Different K-1s for different folks.

• Author: Farber, Paul
• Position: Partnership taxation

In theory, the mechanics of taxing income from partnerships are simple. The partnership reports to each partner his distributive share of partnership ordinary income or loss and any other "item, which if separately taken into account by any partner would result in an income tax liability for that partner different from that which would result if that partner did not take the item into account separately." In practice, difficulty arises because the same item is taxed to different partners in different ways, depending on (1) the type of entity (individual, corporation, etc.) the partner is, (2) the partner's citizenship or residence (domestic or foreign) and (3) other factors.

For example, assume a partnership is engaged only in simple investment (i.e., nontrading) activities. Even in an era when most partners were domestic, ordinary expenses of that partnership represented Sec. 162 deductions to C corporation partners, but represented Sec. 212 deductions to partners who were individuals, estates, trusts or even S corporations (all of whose shareholders must be individuals, estates or certain trusts). Similarly, a partner's share of an investment partnership's worthless debt (not represented by a security) is an ordinary Sec. 166(a) deduction to a corporate partner (other than an S corporation), but a Sec. 166(d)(1)(B) short-term capital loss to an individual partner. The reporting complexities grow if the investment partnership's activities rise to the level of trader status.

Perhaps this situation does not cause too much practical difficulty in reporting to various types of domestic partners. However, there are an ever-increasing number of foreign partners in partnerships (either domestic or foreign) and Schedule K-1 of Form 1065, U.S. Partnership Return of Income, does not really accommodate their needs. If foreign partners are involved, a number of additional complications are created, including:

1. Dividend and interest income from foreign sources are not gross income to foreign partners.

2. Capital gains (even those realized from the sale in the U.S. of securities of U.S. issuers) are generally not gross income to foreign partners, by reason of Sec. 865(i).

3. Interest on deposits in U.S. banks is not taxable to foreign partners, by reason of Secs. 871(i) and 881(d).

4. A foreign partner's share of partnership expenses is simply not a deduction of any type, as it does not relate to income "effectively connected" with a U.S. trade or...