2025 Houston Law Guide | Federal and Texas State Law Guidance

Tag: personal-finance

  • Partnership Fundamentals: What You Need to Know About Formation and Taxation

    What Exactly Is a Partnership for Tax Purposes?

    For federal tax purposes, “partnership” is defined broadly in § 761(a) as any syndicate, group, pool, joint venture, or other unincorporated organization through which a business or financial venture is carried on, provided it is not classified as a corporation, trust, or estate. Not all co-ownership arrangements qualify. For example, § 761(a)(1) and Treas. Reg. § 1.761-2(a)(2) exclude groups formed solely to hold investment property without conducting a trade or business. Likewise, co-owners of property who merely lease real estate without providing services are not treated as a partnership, but adding services can convert the arrangement into a partnership. See Treas. Reg. § 301.7701-1(a)(2).

    In other words, the IRS does not require you to file partnership papers for you to be treated as a partnership. If you and someone else are carrying on a business together—even informally—the IRS may classify you as a partnership. Simply co-owning property isn’t enough, but providing services alongside that ownership can be.

    Do You Need to File Anything Under State Law to Have a Partnership?

    Surprisingly, the answer is no. Treasury Regulation § 301.7701-1(a)(1) makes clear that a partnership may exist for federal tax purposes even without a formal entity recognized under state law. Courts look primarily to intent. In Commissioner v. Culbertson, 337 U.S. 733 (1949), the Supreme Court explained that a partnership exists when parties, in good faith and with a business purpose, intend to carry on an enterprise together and share in its profits. Contributions of labor or capital are not strictly required.

    Put simply, you don’t need to go through state filings for the IRS to treat you as a partnership. If two or more people intend to run a business and divide the profits, the law may recognize a partnership—even if no one invested money or contributed labor at the start.

    How Are Startup Costs Treated for Tax Purposes?

    When forming a partnership, certain expenses must be capitalized under § 709(a). Organizational expenses—those incident to creating the partnership and chargeable to the capital account—may be deducted up to $5,000 immediately, reduced once costs exceed $50,000, with a full phase-out at $55,000. See § 709(b). Any remaining expenses may be amortized over 180 months. Importantly, syndication fees (such as the cost of issuing partnership interests) do not qualify for this election and must be capitalized. If the partnership liquidates early, unamortized expenses may be deducted under § 165.

    In other words, some startup costs can be written off right away, but once your expenses get too high, the deduction shrinks and disappears. The balance must be spread out over 15 years. Certain fees—like those for raising capital—can never be deducted this way and must be added to the business’s long-term costs.

    How Does the IRS Decide Whether an Entity Is a Partnership or a Corporation?

    The “check-the-box” regulations in Treas. Reg. § 301.7701-3 give taxpayers flexibility. By default, unincorporated entities with more than one member are treated as partnerships, while single-member entities are disregarded as separate from their owners. Either type of entity may elect to be taxed as a corporation by filing the appropriate election. This system allows business owners to tailor tax treatment to their goals, though the choice carries long-term implications for taxation and liability.

    Put simply, if you form an LLC, the IRS has default settings: one owner means it’s ignored for tax purposes, two or more owners means it’s treated as a partnership. But you can “check the box” to be taxed as a corporation if that makes more sense for your goals. The choice is powerful but also sticky, so it should be made carefully.

    What Should I Think About When Choosing Between a Partnership and a Corporation?

    The decision between a flow-through entity and a corporation depends on multiple factors. Partnerships avoid entity-level tax and allow losses to flow through to partners. Corporations, by contrast, can defer shareholder-level tax but face double taxation on distributions. Other considerations include the availability of the § 199A deduction, exposure to employment taxes, local filing fees, creditor protection, and the ability to raise capital. No single factor controls; the optimal choice depends on the owners’ income profile and long-term strategy.

    In other words, partnerships usually mean simpler taxes because profits and losses go straight to the owners. Corporations can help with liability protection and raising money, but they come with extra layers of tax. The right choice depends on your income level, risk tolerance, and long-term plans.

