distributions all in separate accounts, while others like just one capital account per partner. Capital accounts may be maintained on one or more different systems of accounting (cash, accrual or tax basis) and consequently represent a historical accounting. Capital accounts are not a representation of changes in value of the partnership investment.

Q: Then the company goes on to earn money in the coming years. As I understand it, income is allocated to the partners, but as money is distributed there is no additional income as long as the distributions are not greater than the balance of each partner’s capital account. Distributions past the capital accounts would then be taxed as income. Correct?

A: As the company makes income or incurs a loss, that income/loss is allocated to the partners and either increases or decreases the capital accounts. The partnership agreement will govern how the income or loss is allocated to the partners, and each partner is taxed on his allocated income or loss (subject to various limitations). Often loss allocations are stopped when a partner’s capital hits zero, but this needs to be spelled out in the agreement. Obviously it is important to have a knowledgeable professional review your agreement.

Cash and property distributions to the partners generally do not result in additional taxable income and serve to reduce the partner’s capital account. Again, usually distributions are not made if they would drive the capital account below zero, but this should also be specified in the agreement. Partners can be taxed on distributions in excess of their “basis” in the company. Basis is determined separately from the capital account, so each partner needs to track his own basis carefully. If the distribution does exceed basis, it is considered a capital gain and taxed at the lower capital gain rates.

Q: The final question is, if several years down the road the building is sold, what is the tax liability? Is it simply the capital gains on the building that are passed through, or is it now the whole sale price of the building that is taxable? And in this final scenario, does it make any difference if the sale proceeds are actually distributed to the members or retained in the company?

A: If the building is later sold, the sales proceeds minus the adjusted basis minus expenses of the sale results in a taxable gain or loss. This again is allocated to each partner based on the partnership agreement. Some of the gain may be taxed at ordinary rates, some at a 25 percent capital gain rate and some at a lower capital gain rate depending on the partner’s income level. It doesn’t matter if the cash is distributed to the partner. Just like the income allocation above, the prorated share of the gain is taxable regardless of how the cash flows, but the capital accounts are also increased for this gain. Any cash distributed follows the same rules as for any distribution discussed above.

So here is a simple example: Adam and Eve are equal partners. Each contributes $300,000 to the partnership, and then a building is purchased for $500,000. Each of the partners’ capital accounts is at $300,000.

In 2013 the company incurs a loss of $50,000, which is allocated $25,000 to each partner. No money is distributed to the partners. The tax loss reduces each partner’s capital account to $275,000.

In 2014 the company has net income of $80,000, and each partner receives a distribution of $10,000 cash. Income of $40,000 is allocated to each partner, which the partners report on their individual tax returns. Each capital account is increased for the $40,000 of allocated income and decreased for the $10,000 distribution. The capital account balances are now at $305,000 ($275,000 + $40,000 – $10,000).

As you can see, even a simple example gets complicated. Capital accounts are very misunderstood, so keep those questions coming!

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To ensure compliance imposed by IRS Circular 230, any U.S. federal tax advice contained in this article is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed by governmental tax authorities. The answers in this column are meant to offer general information. You should consult your tax adviser regarding the specifics of your situation.

Peter Robbins is a partner in the Boise office of CliftonLarsonAllen, LLP specializing in tax matters for small businesses, individuals, and trusts and estates.

Have a question for Robbins? Email your question to news@idahobusinessreview.com. Enter “Talking Tax” in the subject line.

About Peter G. Robbins, CPA