My Partnership Can Be On The Cash Method….Right?
This certainly sounds like a fairly simple, straightforward question. But, unfortunately, like most tax questions nowadays, the answer is not as simple as you would think.
The Cash Method of Accounting – Under the cash method, all items that are gross income, whether in the form of cash, property or services, are included for the tax year in which actually or constructively received. Expenditures are deducted for the tax year in which actually made. Constructive receipt occurs in the year in which the taxpayer has unfettered access to income. For example, if an employer has a year-end bonus check prepared and ready to be mailed in year 1 to a cash-basis employee, the employee cannot “turn her back” on the income by telling the employer to “put the check in the desk drawer” until January of year 2. In such a case, the employee would have constructive receipt of the income and would have to report the bonus as income in year 1.
Under the cash method, amounts representing allowable deductions are, as a general rule, taken into account for the 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 the close of the tax year are not currently deductible. The capitalized amount would normally be depreciated or amortized over the appropriate recovery period or term.
The Accrual Method of Accounting – Under the accrual method, income is generally included for the tax year when all the events have occurred that fix the legal right to receive the income and the amount of income can be determined with reasonable accuracy. Similarly, an expense is incurred and is generally deductible in the tax year in which all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability. There are exceptions to the general rules of accrual (e.g., certain advance payments may be deferred by an accrual-method taxpayer; certain types of expenses, such as the payment of taxes and tort liabilities, are not deductible until paid; and the deduction for an expense owing to a related cash-basis person (as defined in the Internal Revenue Code) is not deductible until such time as the related person reports the income).
A taxpayer can also adopt a hybrid method (a combination of the accrual and cash methods) if it clearly reflects income and is consistently used.
Due to the nature of the cash method of accounting, taxpayers have a greater amount of control over the timing of income recognition and the deductibility of expenses than they do under the 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, the accrual method is required whenever any taxpayer is required to maintain inventories. Also, the accrual method can be mandated by the IRS if it more accurately reflects income than does the cash method.
However, these special rules notwithstanding, “small” taxpayers can still use the cash method (i.e., (i) any taxpayer that satisfies a $1 million average gross receipts test, and (ii) any other taxpayer (other than a C corporation, a partnership with a C corporation as a partner, or a “tax shelter” (as defined below)) that satisfies a $10 million average gross receipts test).
Limits on a Partnership’s Use of the Cash Method of Accounting
In general, a partnership cannot elect the cash method of accounting in the following circumstances:
- The partnership has at least one C corporation as a partner; or
- The partnership is a “tax shelter.”
However, a partnership (other than a tax shelter) that has a C corporation as a partner
can nonetheless elect the cash method if: (i) the partnership is engaged in the farming business, (ii) the C corporation partners are “qualified personal services corporations”1 or (iii) the partnership satisfies the $5 million average annual gross receipts test.2
These exceptions notwithstanding, every partnership that is a tax shelter must be on the accrual method of accounting.
When is a Partnership a Tax Shelter?
A tax shelter for this purpose can fall under three categories: (i) an entity other than a C corporation, the interests of which have, at any time, been offered for sale in any offering registered with any federal or state agency; (ii) a “traditional” tax shelter (any entity or any plan or arrangement a significant purpose of which is the avoidance or evasion of federal income tax); or (iii) a “syndicate”. It is the third type of tax shelter that will be focused upon inasmuch as, of the three types of tax shelters, it is the one that probably is most relevant to the readers of this article.
The term “syndicate” is defined as a partnership or other entity (other than a C corporation) if more than 35% of the entity’s losses during the tax year are allocated to limited partners or “limited entrepreneurs.” For this purpose, a “limited entrepreneur” is a person who has an interest in the enterprise (other than as a limited partner) and who does not actively participate in the enterprise’s management. In the case of a business (other than farming), holdings attributable to active management include those held by (1) an individual who actively participates at all times during the period in the entity’s management, (2) family members of those actively participating in management, (3) an individual who actively participated in the management for a period of not less than five years, or (4) the estate of an individual who actively participated.
In determining whether an entity has “losses”, gains from the sale of capital and business assets are excluded.
It would appear that this rule would not apply until such time as the entity generates losses. Thus, an entity that has always been profitable will not be considered to be a syndicate.
Based on the above, a limited partnership that normally generates taxable losses more than 35% of the taxable losses of which are allocable to limited partners (e.g., a typical real estate limited partnership) must be on the accrual method.
With the proliferation of limited liability companies (“LLCs”) over the last two decades, the limited entrepreneur rule has taken on much more importance since there are no “limited partners” in an LLC. The question of whether a limited entrepreneur actively participates in the enterprise’s management is based on the facts and circumstances of the situation. It is generally believed that, in the absence of statutory or regulatory guidance, the managing member(s) of an LLC would generally be participating in the management of the LLC and would therefore not be limited entrepreneurs. Non-managing members normally would not be actively engaged in the management of the LLC and would presumably be treated as limited entrepreneurs for the purpose of applying this test.
In conclusion, the question of whether a partnership or LLC can be on the cash method is not a simple one and is a common trap for the unwary. Your Gettry Marcus executive is prepared to assist you make your way through this morass of rules.
1A qualified personal services corporation is a corporation (i) substantially all of the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; and (ii) substantially all of the stock (by value) is held directly, or indirectly through partnerships, S corporations or other qualified personal services corporations, by employees, retired employees, their estates or beneficiaries of their estates (but only for the 2-year period following the death of such individual).
2A partnership satisfies the $5 million average gross receipts test if the average annual gross receipts of the partnership (including certain related entities) for the immediately prior 3-taxable-year period does not exceed $5 million. If the partnership has been in existence for less than three years, the test is applied for the period during which it has been in existence. The gross receipts for any tax year of less than 12 months must be annualized for purposes of the test.