    How Does the § 199A Deduction Work for Partnerships?

    Section 199A provides a deduction equal to the lesser of (1) 20% of qualified business income (QBI) or (2) 20% of taxable income reduced by net capital gains. See § 199A(a). QBI for each trade or business is further limited to the greater of (i) 50% of W-2 wages or (ii) 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of qualified property. § 199A(b)(2).

    The deduction is subject to income thresholds. For 2022, the phase-out begins at $170,050 for single filers and $340,100 for joint filers, fully phasing out at $220,050 and $440,100. § 199A(b)(3).

    Specified Service Trades or Businesses (SSTBs)—including law, accounting, consulting, financial services, athletics, and other fields where the principal asset is the reputation or skill of the owners—are further restricted. See § 199A(d)(2). For high-income taxpayers, SSTB income may be partially or entirely excluded from QBI.

    Finally, guaranteed payments under § 707(c) do not count as QBI. Nor do payments to partners acting in a non-partner capacity under § 707(a). In addition, Treas. Reg. § 1.199A-5(c)(2)(i) provides that if a trade or business provides property or services to an SSTB and both are commonly owned (50% or more), that portion of income is recharacterized as SSTB income.

    Put simply, § 199A is a valuable tax break that allows many business owners to deduct up to 20% of their income. But it comes with lots of caveats: income limits, restrictions for service professions like law and accounting, and rules against manipulating related businesses to qualify. Whether you get the deduction depends on your income level, industry, and how your partnership pays partners.s to partners acting in a non-partner capacity under § 707(a). In addition, Treas. Reg. § 1.199A-5(c)(2)(i) provides that if a trade or business provides property or services to an SSTB and both are commonly owned (50% or more), that portion of income is recharacterized as SSTB income.

  • I Received a 30-Day Letter from the IRS — Now What?

    Receiving a 30-day letter from the IRS can be unsettling. This notice, usually accompanied by a Revenue Agent’s Report, explains proposed changes to your tax return and calculates the additional tax the IRS believes you owe. For example, the report might show an underpayment of $20,000 based on adjustments to income or deductions. The “30-day” part refers to the short deadline you have to decide how to respond. Here are the main options.

    1. Agree and Pay

    If you review the report and conclude the IRS is correct, you can agree with the changes, sign the waiver included with the letter, and pay the amount due (plus interest). This ends the matter quickly and avoids further administrative or judicial proceedings.

    2. Pay and Preserve Your Rights

    Even if you disagree, you may choose to pay the tax first and then file a formal claim for refund. If the IRS denies the claim or fails to act within six months, you can bring a refund suit in a U.S. District Court (with the possibility of a jury trial) or in the U.S. Court of Federal Claims (bench trial only). This route requires upfront payment but preserves the ability to litigate.

    3. File a Protest and Go to Appeals

    If you do not want to pay right away, you can file a written protest within 30 days. This sends your case to the IRS Independent Office of Appeals, which is separate from the audit function. Appeals officers have authority to settle cases based on the “hazards of litigation,” meaning they evaluate the strengths and weaknesses of both sides. Many taxpayers resolve disputes here without having to go to court.

    4. Take No Action and Await a Notice of Deficiency

    If you ignore the 30-day letter, the IRS will eventually issue a Notice of Deficiency — sometimes called a “90-day letter.” That notice gives you 90 days to file a petition in the U.S. Tax Court. The Tax Court is unique because it allows you to litigate before paying the disputed tax. However, if you miss the 90-day deadline, you lose that option and must pay first before challenging the assessment.

    Making the Right Choice

    Which path is best depends on the size of the proposed adjustment, the strength of your legal position, and whether you can or want to pay the disputed tax upfront. Acting within the deadlines is critical. Ignoring the letter will not make the issue disappear — it only moves the case further down the IRS enforcement pipeline.

  • What Are Separately Stated Items in a Partnership Return?

