2025 Houston Law Guide | Federal and Texas State Law Guidance

Tag: tax-planning

  • 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.

  • Cash vs. Accrual for Partnerships: IRS Rules, Exceptions, and Tax Planning

    Choosing an accounting method determines when your partnership recognizes income and deductions. For many partnerships the cash method defers tax until money actually changes hands; the accrual method accelerates recognition when the right to receive or the obligation to pay arises. Federal law restricts who may use cash accounting. Under I.R.C. § 448(a)(2), a partnership cannot use the cash method if any partner is a C corporation, unless an exception applies. Two principal exceptions are (i) when the C-corporation partner is a personal service corporation (PSC) (§ 448(b)(2)), and (ii) when the partnership’s average annual gross receipts for the preceding three taxable years do not exceed $25 million (§ 448(b)(3)). In addition, a partnership may not use the cash method if it is a “tax shelter” as defined for these purposes in § 461 (§ 448(a)(3)).

    What the cash–accrual choice actually changes

    Under cash accounting, your partnership recognizes $1 of income only when it receives $1 of payment, and a deduction only when it pays the expense. Under accrual accounting, your partnership recognizes income when all events fix the right to receive it and the amount is determinable with reasonable accuracy, and it deducts expenses when all events have occurred that establish the liability and the amount can be determined with reasonable accuracy (subject to the economic performance rules). The difference is purely timing, but timing drives tax.

    Illustrative timing example

    • Facts. On December 28, Year 1, the partnership provides services and invoices $900,000 payable on January 15, Year 2. It also receives an invoice for $300,000 of deductible services performed in late December, which it pays on January 10, Year 2. Assume a 30% combined marginal rate for the partners.
    • Cash method (permitted only if eligible under § 448).
      Year 1 income recognized: $0 (no cash received)
      Year 1 deductions: $0 (no cash paid)
      Year 1 tax on these items: $0
      Year 2 recognizes $900,000 income and $300,000 deductions, for $600,000 net; tax at 30% = $180,000 in Year 2.
    • Accrual method.
      Year 1 income recognized: $900,000 (fixed right to payment)
      Year 1 deductions: $300,000 (fixed liability; economic performance satisfied)
      Year 1 net income: $600,000; tax at 30% = $180,000 in Year 1.

    Same amount of tax, different year. Cash accounting can be attractive when receivables are large at year-end; accrual can be preferable when you routinely incur significant unpaid expenses at year-end.

    The C-corporation partner limitation and the PSC exception

    If a partnership has any C-corp partner, § 448(a)(2) says the partnership cannot use the cash method—unless the C-corp is a PSC (§ 448(b)(2)). A PSC generally is a C corporation whose principal activity is the performance of personal services (for example, law, accounting, health) substantially performed by employee-owners. If your only corporate partner is a PSC, the bar in § 448(a)(2) does not apply, and you may still use cash accounting provided no other restriction applies (e.g., being a tax shelter).

    PSC exception example

    • Facts. P is a three-member partnership providing consulting services. Partners A and B are individuals. Partner C is a PSC. P’s three-year average gross receipts are $38 million.
    • Result. Despite exceeding $25 million, P may still use the cash method because its C-corp partner is a PSC under § 448(b)(2) (and assuming P is not a tax shelter under § 461). If Partner C were a regular C-corp, P would be pushed to accrual under § 448(a)(2).

    The small-partnership gross receipts exception

    Even with a non-PSC C-corp partner, a partnership can use cash accounting if it qualifies as a small partnership under § 448(b)(3)—i.e., its average annual gross receipts for the prior three taxable years do not exceed $25,000,000.

    Computing the three-year average: step-by-step

    • Facts. Gross receipts were: Year −3: $22,000,000; Year −2: $24,000,000; Year −1: $26,000,000.
    • Average. ($22m + $24m + $26m) / 3 = $24,000,000.
      Because $24m ≤ $25m, the partnership may use the cash method (§ 448(b)(3)), even if one partner is a non-PSC C-corp and the partnership is not a tax shelter.
    • If Year −1 had been $30,000,000:
      Average = ($22m + $24m + $30m)/3 = $25,333,333 → exceeds $25m → must use accrual (unless the PSC exception applies).

