The income taxation of partnerships and their partner is based on, but not identical to, United States federal taxation rules of partnerships. Thus, partnerships are flow-through vehicles that are not subject to income: instead the partners are responsible for the income taxes on their distributable share of the partnership’s items of income, even though the income is not distributed. A partner must compute the taxable income including his/her distributable share of partnership’s tax items for the year of the partnership ending within or with taxable year of the partner.
What is a Partnership?
A partnership is a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not a trust or estate or a corporation. In general partnerships include civil, commercial, industrial and professional partnerships as well as two or more persons engaged in a joint venture for profit. Limited liability companies may elect to be classified as partnerships, while under certain circumstances LLCs are mandated to file taxes as partnerships.
Partnership’s Taxable Income
A partnership computes its gross income and deductions, to arrive at taxable income, in the same manner an individual would, with certain exceptions. One exception is that partnerships are not allowed a deduction for carryover net operating losses. Generally, elections affecting the partnership's net income must be made by the partnership.
The use of a partnership’s losses is limited by the partner’s basis in the partnership equity interest and can only be used against the distributable share of other partnerships’ income or the prorate share of corporations of individuals’ income.
Partners must determine their tax liabilities taking into account certain items separately, among them:
- Short and long term capital gains and losses
- Charitable deductions
- Dividends subject to the 15% withholding tax
- Income covered by industrial/development tax grants or tourism concessions
- Net income or loss of the partnership
If the partnership is engaged in a PR trade or business the partners will be deemed engaged in such trade or business with respect to their distributable share of tax items. Accordingly, non-resident partners will be deemed in a trade or business in Puerto Rico in regards to such distributable share of income and will have to file Puerto Rico income tax returns. Furthermore, foreign corporate partners may be subject to the branch profit tax.
The distributable share in the partnership's income, gains, losses and other tax items shall be determined by the partnership agreement unless otherwise provided in the Puerto Rico Internal Revenue Code of 2011. Such distributable share shall be determined according to the partners’ interest in the partnership if the agreement does not provide for distributable shares or if the allocation does not have a substantial economic effect. The character of the income, losses and other tax items included in the partner’s distributable share shall be determined as if such items were realized directly from the source realized by the partnerships (example: sourcing of income).
The managing partner must withhold at the source 30% of the distributable share in the net income of the partnership, less the 7% withholding tax on payment for services rendered in Puerto Rico and the 7% withholding tax for payments made under judicial or extra-judicial claims.
The partners and the partnership do not recognize gain or loss upon the contribution of money or property to the partnership, except in the case of:
- Flexibly depreciated property if an election to recognize gain or losses is made
- Property subject to obligations or liens that are assumed by the partnership to the extent that such assumed obligations or liens exceed the partner’s basis in the contributed property
- The gain realized on the transfer of property to partnership that would be treated as an investment company
Partners do not recognize gain on distributions made by the partnerships to the extent that the cash distributed does not exceed his/her basis in the partnership interest (outside basis) before the distribution. However, special gains recognition rules apply in the case of property previously contributed by a partner and distributed within 7 years if certain conditions are met.
No loss is recognized by partners except in liquidating distributions provided that the amount of the cash distributed and the basis in unrealized receivables and inventory distributed exceed the adjusted basis of the partner in his/her partnership interest (outside basis).
Note that gains and losses recognized in distributions have capital assets character.