    Why Aren’t All Partnership Items Reported Together?

    Partnerships file an annual information return, but unlike corporations, they are not subject to entity-level tax. Instead, income, deductions, credits, and other items flow through to the partners under IRC §702(a). However, not all items are treated the same for tax purposes. Some must be “separately stated” because their treatment depends on each partner’s individual tax circumstances.

    In other words, while ordinary business income can be reported as a lump sum, items like capital gains, charitable contributions, and foreign tax credits may have very different consequences depending on who the partner is. For that reason, the partnership must identify and pass these items through separately.

    What Counts as a Separately Stated Item?

    The Code and regulations identify a list of items that must be disclosed separately on a partner’s Schedule K-1, including:

    • Short-term and long-term capital gains and losses
    • Section 1231 gains and losses
    • Charitable contributions
    • Dividends (qualified or otherwise)
    • Foreign taxes paid or accrued
    • Tax-exempt interest
    • Other items identified in the regulations at Treas. Reg. §1.702-1(a)(8)(i)-(ii)

    Each of these can impact a partner’s tax liability in different ways, so they cannot simply be included in the “bottom line” partnership income.

    Example: Why Separate Reporting Matters

    Imagine a partnership with two equal partners. The partnership earns $100,000 of ordinary business income and also realizes a $20,000 long-term capital gain.

    • If everything were lumped together, each partner would be allocated $60,000 of “income.”
    • But that would obscure the fact that $10,000 of each partner’s allocation is a capital gain.

    For a partner in the 15% capital gains bracket, that $10,000 is taxed more favorably than ordinary income. For a partner with capital losses from other investments, that $10,000 might offset those losses. The Code requires that this item be separately stated so each partner can apply their own tax situation correctly.

    Example: Charitable Contributions

    Suppose the same partnership donates $10,000 to a qualified charity. The deduction must be reported separately because it is subject to each partner’s own §170 limitations (generally based on adjusted gross income). Partner A, with significant AGI, may deduct the full $5,000 share. Partner B, with limited AGI, may only deduct a portion this year and carry the rest forward. Without separate reporting, this individualized limitation would be impossible to apply.

    The Bottom Line

    Separately stated items under IRC §702(a) ensure that each partner’s distributive share reflects the real tax consequences applicable to them individually. While it adds complexity to partnership reporting, it is a necessary safeguard to make sure tax rules apply fairly and consistently.

  • What Tax Elections Can a Partnership Make?

    One of the defining features of partnerships is that the entity, not the individual partners, is responsible for making most tax elections. These elections can significantly affect how income, deductions, and credits are reported, so understanding who controls them is crucial. For example, if a partnership purchases equipment costing $100,000, it must decide whether to claim immediate expensing under §179 or depreciate the equipment over several years under MACRS. That election is made at the partnership level, and whichever method is chosen determines how each partner reports their share of income or loss. An individual partner cannot unilaterally decide to depreciate while others expense — the decision binds everyone.

    Example: Suppose the partnership has $200,000 of ordinary business income before depreciation, with two partners: A owns 50% and B owns 50%.

    • If the partnership elects §179 expensing, the entire $100,000 deduction is taken in Year 1. Taxable income is reduced to $100,000, and each partner is allocated $50,000 of income.
    • If the partnership uses MACRS 5-year straight-line depreciation, only $20,000 is deducted in Year 1. Taxable income is reduced to $180,000, and each partner is allocated $90,000 of income. The remaining $80,000 deduction is spread evenly across future years, continuing to reduce each partner’s share of income by $10,000 annually.

    This comparison shows how a single partnership-level election can dramatically affect the timing of income recognized by each partner, even though the total deduction over time is the same.

    Who Makes Tax Elections in a Partnership?

    Under IRC §703(b), the partnership as an entity makes all elections affecting the calculation of taxable income, except for a few elections reserved to the individual partners. This means decisions about depreciation methods, accounting conventions, and the treatment of organizational expenses are made collectively at the partnership level and bind all partners.