    “Cliff” year illustration with tax impact

    • Facts. In Year 1 your three-year average first exceeds $25m, forcing a switch to accrual for Year 1. On January 1 you have $8,000,000 of accounts receivable and $3,000,000 of accounts payable carried over from Year 0 under cash accounting.
    • Method change mechanics. A change in accounting method generally requires IRS consent and a § 481(a) adjustment to bring previously unrecognized items into income (or expense). Here, the positive § 481(a) adjustment is typically the net of receivables minus payables not previously recognized under cash: $8m − $3m = $5,000,000 added to income. If taken into account over four years (common for positive adjustments), the partnership picks up $1,250,000 per year, increasing partner-level tax accordingly.
    • Tax effect (30% combined rate): Additional $375,000 tax per year for four years. Planning ahead to manage receivables and payables before the switch can materially soften the blow.

    The “tax shelter” prohibition

    Even if the PSC and gross receipts exceptions would otherwise allow cash accounting, a partnership cannot use the cash method if it is a tax shelter (§ 448(a)(3)). For these purposes “tax shelter” is determined under § 461. While most operating partnerships will not be tax shelters, arrangements promoted to generate tax benefits without corresponding economic substance can fall within the definition. If a partnership is a tax shelter, it must use accrual—no small-partnership or PSC relief.

    Tax shelter screen example

    • Facts. Partnership Q has average receipts of $9 million and no corporate partner. It markets interests to outside investors primarily for projected tax losses.
    • Result. If Q is a tax shelter within the meaning of § 461, § 448(a)(3) disqualifies it from the cash method despite being under $25m and lacking a C-corp partner. Q must adopt accrual.

    Strategic considerations when you can choose

    Where cash accounting is permitted, partnerships with long receivable cycles often benefit from deferral. Conversely, capital-intensive businesses with significant year-end payables (or cost accruals) may find accrual advantageous. Your choice can also interact with other provisions (for example, inventories and cost capitalization rules) and with how income is allocated among partners.

    Side-by-side tax deferral math

    • Facts. Year 1 billings of $5,000,000 are invoiced in late December and collected in January; deductible Year 1 services of $1,500,000 are invoiced in December and paid in January. Assume no other differences and a 30% combined marginal rate.
    • Cash method (eligible partnership):
      Year 1 recognizes $0 of the late-December billings and $0 of the unpaid expenses → $0 current-year tax on those items.
      Year 2 recognizes $5,000,000 − 1,500,000 = $3,500,000 net → $1,050,000 tax.
    • Accrual method:
      Year 1 recognizes $5,000,000 − 1,500,000 = $3,500,000 net → $1,050,000 tax.
      Deferral from cash method: $1,050,000 moved from Year 1 to Year 2. The total tax is the same; the time value of deferral is the advantage.

    Common transition pitfalls and how to avoid them

    1. Crossing the $25m threshold unknowingly. The three-year average can creep up quickly. Model your receipts quarterly so you are not surprised by a forced switch under § 448(b)(3).
    2. Ignoring aggregation/affiliation effects. Related-party gross receipts may be aggregated for the test under the statute and regulations; organizational changes can move you over the threshold.
    3. Missing the consent process. Changing methods generally requires a Form 3115 filing and a properly computed § 481(a) adjustment. Skipping this can lead to audit exposure and duplicate income.
    4. Assuming the PSC exception applies. Verify that a corporate partner meets the PSC definition; otherwise, the presence of a regular C-corp forces accrual (§ 448(a)(2)).
    5. Overlooking the tax-shelter rule. If the structure could be characterized as a tax shelter under § 461, cash accounting is off the table (§ 448(a)(3)) regardless of receipts.

    Quick reference to governing provisions

    • Cash method limitations for partnerships with C-corp partner: I.R.C. § 448(a)(2)
    • PSC exception: § 448(b)(2)
    • Small-partnership gross receipts exception (three-year average ≤ $25m): § 448(b)(3)
    • Tax shelter prohibition (by reference to § 461): § 448(a)(3)
    • Tax shelter definition context: § 461
    • Method change conformity (general adjustment rule): § 481(a) (for transitions)