Tax benefits for partners in "trading" partnerships.
Generally, a partner who does not materially participate in a partnership's trade or business activity is considered to be passive with respect to the activity, thereby potentially limiting his ability to deduct losses from the activity. However, a partnership engaged in trading securities is not a passive activity for its partners, according to Temp. Regs. Sec. 1.469-1T(e)(6).
Further, the distributive share of income and deductions of a trading partnership is not treated as portfolio income and deductions as it would be for a partner in an investment partnership. Trader status is determined at the partnership level with the benefits of the trading activity passed out to the individual partners, even if they are limited partners and without regard to their participation in the activity.
The tax benefits for an individual partner of a trading partnership (in contrast to a partner in a passive or investment partnership) include:
* No passive loss limitations: Partners can fully deduct their share of the partnership's operating expenses (such as rent, salaries, office expenses and professional and management fees), without regard to the passive loss limitations.
* Above-the-line deduction of operating expenses: The distributive share of the partnership's operating deductions is deductible when computing adjusted gross income (AGI), rather than as a miscellaneous itemized deduction. Thus, partners in a trading partnership are not subject to the following limitations on operating deductions:
1. Miscellaneous itemized deductions are deductible only to the extent they exceed 2% of AGI; and
2. Certain itemized deductions are deductible only to the extent they exceed 3% of the excess of AGI over a threshold amount.
The above-the-line deduction also causes a reduction in AGI, which may permit a greater deduction for medical expenses, as well as miscellaneous and overall itemized deductions.
* Elimination of AMT issues: A partner in an investment partnership cannot deduct any of his share of the partnership's operating expenses against the alternative minimum tax (AMT) because the deductions are treated as miscellaneous itemized deductions, not deductible when computing the AMT. Since a partner in a trading partnership deducts these expenses as trade or business expenses when computing AGI, they are allowed in full against the AMT.
A partner in a trading partnership still retains the same tax treatment as a partner in an investment partnership with respect to capital gains and investment income. Capital gains are segregated between short and long term. These gains are reported separately to partners, allowing them to take advantage of the tax rate on net long-term capital gains (currently, 28%). The rule that limits the deduction of investment interest expense still applies to a partner who does not materially participate in the partnership's trading activities. However, under this rule, the income of a trading partnership is investment income (even though the income is reported as ordinary trade or business income on the taxpayer's Form 1040, Schedule E, rather than as dividend or interest income).
Nevertheless, the rules applicable to partners in a trading partnership have one potential disadvantage. The deduction by the partner of the trading partnership's operating expenses and allowable investment interest expense reduces his AGI. This reduction may limit the partner's ability to fully deduct charitable contributions. However, the contributions in excess of the deductible ceiling may be carried forward for a period of five years.
In addition to these Federal tax benefits, a partner in a trading partnership can also receive significant state tax benefits, unlike a partner in an investment partnership. Some states (such as Connecticut, Illinois, Massachusetts and New Jersey) compute income tax liability essentially on a gross income base; other states (such as California and New York) place their own limitations on Federal itemized deductions. (New York limits the deductibility of itemized deductions by as much as 50% of the Federal allowable amount.) Since a partner in a trading partnership deducts expenses (including the allowable investment interest expense) as a trade or business expense against AGI, the full benefit of these deductions is gained. This can be especially significant for partners in the growing number of trading partnerships that frequently employ the investment techniques of leveraging and hedging. It is not uncommon for these partnerships to generate substantial ordinary income and a corresponding investment interest expense deduction. The treatment of the allowable investment interest expense as a trade or business expense, rather than as an itemized deduction, creates a full deduction for these expenses in states that do not allow (or severely limit) itemized deductions.
It remains the function of the partnership to determine if it qualifies as a trading partnership or an investment partnership. Once the criteria of a trading partnership are met, individual partners stand to gain from the beneficial treatment of the partnership as generating neither passive nor portfolio items for income tax purposes.
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|Publication:||The Tax Adviser|
|Date:||Aug 1, 1996|
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