    In other words, if you are a partner, you cannot simply choose your own depreciation schedule or accounting method for partnership items. Those decisions are made once, for the entire partnership, and apply uniformly to every partner’s distributive share.

    Example: Depreciation Election in a Partnership

    The Setup

    • Partnership has $200,000 of ordinary income before depreciation in years 1 and 2.
    • It buys $100,000 of 5-year equipment.
    • Two partners: A owns 60%, B owns 40%.
    • Partner A would prefer §179 expensing (immediate deduction).
    • Partner B would prefer MACRS 5-year straight-line depreciation (~$20,000 per year).

    Scenario 1: Partnership Elects §179 Expensing

    • Year 1 Deduction: $100,000
    • Taxable income: $200,000 – $100,000 = $100,000

    Allocations:

    • Partner A (60%): $60,000 income
    • Partner B (40%): $40,000 income
    • Year 2 Deduction: $0 (no depreciation left)
    • Taxable income: $200,000 – $0 = $200,000

    Allocations:

    • Partner A (60%): $120,000 income
    • Partner B (40%): $80,000 income

    Scenario 2: Partnership Uses MACRS Depreciation

    • Year 1 Deduction: $20,000
    • Taxable income: $200,000 – $20,000 = $180,000

    Allocations:

    • Partner A (60%): $108,000 income
    • Partner B (40%): $72,000 income
    • Year 2 Deduction: $20,000
    • Taxable income: $200,000 – $20,000 = $180,000

    Allocations:

    • Partner A (60%): $108,000 income
    • Partner B (40%): $72,000 income

    Why Partners Cannot “Split” Elections
    If Partner A expensed and Partner B depreciated, Year 1 would look like this:

    • A’s share of income: $60,000 – (A’s “share” of $60,000 deduction) = $0
    • B’s share of income: $80,000 – (B’s “share” of $20,000 deduction) = $60,000

    By Year 2, A would have no deduction while B would still get $8,000 of depreciation. That kind of mismatch is exactly why IRC §703(b) requires the partnership to make one election for all partners.

    Are There Exceptions Where Partners Make Their Own Elections?

    Yes. While the partnership controls most elections, certain ones are made at the partner level. These include elections under:

    • §108(b)(5): Reduction of basis of depreciable property when income from cancellation of debt is excluded.
    • §108(c)(3): Elections relating to qualified real property business indebtedness.
    • §617: Deduction and recapture rules for mining exploration expenditures.
    • §901: The foreign tax credit.

    Each of these elections reflects an area where Congress determined that the consequences are highly personal to the individual taxpayer’s circumstances.

    Example: Suppose a partnership incurs foreign income taxes. The election to claim a foreign tax credit under §901 is made individually by each partner. One partner might claim the credit, while another might deduct the taxes instead, depending on which treatment yields the greater benefit given their overall tax situation.

    What Happens With Contributed Property?

    Special rules apply when a partner contributes property with built-in accounting attributes. Under IRC §168(i)(7), if a partner contributes depreciable property to the partnership, the partnership must continue to use the contributor’s method and recovery period for that property. This prevents a “reset” of depreciation schedules simply by shifting the asset into partnership form.

    Example: If a partner has a machine that has been depreciated for three years under MACRS and contributes it to the partnership, the partnership cannot restart depreciation as if it were newly acquired. Instead, it must continue using the same depreciation method and remaining recovery period the partner was already using.

    Why Does This Matter for Partners?

    Because elections can shape the timing and character of income, they influence not only when tax is paid but also how it interacts with other parts of the Code. Uniformity at the partnership level promotes consistency and prevents manipulation, but it also means individual partners must live with decisions they did not personally make.

    For new partners, this highlights the importance of due diligence before buying into a partnership. The entity may already have made elections that bind every partner going forward. For existing partnerships, these rules underscore the need for careful planning, because the wrong election could have ripple effects for years.