Question

What are the acceptable methods of accounting for partnership? Choose a well-known business that is organized as a partnership, and explain the benefits of that business operating as a partnership. What are the disadvantages or challenges that this business would encounter because it is organized as a partnership? Explain.?

Answer 1

Answer

Cash Method of Accounting – Under cash method, all items that are gross income, whether in form of cash, property / services, are included for the tax year in which actually / constructively received. Expenditures are deducted for the tax year in which actually made. Constructive receipt occurs in year in which taxpayer has unfettered access to income.

Amounts representing allowable deductions are, as a general rule, taken into account for tax year in which paid. However, expenditures that otherwise have to be capitalized because they create an asset having a useful life that extends substantially beyond close of tax year are not currently deductible. Capitalized amount would normally be depreciated or amortized over appropriate recovery period or term.

Accrual Method of Accounting – Under accrual method, income is generally included for tax year when all events have occurred that fix legal right to receive income and amount of income may be determined with reasonable accuracy. Similarly, an expense is incurred and is generally deductible in tax year in which all events have occurred that establish fact of liability, amount of liability may be determined with reasonable accuracy, & economic performance has occurred with respect to liability. There are exceptions to general rules of accrual.

A taxpayer may also adopt a hybrid method if it clearly reflects income and is consistently used.

Due to nature of cash method of accounting, taxpayers have a greater amount of control over timing of income recognition & deductibility of expenses than they do under accrual method of accounting, which is why Congress has gone out of its way to put limits on taxpayers’ ability to adopt the cash method of accounting.

Overall Limitations on Use of Cash Method

In general, accrual method is required whenever any taxpayer is required to maintain inventories. Also, accrual method may be mandated by IRS if it more accurately reflects income than doe’s cash method.

Limits on a Partnership’s Use of Cash Method of Accounting

In general, a partnership cannot elect cash method of accounting in following circumstances:

a) Partnership has at least one C corporation as a partner; /

b) Partnership is a “tax shelter.”

However, a partnership that has a C corporation as a partner

can nonetheless elect cash method if: (a) partnership is engaged in the farming business, (b) C corporation partners are “qualified personal services corporations”¹ or (c) partnership satisfies the 5 million average annual gross receipts test.²

These exceptions notwithstanding, every partnership that is a tax shelter must be on accrual method of accounting.

When is a Partnership a Tax Shelter?

A tax shelter for this purpose may fall under three categories: (a) an entity other than a C corporation, interests of which have, at any time, been offered for sale in any offering registered with any federal / state agency; (b) a “traditional” tax shelter / (c) a “syndicate”. It is the third type of tax shelter that will be focused upon inasmuch as, of three types of tax shelters, it is one that probably is most relevant to readers of this article.